**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,DC  20549**

 

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**FORM 10-Q**

 

**(Mark one)**

 
| ý     | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                                                                                                                                      |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                                                                                         |
| ** ** | ** ** | **For the quarterly period ended April 2,  2005**                                                                                                                                                                                                                                                       |
|       |       |                                                                                                                                                                                                                                                                                                         |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                                                                                                                                     |
|       |       |                                                                                                                                                                                                                                                                                                         |
| ** ** | ** ** | **For the transition period from                      to                      ** |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                   |
| ** ** | ** ** | **Commission file number:    0-23633**                                                                                                                                                                                                                                                        |
|            |            |                                                                                                                                                                                                                                                                                                              |  |  |  |  |

 

**1-800 CONTACTS, INC.**

(Exact name ofregistrant as specified in its charter)

 
| **Delaware**                                                     | ** ** | **87-0571643**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **66 E.  Wadsworth Park Drive,  Draper, UT**                     | ** ** | **84020**                             |
| (Address of  principal executive offices)                        |       | (Zip Code)                            |
|                                                             |       |                                  |
| **(801)  924-9800**                                              |
| (Registrant’s  telephone number, including area code)       |

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports) and (2) has beensubject to such filing requirements for the past 90 days.

 

| ý  Yes |   | o  No |
|-----------------------|--------|-----------------|

 

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange act).

 

| ý  Yes |   | o  No |
|-----------------------|--------|-----------------|

 

As of May 4, 2005, the Registrant had 13,306,958shares of Common Stock, par value $0.01 per share, outstanding.

 

 

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**1-800CONTACTS, INC.**

 

**INDEX**

 

 
| **PART I.**                     | **FINANCIAL  INFORMATION** |                                                                                                               |
|--------------------------------------|----------------------------|--------------------------------------------------------------------------------------------------------------------|
| Item 1.                              | Financial Statements       |                                                                                                               |
|                                 |                       | Condensed  Consolidated Balance Sheets as of January 1, 2005 and April 2, 2005                           |   |
|                                 |                       | Condensed  Consolidated Statements of Operations for the Quarters Ended April 3,  2004 and April 2, 2005 |   |
|                                 |                       | Condensed  Consolidated Statements of Cash Flows for the Quarters Ended April 3,  2004 and April 2, 2005 |   |
|                                 |                       | Notes  to Condensed Consolidated Financial Statements                                                              |   |
| Item  2.                             |                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                        |   |
| Item  3.                             |                       | Quantitative  and Qualitative Disclosures About Market Risk                                                        |   |
| Item 4.                              |                       | Controls and Procedures                                                                                            |   |
|                                 |                       |                                                                                                               |   |
| **PART II. OTHER  INFORMATION** |                       |
| Item 1.                              |                       | Legal Proceedings                                                                                                  |   |
| Item  2.                             |                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                       |   |
| Item 3.                              |                       | Defaults upon  Senior Securities                                                                                   |   |
| Item  4.                             |                       | Submission  of Matters to a Vote of Security Holders                                                               |   |
| Item 5.                              |                       | Other Information                                                                                                  |   |
| Item 6.                              |                       | Exhibits                                                                                                           |   |
|                                      |                            |                                                                                                                    |  |  |  |

 

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**PART 1.****  FINANCIAL INFORMATION**

**Item 1.****  FinancialStatements**

 

**1-800CONTACTS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                            | ** ** | **January 1,  2005** | ** ** | **April 2,  2005** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| **ASSETS**                                                            |       |                      |       |                    |       |
| CURRENT  ASSETS:                                                      |       |                      |       |                    |       |
| Cash                                                                  |       | $                         | 3,105      |                    | $          | 1,120 |   |
| Accounts  receivable, net                                             |       | 3,178                     |       | 3,616                   |       |
| Other  receivables                                                    |       | 2,398                     |       | 1,951                   |       |
| Inventories,  net                                                     |       | 22,206                    |       | 21,655                  |       |
| Deferred  income taxes                                                |       | 1,328                     |       | 1,564                   |       |
| Other  current assets                                                 |       | 1,546                     |       | 1,443                   |       |
| Total  current assets                                                 |       | 33,761                    |       | 31,349                  |       |
| PROPERTY  AND EQUIPMENT, net                                          |       | 20,618                    |       | 20,438                  |       |
| DEFERRED  INCOME TAXES                                                |       | 720                       |       | 691                     |       |
| GOODWILL                                                              |       | 34,320                    |       | 34,219                  |       |
| DEFINITE-LIVED  INTANGIBLES, net                                      |       | 17,897                    |       | 16,679                  |       |
| OTHER  ASSETS                                                         |       | 1,669                     |       | 2,168                   |       |
| Total  assets                                                         |       | $                         | 108,985    |                    | $          | 105,544 |   |
|                                                                  |       |                      |       |                    |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                        |       |                      |       |                    |       |
| CURRENT  LIABILITIES:                                                 |       |                      |       |                    |       |
| Current  portion of long-term debt                                    |       | 1,632                     |       | 1,625                   |       |
| Current  portion of capital lease obligations                         |       | 47                        |       | 46                      |       |
| Income  taxes payable                                                 |       | 1,560                     |       | 2,723                   |       |
| Accounts  payable                                                     |       | 9,762                     |       | 11,639                  |       |
| Accrued  liabilities                                                  |       | 7,303                     |       | 8,705                   |       |
| Unearned  revenue                                                     |       | 3,500                     |       | 4,073                   |       |
| Total  current liabilities                                            |       | 23,804                    |       | 28,811                  |       |
| LONG-TERM LIABILITIES:                                                |       |                      |       |                    |       |
| Line  of credit                                                       |       | 14,404                    |       | 8,416                   |       |
| Long-term  debt, net of current portion                               |       | 8,170                     |       | 7,707                   |       |
| Capital  lease obligations, net of current portion                    |       | 98                        |       | 84                      |       |
| Deferred  income tax liabilities                                      |       | 1,458                     |       | 1,007                   |       |
| Unearned  revenue, net of current portion                             |       | 1,667                     |       | —                  |       |
| Other  long-term liabilities                                          |       | 880                       |       | 838                     |       |
| Total  long-term liabilities                                          |       | 26,677                    |       | 18,052                  |       |
| STOCKHOLDERS’  EQUITY:                                           |       |                      |       |                    |       |
| Common  stock, 13,299 and 13,307 issued and outstanding, respectively |       | 133                       |       | 133                     |       |
| Additional  paid-in capital                                           |       | 46,061                    |       | 46,620                  |       |
| Deferred  compensation on restricted stock grants                     |       | (103                      | )          | (551                    | )          |
| Retained  earnings                                                    |       | 12,218                    |       | 12,401                  |       |
| Accumulated  other comprehensive income                               |       | 195                       |       | 78                      |       |
| Total  stockholders’ equity                                      |       | 58,504                    |       | 58,681                  |       |
| Total  liabilities and stockholders’ equity                      |       | $                         | 108,985    |                    | $          | 105,544 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

3

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**1-800CONTACTS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                            | ** ** | **Quarter Ended**       | ** ** |
|-------------------------------------------------------|------------|-------------------------|------------|
| ** **                                            | ** ** | **April 3,  2004** | ** ** | **April 2,  2005** | ** ** |
| NET  SALES                                            |       | $                       | 50,849     |   | $ | 60,283 |   |
| COST  OF GOODS SOLD                                   |       | 31,553                  |       | 37,775 |   |
| Gross  profit                                         |       | 19,296                  |       | 22,508 |   |
| OPERATING  EXPENSES:                                  |       |                    |       |   |   |
| Advertising                                           |       | 8,815                   |       | 6,538 |   |
| Legal  and professional                               |       | 1,840                   |       | 1,284 |   |
| Research  and development                             |       | 892                     |       | 1,055 |   |
| Purchased  in-process research and development        |       | 83                      |       | — |   |
| Other  operating                                      |       | 9,882                   |       | 11,517 |   |
| Total  operating expenses                             |       | 21,512                  |       | 20,394 |   |
| INCOME  (LOSS) FROM OPERATIONS                        |       | (2,216                  | )          | 2,114 |   |
| OTHER  EXPENSE, net                                   |       | (356                    | )          | (641 | ) |
| INCOME  (LOSS) BEFORE BENEFIT (PROVISION)             |       |                    |       |   |   |
| FOR  INCOME TAXES                                     |       | (2,572                  | )          | 1,473 |   |
| BENEFIT  (PROVISION) FOR INCOME TAXES                 |       | 366                     |       | (1,290 | ) |
| NET  INCOME (LOSS)                                    |       | $                       | (2,206     | ) | $ | 183 |   |
|                                                  |       |                    |       |   |   |
| PER  SHARE INFORMATION:                               |       |                    |       |   |   |
| Basic  and diluted net income (loss) per common share |       | $                       | (0.17      | ) | $ | 0.01 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

4

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**1-800CONTACTS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                           | ** ** | **Quarter Ended**       | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                           | ** ** | **April 3,  2004** | ** ** | **April 2,  2005** | ** ** |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                               |       |                    |       |   |   |
| Net  income (loss)                                                                                   |       | $                       | (2,206     | ) | $ | 183 |   |
| Adjustments  to reconcile net income (loss) to net cash (used in) provided by operating  activities: |       |                    |       |   |   |
| Depreciation  and amortization                                                                       |       | 1,676                   |       | 2,126 |   |
| Amortization  of debt issuance costs and discounts                                                   |       | 147                     |       | 48 |   |
| Foreign  currency exchange (gain) loss                                                               |       | (77                     | )          | 312 |   |
| Stock-based  compensation                                                                            |       | —                  |       | 5 |   |
| Purchased  in-process research and development                                                       |       | 83                      |       | — |   |
| Loss  on sale of property and equipment                                                              |       | 73                      |       | 107 |   |
| Deferred  income taxes, net of effects of acquisition                                                |       | (366                    | )          | (626 | ) |
| Changes  in operating assets and liabilities, net of effects of acquisition:                         |       |                    |       |   |   |
| Accounts  receivable, net                                                                            |       | (190                    | )          | (321 | ) |
| Inventories,  net                                                                                    |       | (2,051                  | )          | 489 |   |
| Other  receivables                                                                                   |       | (566                    | )          | 447 |   |
| Other  current assets                                                                                |       | (265                    | )          | 72 |   |
| Income  taxes payable                                                                                |       | —                  |       | 1,190 |   |
| Accounts  payable                                                                                    |       | 318                     |       | 1,938 |   |
| Accrued  liabilities                                                                                 |       | 1,627                   |       | 1,276 |   |
| Unearned  revenue                                                                                    |       | —                  |       | (1,070 | ) |
| Net  cash (used in) provided by operating activities                                                 |       | (1,797                  | )          | 6,176 |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                               |       |                    |       |   |   |
| Purchase  of property and equipment                                                                  |       | (1,381                  | )          | (1,282 | ) |
| Proceeds  from sale of property and equipment                                                        |       | —                  |       | 27 |   |
| Purchase  of definite-lived intangible assets                                                        |       | (692                    | )          | — |   |
| Cash  paid for acquisition of VisionTec                                                              |       | (3,776                  | )          | — |   |
| Deposits  and other                                                                                  |       | 109                     |       | (598 | ) |
| Net  cash used in investing activities                                                               |       | $                       | (5,740     | ) | $ | (1,853 | ) |

 

5

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| ** **                                           | ** ** | **Quarter Ended**       | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **April 3,  2004** | ** ** | **April 2,  2005** | ** ** |
| CASH  FLOWS FROM FINANCING ACTIVITIES:               |       |                    |       |   |   |
| Proceeds  from exercise of common stock options      |       | $                       | 123        |   | $ | 78 |   |
| Net  borrowings (repayments) on line of credit       |       | 15,555                  |       | (5,988 | ) |
| Principal  payments on capital lease obligations     |       | (82                     | )          | (13 | ) |
| Debt  issuance costs                                 |       | (179                    | )          | — |   |
| Principal  payments on long-term debt                |       | (7,983                  | )          | (421 | ) |
| Net  cash provided by (used in) financing activities |       | 7,434                   |       | (6,344 | ) |
| EFFECT  OF FOREIGN EXCHANGE RATES ON CASH            |       | (15                     | )          | 36 |   |
|                                                 |       |                    |       |   |   |
| NET  DECREASE IN CASH                                |       | (118                    | )          | (1,985 | ) |
| CASH  AT BEGINNING OF PERIOD                         |       | 1,075                   |       | 3,105 |   |
| CASH  AT END OF PERIOD                               |       | $                       | 957        |   | $ | 1,120 |   |
|                                                 |       |                    |       |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                 |       |                    |       |   |   |
| Cash  paid for interest                              |       | $                       | 264        |   | $ | 262 |   |
| Cash  paid for income taxes                          |       | —                  |       | 725 |   |

 

SUPPLEMENTALDISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:

 

During the first quarterof 2004, the Company purchased the stock of VisionTec (subsequently renamedClearLab UK, Ltd.).

The purchaseconsideration included cash of $3,776 and common stock with a fair value of$3,200.

 

See accompanyingnotes to condensed consolidated financial statements.

 

6

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**1-800 CONTACTS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

# **NOTE 1.**  PRESENTATION OF CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS

# ** **

The accompanyingcondensed consolidated financial statements have been prepared by the Company,without audit, pursuant to the rules and regulations of the Securities andExchange Commission.  Certain informationand disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules andregulations.  These condensedconsolidated financial statements reflect all adjustments (consisting only ofnormal recurring adjustments), which in the opinion of management, arenecessary to present fairly the results of operations of the Company for theperiods presented.  It is suggested thatthese condensed consolidated financial statements be read in conjunction withthe audited financial statements and the notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended January 1, 2005.

 

# **NOTE 2.**  INVENTORIES

# ** **

Inventories are recorded at the lower of cost (usingthe first-in, first-out method) or market value.  Elements of cost in the Company’smanufactured inventories generally include raw materials, direct labor, manufacturingoverhead and freight-in.   Inventoriesconsisted of the following (in thousands):

 

| ** **                    | ** ** | **January 1,  2005** | ** ** | **April 2,  2005** | ** ** |
|-------------------------------|------------|---------------------------|------------|-------------------------|------------|
| Purchased  contact lenses     |       | $                         | 16,216     |                    | $          | 15,988 |   |
| Manufactured  contact lenses: |       |                      |       |                    |       |
| Raw  materials                |       | 930                       |       | 1,021                   |       |
| Work  in process              |       | 1,796                     |       | 1,816                   |       |
| Finished  goods               |       | 3,264                     |       | 2,830                   |       |
| Total                         |       | $                         | 22,206     |                    | $          | 21,655 |   |
|                               |            |                           |            |                         |            |  |  |  |  |

 

Provision is made to reduce excess and obsoleteinventories to their estimated net realizable values.  As of January 1, 2005 and April 2,2005, reserves for excess and obsolete inventories were approximately $1.2million.

 

**NOTE 3.****  NET INCOME (LOSS) PER COMMONSHARE**

 

Basic net income (loss)per common share (“Basic EPS”) excludes dilution and is computed by dividingnet income (loss) by the weighted-average number of common shares outstandingduring the period.  Diluted net income(loss) per common share (“Diluted EPS”) reflects the potential dilution thatcould occur if stock options, restricted stock awards or other common stockequivalents were exercised or converted into common stock.  The computation of Diluted EPS does notassume exercise or conversion of securities that would have an antidilutiveeffect on net income (loss) per common share. For the quarters ended April 3,2004 and April 2, 2005, options to purchase 1,400,481 and 830,124 sharesof common stock, respectively, were not included in the computation of DilutedEPS because the effect would be antidilutive.

 

7

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The following is areconciliation of the numerator and denominator used to calculate Basic andDiluted EPS (in thousands, except per share amounts): 

 
| ** **             | ** ** | **Quarter Ended April 3, 2004** | ** ** | **Quarter Ended April 2, 2005** | ** ** |
|------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| ** **             | ** ** | **Net Loss**                         | ** ** | **Weighted  Average  Shares**        | ** ** | **Per-Share  Amount** | ** ** | **Net Income** | ** ** | **Weighted  Average  Shares** | ** ** | **Per-Share  Amount** | ** ** |
|                   |       |                                 |       |                                 |       |   |   |   |   |   |   |   |   |
| Basic EPS              |       | $                                    | (2,206     | )                                    | 13,188     |   | $ | (0.17 | ) | $ | 183 |   | 13,302 |   | $ | 0.01 |   |
| Effect of stock awards |       | —                               |       | —                               |       |   |   | — |   | 191 |   |   |   |
| Diluted EPS            |       | $                                    | (2,206     | )                                    | 13,188     |   | $ | (0.17 | ) | $ | 183 |   | 13,493 |   | 0.01 |   |
|                        |            |                                      |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 4.****  COMPREHENSIVE INCOME (LOSS)**

 

Comprehensive income(loss) for the quarters ended April 3, 2004 and April 2, 2005consists of the following components (in thousands):

 
| ** **                         | ** ** | **Quarter Ended**      | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **April 3, 2004** | ** ** | **April 2, 2005** | ** ** |
| Net  income (loss)                 |       | $                      | (2,206     | ) | $ | 183 |   |
| Foreign  currency translation loss |       | (22                    | )          | (117 | ) |
| Comprehensive  income (loss)       |       | $                      | (2,228     | ) | $ | 66 |   |

 

The foreign currencytranslation loss results primarily from changes in exchange rates relative tothe U.S. dollar from the translation of the Company’s Singapore and UnitedKingdom subsidiaries’ financial statements.

 

**NOTE 5.****  STOCK-BASED COMPENSATION**

 

The Company appliesAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees,” and related interpretations and uses the intrinsic method ofaccounting for its stock option grants to employees and directors.  No compensation expense has been recognizedfor stock option awards granted at or above fair market value of the stock onthe date of grant.

 

Financial AccountingStandards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” andSFAS No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure,” established accounting and disclosure requirements using afair-value based method of accounting for stock-based employee compensationplans. As permitted by existing accounting standards, the Company has electedto continue to apply the intrinsic-value-based method of accounting describedabove, and has adopted only the disclosure requirements of SFAS No. 123.

 

If compensation expensefor all stock options had been determined consistent with SFAS No. 123,the Company’s net income (loss) and basic and diluted net income (loss) percommon share would have been as follows (in thousands, except per shareamounts):

 

8

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| ** **                                             | ** ** | **Quarter Ended**      | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **April 3, 2004** | ** ** | **April 2, 2005** | ** ** |
| Net  income (loss):                                    |       |                   |       |   |   |
| As  reported                                           |       | $                      | (2,206     | ) | $ | 183 |   |
| Fair-value  based compensation, net of tax             |       | (416                   | )          | (309 | ) |
| Pro  forma                                             |       | $                      | (2,622     | ) | $ | (126 | ) |
|                                                   |       |                   |       |   |   |
| Basic  and diluted net income (loss) per common share: |       |                   |       |   |   |
| As  reported                                           |       | $                      | (0.17      | ) | $ | 0.01 |   |
| Pro  forma                                             |       | $                      | (0.20      | ) | $ | (0.01 | ) |
|                                                        |            |                        |            |  |  |  |  |  |  |

 

The weighted average pershare fair value of options granted during the quarters ended April 3,2004 and April 2, 2005 was $12.59 and $11.30, respectively.  The fair value of each option grant has beenestimated on the grant date using the Black-Scholes option-pricing model withthe following weighted average assumptions:

 
| ** **               | ** ** | **Quarter Ended**       | ** ** |
|--------------------------|------------|-------------------------|------------|
| ** **               | ** ** | **April 3,  2004** | ** ** | **April 2,  2005** | ** ** |
| Risk-free  interest rate |       | 3.0                     | %          | 3.73 | % |
| Expected  dividend yield |       | 0.0                     | %          | 0.0 | % |
| Volatility               |       | 68.0                    | %          | 65.5 | % |
| Expected  life           |       | 5 years                 |       | 5 years |   |

 

**NOTE 6.****   RECENT TRANSACTIONS**

 

***Japanese License and Royalty Agreement***

 

On December 15, 2004the Company announced that it had signed an agreement which grants MeniconCo., Ltd. (Menicon), Japan’s largest independent contact lensmanufacturer, exclusive rights to develop, manufacture and market certaindisposable contact lenses and related intellectual property in Japan.

 

Under the terms of theagreement, Menicon licenses from the Company different types of intellectualproperty, including contact lens material, manufacturing technology and relatedknowledge.  In consideration, Menicon isexpected to pay nonrefundable license fees of $18 million, of which$5 million was paid in December 2004 upon signing the agreement. Theremaining $13 million is expected to be paid over the next three to fiveyears as the Company fulfills its obligations and as corresponding milestonesrelating to Japanese regulatory approval and Menicon’s launch of the product inthe Japanese market are met. Of the total $18 million license fee,$10 million is guaranteed.  TheCompany evaluated the agreement under Emerging Issues Task Force 00-21, RevenueArrangements with Multiple Deliverables, and determined that this arrangementshould be considered a single unit of accounting.  Therefore, in applying the principles ofStaff Accounting Bulletin No. 104 to the license agreement, the Companyconsidered the terms and conditions of the agreement to arrive at aproportional performance methodology of recognizing revenue.  Accordingly, the Company is recognizing theguaranteed portion of the license fees from this agreement on a straight-linebasis, limited by the amount of cash received, over the period of the Company’scontinued involvement in meeting its obligations, estimated to be two and onehalf years.  The Company will recognizethe remaining milestone payments as the agreed upon milestones are achieved.

 

If Menicon has notreceived regulatory approval within five years, it may return all intellectualproperty covered by the agreement and in-process regulatory approvals to theCompany, and the Company may pursue the Japanese market on its own andterminate the exclusive agreement.

 

Under the terms of theagreement, Menicon will also pay royalties for a period of at least15 years from the product launch date in Japan on contact lenses sold thatwere manufactured using the licensed technology, with a guaranteed minimum of$5 million per year beginning the earlier of the second year after productlaunch or 2012. The

 

9

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agreementdoes not include the sale of any of the Company’s current equipment, facilitiesor capacity, and is limited to the Japanese contact lens market.

 

***Optical Retail Store Agreement***

 

During the latter part of2004, the Company entered into an agreement with a regional optical retailchain in Utah in which the two companies would jointly market and sell contactlenses in Utah.  In December 2004,the companies began jointly serving these Utah customers. The agreement is forone year, with one year renewals at the option of both parties.

 

Under the agreement, theCompany fulfills substantially all orders taken at the retail optical chain forcontact lenses and both parties share in the operating results of the combinedcontact lens business based on a certain allocation percentage. However, theCompany has guaranteed that the retail chain will receive at least $0.5 millionof annual earnings under the arrangement. Additionally, the Company committedto purchase approximately $0.3 million per year in inventory from the retailchain’s source of supply.  Under thearrangement, the Company records gross revenues for all orders fulfilled andrecords operating expense for the retail chain’s share of the net operatingresults.

 

**NOTE 7.****  COMMON STOCK TRANSACTIONS**

 

During the quarter ended April 2,2005, employees exercised stock options to purchase 7,214 shares of commonstock for a total of approximately $78,000. The Company recorded an increase in additional paid-in capital ofapproximately $28,000 as a result of the income tax benefit related to thesestock option exercises.

 

During the quarter ended April 2,2005, the Company granted nonqualified stock options to purchase 1,000 sharesof common stock to employees of the Company. The exercise price of the options was $22.00 per share, which was notless than the quoted fair market value at the grant date. The options vest equallyover a four-year period and expire in five years.

 

During the quarter ended April 2,2005, the Board of Directors granted 20,000 shares of restricted common stockto two employees of the Company.  Thestock was valued at the closing stock price on March 21, 2005, which was$22.67.  The restrictions on the commonstock lapse in equal amounts over a five-year period. ** **The Company recorded expense ofapproximately $5,000 related to restricted stockduring the period and as of April 2, 2005 approximately $551,000 has beendeferred and will be recognized over the vesting period.

 

**NOTE 8.****  DEBT OBLIGATIONS**

 

 The Company has a loanagreement with a U.S. bank providing for a revolving credit facility forborrowings of up to $26.4  million as of April 2, 2005 and is reducedthereafter on the first day of each September, December, March and June by$0.4 million until the maturity date of February 27, 2007.Additionally, the agreement provides for letters of credit up to a maximum of$15 million outstanding or payable at any time. The loan agreementspecifies that if the maximum leverage ratio, as defined in the agreement, isgreater than 2.5, then the amounts outstanding on the revolving credit facilitytogether with the amount of all outstanding letters of credit can at no timeexceed the Company’s book value of inventory. As of April 2, 2005, theCompany was not subject to this restriction and could borrow up to$26.4 million. Outstanding borrowings on the revolving credit facilitybear interest at a floating rate equal to the lender’s prime interest rate plusa margin or the lender’s LIBOR rate plus a margin. The interest rate isadjusted quarterly and ranges between prime plus 0.0 percent and primeplus 1.25 percent or between the applicable LIBOR rate plus 2.0 percentand the applicable LIBOR rate plus 3.25 percent, depending on the Company’smaximum leverage ratio. As of April 2, 2005, the prime rate margin is 0.0percent and the LIBOR rate margin is 2.0 percent. Interest is payablemonthly. As April 2, 2005, the Company’s outstanding borrowings on thecredit facility, including bank overdrafts, were $8.4 million. Of thisamount, $5.0 million bore interest at the lender’s LIBOR rate plus2.0 percent (4.85% at April 2, 2005) and the remaining$3.4 million bore interest at the lender’s prime rate plus0.0 percent (5.75% at April 2, 2005). The facility requires thequarterly payment of an unused credit fee which ranges from 0.38 percentto 0.5 percent, depending on the Company’s maximum leverage ratio.

 

10

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All outstanding balanceson this credit facility are secured by substantially all of the Company’s U.S.assets, subsidiary debt instruments, 100 percent ownership interests inall domestic subsidiaries and 65 percent ownership interests in foreignsubsidiaries directly owned by the Company. The loan agreement includes variousfinancial covenants including a capital expenditure limit, a maximum leverageratio, a minimum working capital requirement, a minimum fixed charge coverageratio and a minimum net worth requirement. The loan agreement does not permitthe Company or its subsidiaries to dissolve, sell, dispose or merge all oftheir assets or acquire all of the assets of any entity without the writtenconsent of the U.S. bank, unless the transaction meets the definition of a “PermittedAcquisition Basket”, as defined in the agreement. The loan agreement alsoplaces a limit on the amount the Company can loan to any entity, outside thenormal course of business. Additionally, the agreement does not permit theCompany to declare or pay any cash dividends, to repurchase its stock or toperform other similar equity transactions prior to December 31, 2005;thereafter, such transactions are subject to other terms. This agreementdefines several customary events of default including any material adversechange or any event that occurs which may cause a material adverse change inthe Company’s or its subsidiaries’ condition.

 

As of April 2, 2005, the Company had an unsecured, non-interestbearing note to ClearLab International’s chief technology officer with aprincipal balance of SGD$1,750,000 (USD$1,060,000).  The note payable is discounted at 7%.  Payments are due in equal monthly installmentsthrough July 2007.

 

As of April 2, 2005 the Company had a term loanpayable to a Singapore bank with a principal balance of SGD$7,110,000(USD$4,306,000) that bears interest at 6.75% and is secured by substantiallyall of the assets of ClearLab International.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments through December 2007.  Thisnote also contains various financial covenants including minimums on net worthand shareholders’ funds.  1-800 CONTACTS,INC. has guaranteed this term loan.

 

As of April 2, 2005, the Company also had a notepayable to the former parent of ClearLab International with a principal balanceof SGD$6,892,000 (USD$4,175,000) that bears interest at 6% and has asubordinated position to the term loan payable to the Singapore bank.  The note payable is discounted at 7%.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed this note.

 

Cross default clausesexist such that if the Company were in default on its U.S. debt, the Companywould also be in default on its Singapore debt. If the Company were in defaulton its Singapore bank term loan, the Company would also be in default on itsnote payable to the parent of IGEL and its restated loan agreement with itsU.S. bank.

 

**NOTE 9.****  COMMITMENTS AND CONTINGENCIES**

 

***Legaland Regulatory Matters***

 

The sale and delivery ofcontact lenses are governed by both federal and state laws and regulations,including the federal Fairness to Contact Lens Consumer Act (“FCLCA”).  The FCLCA requires that contact lenses onlybe sold to consumers based on the seller obtaining a copy of the prescriptionitself or verifying the prescription by direct communication with the customer’sprescriber. Consistent with this requirement, the Company’s current operatingpractice is to require all customers to provide either a valid copy of theirprescription or the contact information for their prescriber so that theCompany can verify their prescription by direct communication with theirprescriber.  If the Company does not havea valid copy of the customer’s prescription, the Company directly communicatesto the customer’s prescriber the precise prescription information received fromthe customer and informs the prescriber that it will proceed with the salebased on this prescription information unless the prescriber advises it withineight business hours that such prescription information is expired or otherwiseinvalid.  If the prescriber properlyadvises the Company within this time period that the customer’s prescription isexpired or otherwise invalid, the Company’s practice is to cancel the customer’sorder.  On the other hand, if theprescriber either advises the Company that the prescription is valid or failsto respond properly within the required time period, the Company’s practice isto complete the sale based on the prescription information communicated to theprescriber, as expressly permitted by the FCLCA.  The Company retains copies of the writtenprescriptions that it receives and maintains records of its communications withthe customer’s prescriber.  The Companybelieves that it is complying with the regulations of the FCLCA.

 

From time to time theCompany is involved in legal matters generally incidental to its business.  It is the opinion of management, afterdiscussion with legal counsel that, except for legal and professional fees thatthe Company incurs from time to time, the ultimate dispositions of all of thesematters will not have a material impact on the financial position, liquidity orresults of operations of the Company. However, there can be no assurance that the Company will be successfulin its efforts to satisfactorily resolve these matters and the ultimate outcomecould result in a material negative impact on the Company’s financial position,liquidity or results of operations.

 

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***AdvertisingCommitments***

 

As of April 2, 2005,the Company had entered into certain noncancelable commitments with variousadvertising companies that will require the Company to pay approximately $9.3million for advertising during the remainder of 2005.

 

**NOTE10.****  SEGMENT INFORMATION**

 

The Company has two operating segments. Theseoperating segments represent components of the Company for which separatefinancial information is available and are evaluated regularly by management indetermination of resource allocation and performance assessment. The Company’sU.S. Retail segment includes the operations of 1-800 CONTACTS, a directmarketer of replacement contact lenses. The Company’s International segmentincludes the operations of ClearLab International and ClearLab UK, developers,marketers, manufacturers and distributors of contact lenses.  The U.S.Retail segment includes revenue from the optical retail store agreement and theInternational segment includes revenue from the Japanese license and royaltyagreement.   Operating segment information for the firstquarter ended April 3, 2004 and April 2, 2005 is as follows (inthousands):

 
| **Quarter Ended April 3, 2004**          | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|-----------------|------------|-------------------|------------|------------------|------------|-----------|------------|
|                                          |       |            |       |              |       |             |       |      |       |
| Net sales                                     |       | $               | 49,451     |              | $          | 1,398            |       | $         | —     |   | $ | 50,849 |   |
| Gross profit                                  |       | 18,930          |       | 366               |       | —           |       | 19,296    |       |
| Research and development                      |       | 536             |       | 356               |       | —           |       | 892       |       |
| Purchased in-process research and development |       | —          |       | 83                |       | —           |       | 83        |       |
| Other operating expense                       |       | 8,970           |       | 912               |       | —           |       | 9,882     |       |
| Loss from operations                          |       | $               | (1,149     | )                 | $          | (1,067           | )          | $         | —     |   | $ | (2,216 | ) |

 
| **Quarter Ended April 2, 2005**                                   | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total** | ** ** |
|------------------------------------------------------------------------|------------|-----------------|------------|-------------------|------------|------------------|------------|-----------|------------|
|                                                                   |       |            |       |              |       |             |       |      |       |
| Net sales (International segment includes intersegment  sales of $371) |       | $               | 56,366     |              | $          | 4,288            |       | $         | (371       | ) | $ | 60,283 |   |
| Gross profit                                                           |       | 22,187          |       | 603               |       | (282             | )          | 22,508    |       |
| Research and development                                               |       | —          |       | 1,055             |       | —           |       | 1,055     |       |
| Other operating expense                                                |       | 10,078          |       | 1,439             |       | —           |       | 11,517    |       |
| Income (loss) from operations                                          |       | $               | 4,403      |              | $          | (2,007           | )          | $         | (282       | ) | $ | 2,114 |   |

 

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The following reconciles totalsegment income (loss) from operations to income (loss) before provision forincome taxes for the applicable fiscal year ended (in thousands):

 
| ** **                                             | ** ** | **Quarter Ended**      | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **April 3, 2004** | ** ** | **April 2, 2005** | ** ** |
| Income (loss) from operations                          |       | $                      | (2,216     | ) | $ | 2,114 |   |
| Interest expense, net                                  |       | (427                   | )          | (301 | ) |
| Foreign currency exchange transaction gain (loss), net |       | 75                     |       | (312 | ) |
| Other, net                                             |       | (4                     | )          | (28 | ) |
| Income (loss) before provision for income taxes        |       | $                      | (2,572     | ) | $ | 1,473 |   |

 

Identifiable segment assets areas follows (in thousands):

 
| **Fiscal Year Ended January 1, 2005** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|-----------------|------------|-------------------|------------|-----------|------------|
|                                       |       |            |       |              |       |      |       |
| Long-lived assets, net                     |       | $               | 33,374     |              | $          | 39,461    |       | $ | 72,835 |   |
| Total assets                               |       | 56,216          |       | 52,769            |       | 108,985   |       |
|                                            |            |                 |            |                   |            |           |            |  |  |  |

 
| **Quarter Ended April 2, 2005** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-----------------|------------|-------------------|------------|-----------|------------|
|                                 |       |            |       |              |       |      |       |
| Long-lived assets, net               |       | $               | 34,320     |              | $          | 39,875    |       | $ | 74,195 |   |
| Total assets                         |       | 55,189          |       | 50,355            |       | 105,544   |       |
|                                      |            |                 |            |                   |            |           |            |  |  |  |

 

**NOTE 11.****  RECENTLY ISSUED ACCOUNTINGSTANDARDS**

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”),which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”)and supercedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees.” SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values beginning with the first annual periodafter January 1, 2006, with early adoption encouraged. The pro formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. The Company is required toadopt SFAS 123R in the first fiscal quarter 2006, beginning January 1,2006. Under SFAS 123R, the Company must determine the appropriate fairvalue model to be used for valuing share-based payments, the amortizationmethod for compensation cost and the transition method to be used at date ofadoption. The transition methods include prospective and retroactive adoptionoptions. Under the retroactive option, prior periods may be restated either asof the beginning of the year of adoption or for all periods presented. Theprospective method requires that compensation expense be recorded for allunvested stock options at the beginning of the first quarter of adoption ofSFAS 123R, while the retroactive methods would record compensation expensefor all unvested stock options and beginning with the first period restated.The Company is evaluating the requirements of SFAS 123R and expects thatthe adoption of SFAS 123R will have a material impact on its consolidatedresults of operations and earnings per share. The Company has not yetdetermined the method of adoption or the effect of adopting SFAS 123R.

 

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**Item 2.**    ***Management’s Discussion andAnalysis of Financial Condition and Results of Operations***

 

**Overview**

 

The Company is a leadingdirect marketer of replacement contact lenses and also conducts contact lensmanufacturing, development and distribution operations in Singapore and theUnited Kingdom.  The Company’s U.S.Retail operations sell almost all of the popular brands of contacts lenses,including those manufactured by Johnson & Johnson Vision Care, CIBAVision, Bausch & Lomb, and CooperVision.

 

**Recent Transactions andAgreements**

 

***International Operations (ClearLab).****** ***On February 24, 2004, the Company acquiredVisionTec, a developer and manufacturer of daily contact lenses based in theUnited Kingdom.  VisionTec developed a method for low cost, high qualityproduction of daily disposable contact lenses using a unique proprietarymaterial.  VisionTec has subsequently been renamed ClearLab UK Ltd (“ClearLabUK”).  The business operates as a research and development and amanufacturing affiliate of ClearLab International.  The Company beganshipping its daily disposable contact lenses in the first quarter of fiscal2004 and is currently expanding its production capabilities for these lenses.

 

ClearLab, the Company’sinternational contact lens development, manufacturing and distributionbusiness, includes the operations of ClearLab International and ClearLabUK.  ClearLab recently began to sellfrequent replacement lenses in the U.S. through the Company’s retail opticalpartnership. ClearLab will increase its product offerings to the internationalmarkets throughout the remainder of fiscal 2005 from its production facilitiesin Singapore and the U.K. as demand for its product continues to grow.

 

***Japanese License and RoyaltyAgreement.***   On December 15,2004 the Company announced that it had signed an agreement which grants MeniconCo., Ltd. (Menicon), Japan’s largest independent contact lensmanufacturer, exclusive rights to develop, manufacture and market certaindisposable contact lenses and related intellectual property in Japan.

 

Under the terms of theagreement, Menicon licenses from the Company different types of intellectualproperty, including contact lens material, manufacturing technology and relatedknowledge.  In consideration, Menicon isexpected to pay nonrefundable license fees of $18 million, of which $5 millionwas paid in December 2004 upon signing the agreement. The remaining$13 million is expected to be paid over the next three to five years asthe Company fulfills its obligations and as corresponding milestones relatingto Japanese regulatory approval and Menicon’s launch of the product in theJapanese market are met. Of the total $18 million license fee,$10 million is guaranteed. Accordingly, the Company is recognizing the guaranteed portion of thelicense fees from this agreement on a straight-line basis, limited by theamount of cash received, over the period of the Company’s continued involvementin meeting its obligations, estimated to be two and one half years.  The Company will recognize the remainingmilestone payments as the agreed upon milestones are achieved.

 

If Menicon has not receivedregulatory approval within five years, it may return all intellectual propertycovered by the agreement and in-process regulatory approvals to the Company,and the Company may pursue the Japanese market on its own and terminate theexclusive agreement.

 

Under the terms of theagreement, Menicon will also pay royalties for a period of at least15 years from the product launch date in Japan on contact lenses sold thatwere manufactured using the licensed technology, with a guaranteed minimum of$5 million per year beginning the earlier of the second year after productlaunch or 2012. The agreement does not include the sale of any of the Company’scurrent equipment, facilities or capacity, and is limited to the Japanesecontact lens market.

 

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***Optical Retail Store Agreement.****** ***During the latter part of 2004, the Company entered intoan agreement with a regional optical retail chain in Utah in which the twocompanies would jointly market and sell contact lenses in Utah.  In December 2004, the companies beganjointly serving these Utah customers. The agreement is for one year, with oneyear renewals at the option of both parties.

 

Under the agreement, theCompany fulfills substantially all orders taken at the retail optical chain forcontact lenses and both parties share in the operating results of the combinedcontact lens business based on a certain allocation percentage. However, theCompany has guaranteed that the retail chain will receive at least $0.5 millionof annual earnings under the arrangement. Additionally, the Company committedto purchase approximately $0.3 million per year in inventory from the retailchain’s source of supply.

 

***Supplier Agreements.*** The Company hasagreements with its top three vendors for improved pricing and marketingsupport.  This support comes in the formof cooperative marketing and rebate programs designed to promote themanufacturer’s products and build sales. As part of its ongoing relationship with its suppliers, the Companyperiodically reviews its specific marketing plans and negotiates cooperativemarketing programs and product pricing.

 

***Cole National MarketingAgreement/Doctor Referral Network.***  On June 30, 2003, the Company and Coleannounced that they had signed an agreement under which the Company’s customerscan receive discounted eye exams and value pricing on eyeglasses, sunglassesand other vision products that the Company does not sell from a network of eyecare practitioners contracted with Cole Managed Vision and associated with morethan 1,500 Pearle Vision, Pearle VisionCare, Sears Optical and Target Opticalstores in the U.S.  During fiscal 2004,the agreement was extended through March 31, 2005.  During the first quarter of fiscal 2005, theCompany and Luxottica Group, who recently acquired Cole, extended the agreementthrough July 1, 2005.  Under thisagreement, Cole is offering its network of eye care practitioners to theCompany to be used for contact lens exam referrals and the Company retains thecontact lens business of customers referred to Cole stores.

 

The Company recently announcedthat it does not intend to renew this agreement beyond July 1, 2005.  The Company’s objective is to enter anagreement or agreements with similar terms as the optical retail storepartnership agreement to enable the Company to create a seamless experiencenationwide for consumers that includes exams as well as in-store, phone andonline service. The Company has had discussions with various parties concerningretail optical agreements.

 

# **Regulatory Considerations**

# ** **

***Fairness to Contact Lens Consumer Act.****** *** In November 2003,Congress passed the Fairness to Contact Lens Consumer Act (“FCLCA”), whichestablished a national uniform standard for both eye care practitioners and directmarketers with regard to releasing and verifying consumer contact lensprescriptions as well as other requirements relating to the sale of contactlenses.  The FCLCA became effective February 4,2004, and now requires all eye care practitioners to give patients a copy oftheir prescription as soon as they have been fitted for contact lenses, whetherthe patients ask for it or not.  It alsodirects contact lens sellers to contact eye care practitioners to request verificationof consumer prescriptions before shipping all orders (if the prescription isnot already on file), and it provides that failure to respond within eightbusiness hours shall result in the prescription being presumed valid, therebyeliminating the ability of eye care practitioners to impede sales by directmarketers simply by ignoring or refusing to respond to their requests to verifyprescriptions.  The FCLCA also providesthat prescriptions will be valid for a minimum of at least one year (absentsome special medical reason justifying a shorter period).  It also directed the Federal TradeCommission (“FTC”) to conduct a study examining the strength of competition inthe market for contact lenses and to submit a report to Congress within twelvemonths of the FCLCA effective date. This FTC study completed and published thisstudy on February 15, 2005, with no recommendations for further changes infederal law.

 

Satisfying theprescription verification requirement of the FCLCA obligates a contact lensseller either to obtain a copy of the prescription itself or to verify theprescription by direct communication with the customer’s prescriber.  Consistent with this requirement, the Company’scurrent operating practice is to require all customers to provide either avalid copy of their prescription or the contact information for theirprescriber so that the Company

 

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canverify their prescription by direct communication with their prescriber.  If the Company does not have a valid copy ofthe customer’s prescription, the Company directly communicates to the customer’sprescriber the precise prescription information received from the customer andinforms the prescriber that it will proceed with the sale based on thisprescription information unless the prescriber advises it within eight businesshours that such prescription information is expired or otherwise invalid.  If the prescriber properly advises theCompany within this time period that the customer’s prescription is expired orotherwise invalid, the Company’s practice is to cancel the customer’sorder.  On the other hand, if theprescriber either advises the Company that the prescription is valid or failsto respond properly within the required time period, the Company’s practice isto complete the sale based on the prescription information communicated to theprescriber, as expressly permitted by the FCLCA.  The Company retains copies of the writtenprescriptions that it receives and maintains records of its communications withthe customer’s prescriber.  The FCLCAprovides for several means of direct communication with eye care practitioners,and the Company may alter its prescription verification procedures from time totime in keeping with the FCLCA and FTC guidelines.

 

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# **Results of Operations**

 

The Company’s fiscal yearconsists of a 52/53-week period ending on the Saturday nearest to December 31.Fiscal 2005 is a 52-week year and will end on December 31, 2005.

 

The Company has twooperating segments referred to below. The Company’s domestic segment is represented by operations within theU.S. and is referred to as “U.S. Retail” by the Company, whereas the Company’sinternational segment is represented by operations in both Singapore and theU.K. and is referred to as “ClearLab” by the Company.

 

The following tablepresents the Company’s results of operations expressed as a percentage of netsales for the periods indicated:
| ** **                                                 | ** ** | **Quarter Ended**      | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **April 3, 2004** | ** ** | **April 2, 2005** | ** ** |
| Net sales                                                  |       | 100.0                  | %          | 100.0 | % |
| Cost of goods sold                                         |       | 62.0                   |       | 62.7 |   |
| Gross profit                                               |       | 38.0                   |       | 37.3 |   |
| Advertising                                                |       | 17.3                   |       | 10.8 |   |
| Legal and professional                                     |       | 3.6                    |       | 2.1 |   |
| Research and development                                   |       | 1.8                    |       | 1.8 |   |
| Purchased in-process research and development              |       | 0.2                    |       | 0.0 |   |
| Other operating expenses                                   |       | 19.4                   |       | 19.1 |   |
| Total operating expenses                                   |       | 42.3                   |       | 33.8 |   |
| Income (loss) from operations                              |       | (4.3                   | )          | 3.5 |   |
| Other expense, net                                         |       | (0.7                   | )          | (1.1 | ) |
| Income (loss) before benefit (provision) for income  taxes |       | (5.0                   | )          | 2.4 |   |
| Benefit (provision) for income taxes                       |       | 0.7                    |       | (2.1 | ) |
| Net income (loss)                                          |       | (4.3                   | )%         | 0.3 | % |

 

***Net sales***. Net sales for the quarter ended April 2, 2005 increased 19% to$60.3 million from $50.8 million for the quarter ended April 3, 2004.  Net sales for U.S. Retail in the firstquarter of fiscal 2005 were $56.4 million compared to $49.4 million for thefirst quarter of fiscal 2004.  Theincrease in U.S. Retail net sales is mainly due to an increase in average ordersize due principally to an increased number of rebate programs institutedduring fiscal 2004 and the first quarter of fiscal 2005, an increase inaccessory sales, and an increase in retail sales prices on phone orders in thesecond quarter of fiscal 2004.  Net salesalso benefited during the first quarter of fiscal 2005, as compared to the firstquarter of fiscal 2004, due to a decrease in the number and percentage oforders the Company canceled as a result of prescription verification procedures(see “Regulatory Considerations”). The Company believes the cancellation ratehas stabilized and does not anticipate any further significant reduction infiscal 2005.  The Company is continuallytaking steps to minimize canceled orders, including continued development of amore integrated national retail store network and the continued development ofinternal procedures to help obtain the necessary prescription information thatis required to fulfill an order.

 

U.S. Retail net sales forthe first quarter of fiscal 2005 were negatively impacted by the Company’sdecision during the fourth quarter of fiscal 2004 to suspend sales of aspecific brand of lens, as the Company is unable to obtain sufficientquantities of this lens from anyone other than the manufacturer, who refuses tosell the Company this lens. Sales of this lens represented approximately 2.5%of the Company’s fiscal 2004 U.S. Retail net sales.

 

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Net sales for ClearLabfor the first quarter of fiscal 2005 were $4.3 million as compared to net salesof $1.4 million for the first quarter of fiscal 2004.  ClearLab’s results for the first quarter offiscal 2005 include $1.0 million in license fees from the Company’s Japaneselicense agreement, and $0.4 million of intercompany sales to the Company’s U.S.retail business which are eliminated for consolidation purposes until the productis sold to customers.  During the firstquarter of fiscal 2005, ClearLab realized increased sales to existing and newcustomers as it has enhanced its product offerings and expanded its productioncapabilities.

 

***Gross profit.***  Consolidated gross profit as a percentage ofnet sales decreased slightly to 37.3% for the quarter ended April 2, 2005from 38.0% for the quarter ended April 3, 2004.  Gross profit as a percentage of net sales forthe Company’s U.S. Retail operations increased to 39.4% in the first quarter offiscal 2005 from 38.3% in the first quarter of fiscal 2004.  U.S. Retail gross profit for the firstquarter of fiscal 2005 benefited from a retail price increase principally onphone orders in the second quarter fiscal 2004.

 

Grossprofit as a percentage of net sales for the Company’s international operationshave been negatively impacted by the February 24, 2004 acquisition ofClearLab UK due to the start-up nature of these operations.  The Company expects to see continuedimprovement in gross margins from ClearLab throughout fiscal 2005 as sales andproduction increase.

 

***Advertising expense.****** ***Advertising expense for thequarter ended April 2, 2005 decreased $2.3 million, or 26%, to $6.5million from the first quarter ended April 3, 2004.  As a percentage of net sales, advertisingexpense decreased to 10.8% for the first quarter of fiscal 2005 from 17.3% forthe first quarter of fiscal 2004.  TheCompany anticipates total advertising expense to be in the range of $23 millionand $25 million for fiscal year 2005, including approximately $7.0 millionduring the second quarter of fiscal 2005. However, if opportunities present themselves, the Company may increaseadvertising spending above currently planned levels.  The Company’s experience has been thatincreases in advertising expenditures have a direct impact on the growth of netsales not only in the current period but also in future periods.

 

The Company expenses alladvertising costs when the advertising first takes place.  As a result, quarter-to-quarter comparisonsare impacted within and between quarters by the timing of television, radio andInternet advertisements and by the mailing of the Company’s printedadvertisements. The volume of mailings and other advertising may vary indifferent quarters and from year to year depending on the Company’s assessmentof prevailing market opportunities.

 

***Legal and professional fees.***  Legal and professional fees for the quarterended April 2, 2005 decreased $0.6 million, or 30%, from the quarter endedApril 3, 2004.  As a percentage ofnet sales, legal and professional fees decreased to 2.1% for the first quarterof fiscal 2005 from 3.6% for the first quarter of fiscal 2004.

 

During the first fiscalquarter of 2004 the Company invested considerable effort preparing comments forthe Federal Trade Commission (“FTC”) relating to final rules associatedwith the FCLCA.  During the first quarterof fiscal 2005, the Company continued to incur professional fees forSarbanes-Oxley compliance and other internal control initiatives, as well asongoing legal, lobbying and regulatory initiatives.

 

The Company will continueto focus its efforts on compliance with federal rules and regulations aswell as continue to support legal and legislative initiatives that it believeswill benefit contact lens wearers and the industry.

 

***Research and development expenses.***  Research and development expenses for thequarter ended April 2, 2005 increased to $1.1 million from $0.9 millionfor the quarter ended April 3, 2004. However, the expenses were constant as a percentage of net sales at 1.8%for each of the periods.  During thefirst quarter of fiscal 2005, the Company continued to fund research anddevelopment efforts for ClearLab’s operations.

 

Total fiscal 2005research and development costs will be dependent on progress with research anddevelopment efforts relating to expanding ClearLab’s product offering anddeveloping its intellectual property.

 

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***Other operating expenses.***  Other operating expenses for the quarterended April 2, 2005 increased $1.6 million, or 17%, to $11.5 million, fromthe quarter ended April 3, 2004. U.S. Retail accounted for approximately $1.1 million of the increase forthe first quarter of fiscal 2005, whereas ClearLab accounted for approximately$0.5 million of the increase.  Themajority of the increase for U.S. Retail relates to the continued enhancementof its operating infrastructure and management team to meet the demands of thebusiness and variable costs associated with higher net sales and therequirements of the FCLCA.  A majority ofClearLab’s increase related to the enhancement of its operating infrastructureand scale up of its manufacturing capabilities, including the operations ofClearLab UK.

 

As a percentage of netsales, however, other operating expenses decreased to 19.1% for the firstquarter of fiscal 2005 from 19.4% for the first quarter of fiscal 2004.  Other operating expenses as a percentage ofnet sales for the U.S. Retail operations also decreased during the firstquarter of fiscal 2005 to 17.9% from 18.1% from the first quarter of fiscal2004.  The Company expects otheroperating expenses to fluctuate as a percentage of net sales as the Companycontinues to grow and expand its U.S. and international operations.

 

***Other expense, net.***  Other expense increased to approximately $0.6million for the quarter ended April 2, 2005 from approximately $0.4million for the quarter ended April 3, 2004.  For the first quarter of fiscal 2005, otherexpense consisted mainly of interest expense of approximately $0.3 million andforeign exchange transaction losses of approximately $0.3 million.   Other expense for the first quarter offiscal 2004 consisted mainly of interest expense of approximately $0.4, offsetslightly by foreign transaction exchange gains. The exchange transaction gainsand losses related primarily to intercompany loans to ClearLab.

 

***Income taxes.****** ***The Company is taxed in threeseparate jurisdictions – U.S., Singapore and the United Kingdom.  The Company records quarterly income taxes atthe effective tax rate expected for the year. The Company’s effective U.S. income tax rate for the quarter ended April 2,2005 is approximately 39% which is consistent with the 39% reported for thequarter ended April 3, 2004.  Duringthe first quarter of fiscal 2005, the Company did not record a tax benefit forthe loss from the operations of ClearLab International due to the uncertaintywith respect to the realization of a tax benefit in Singapore.  As of the first quarter of 2005, the Companyprovided a valuation allowance for the full amount of deferred income taxassets in Singapore.   For the firstquarter of fiscal 2005, the Company recorded a tax benefit for the loss fromoperations of ClearLab UK using an effective tax rate of approximately29%.  The Company did not provide avaluation allowance for the deferred income tax assets in the United Kingdombecause the deferred tax liabilities recorded as of the date of acquisition ofClearLab UK were in excess of the deferred tax assets generated by the lossfrom operations during fiscal 2004 and the first quarter of fiscal 2005, whichoperating loss can be carried forward indefinitely.  The Company’s effective income tax rates maychange as facts and circumstances change. The Company anticipates that its fiscal 2005 effective income tax ratefor the U.S. and the United Kingdom will be consistent with the respectiveeffective rates recorded during the first quarter of fiscal 2005.

 

**Liquidity and Capital Resources**

 

The Company’s principal sources of liquidity have beencash provided by operating activities and proceeds from debt financings.  The Company’s principal uses of cash havebeen to meet debt service requirements, finance acquisitions, finance capitalexpenditures, fund working capital needs and repurchase common stock.  The Company anticipates that, with theexception of repurchases of common stock, these uses will continue to be theprincipal demands on its cash in the future. As of April 2, 2005, the Company had net working capital ofapproximately $2.5 million, compared to $10.0 million as of January 1,2005.  The majority of this decrease in networking capital is offset by a corresponding $6.0 million decrease in theCompany’s revolving credit facility, which is classified as long-term andtherefore not included in the calculation of net working capital.

 

The Company believes thatits cash on hand, together with cash generated from operating activities and theborrowings available through the credit facility, will be sufficient to supportplanned operations through the foreseeable future.  Should the Company’s plans or expectationschange, the Company may be required to seek additional sources of funds and therecan be no assurance that such funds will be available on satisfactoryterms.  Failure to obtain such financingcould delay or prevent the Company’s planned growth, which could adverselyaffect the Company’s business, financial condition, liquidity and results ofoperations.

 

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As a result of regulatory requirements, the Company’sliquidity, capital resources and results of operations may be negativelyimpacted in the future if the Company incurs increased costs (including legalfees) or fines, is prohibited from selling its products or experiences lossesof a substantial portion of the Company’s customers for whom the Company isunable to obtain or verify a prescription due to the requirements of the FCLCA.

 

 The Company has a loanagreement with a U.S. bank providing for a revolving credit facility forborrowings of up to $26.4  million as of April 2, 2005 and is reducedthereafter on the first day of each September, December, March and June by$0.4 million until the maturity date of February 27, 2007.Additionally, the agreement provides for letters of credit up to a maximum of$15 million outstanding or payable at any time. The loan agreementspecifies that if the maximum leverage ratio, as defined in the agreement, isgreater than 2.5, then the amounts outstanding on the revolving credit facilitytogether with the amount of all outstanding letters of credit can at no timeexceed the Company’s book value of inventory. As of April 2, 2005, theCompany was not subject to this restriction and could borrow up to$26.4 million. Outstanding borrowings on the revolving credit facilitybear interest at a floating rate equal to the lender’s prime interest rate plusa margin or the lender’s LIBOR rate plus a margin. The interest rate isadjusted quarterly and ranges between prime plus 0.0 percent and primeplus 1.25 percent or between the applicable LIBOR rate plus2.0 percent and the applicable LIBOR rate plus 3.25 percent,depending on the Company’s maximum leverage ratio. As of April 2, 2005,the prime rate margin is 0.0 percent and the LIBOR rate margin is2.0 percent. Interest is payable monthly. As April 2, 2005, theCompany’s outstanding borrowings on the credit facility, including bankoverdrafts, were $8.4 million. Of this amount, $5.0 million boreinterest at the lender’s LIBOR rate plus 2.0 percent (4.85% at April 2,2005) and the remaining $3.4 million bore interest at the lender’s primerate plus 0.0 percent (5.75% at April 2, 2005). The facility requiresthe quarterly payment of an unused credit fee which ranges from0.38 percent to 0.5 percent, depending on the Company’s maximumleverage ratio.

 

All outstanding balanceson this credit facility are secured by substantially all of the Company’s U.S.assets, subsidiary debt instruments, 100 percent ownership interests inall domestic subsidiaries and 65 percent ownership interests in foreignsubsidiaries directly owned by the Company. The loan agreement includes variousfinancial covenants including a capital expenditure limit, a maximum leverageratio, a minimum working capital requirement, a minimum fixed charge coverageratio and a minimum net worth requirement. The loan agreement does not permitthe Company or its subsidiaries to dissolve, sell, dispose or merge all oftheir assets or acquire all of the assets of any entity without the writtenconsent of the U.S. bank, unless the transaction meets the definition of a “PermittedAcquisition Basket”, as defined in the agreement. The loan agreement alsoplaces a limit on the amount the Company can loan to any entity, outside thenormal course of business.  Additionally,the agreement does not permit the Company to declare or pay any cash dividends,to repurchase its stock or to perform other similar equity transactions priorto December 31, 2005; thereafter, such transactions are subject to otherterms. This agreement defines several customary events of default including anymaterial adverse change or any event that occurs which may cause a materialadverse change in the Company’s or its subsidiaries’ condition.  As of April 2,2005, the Company was in compliance with all applicable covenants andrestrictions.

 

The Company’s Singaporebank term loan contains various financial covenants including minimums on networth and shareholders’ funds of the Singapore operations. 1-800CONTACTS, INC. has guaranteed this term loan.

 

Cross default clausesexist such that if the Company were in default on its U.S. debt, the Companywould also be in default on its Singapore debt. If the Company were in defaulton its Singapore bank term loan, the Company would also be in default on itsnote payable to the parent of IGEL and its restated loan agreement with itsU.S. bank.

 

***Cashflows from operating activities.***  For the quarters ended April 2, 2005 andApril 3, 2004, net cash provided by (used in) operating activities wasapproximately $6.2 million and ($1.8 million), respectively.  In the first quarter of fiscal 2005, cash wasprimarily provided by increases in accounts payable, accrued liabilities andincome taxes payable and decreases in other current assets and inventories.  This increase in cash was partially offset bydecreases in unearned revenues and increases in net accounts receivable.  In the first quarter of fiscal 2004, cash wasused primarily for increases in inventories, other current assets and to fundthe net loss, partially offset by an increase in accrued liabilities andaccounts payable.

 

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***Cash flows from investing activities.***  The Company used approximately $1.9 millionand $5.7 million for investing activities in the quarters ended April 2,2005 and April 3, 2004, respectively. In the first quarter of fiscal 2005, the Company paid approximately $0.6million in deposits associated mainly with the expansion of and improvement inthe Company’s infrastructure at ClearLab.  In the first quarter of fiscal 2004, the Company paid approximately $3.8million in cash (including $0.6 million in transaction costs) in connectionwith the acquisition of VisionTec.  TheCompany also purchased approximately $0.7 million of intangible assets in thefirst quarter of fiscal 2004.

 

Capital expenditures forthe first quarters of fiscal 2005 and 2004 were approximately $1.3 million and$1.4 million, respectively.  Of thoseamounts, approximately $0.7 million and $0.8 million related to theinternational operations, respectively. The Company anticipates additional capital expenditures in fiscal 2005for infrastructure as it continues to expand and improve operating facilities,telecommunications systems and management information systems in order tohandle future operations of both its U.S. and international operations.

 

***Financing activities.***  During the quarters ended April 2, 2005and April 3, 2004, net cash (used in) provided by financing activities wasapproximately ($6.3 million) and $7.4 million, respectively.  In the first quarter of 2005, the Companypaid down its credit facility by approximately $6.0 million and made principalpayments on debt obligations and capital lease obligations of approximately$0.4 million.  In the first quarter of2004, the Company had net borrowings on its credit facility of approximately$15.6 million and made principal payments on debt obligations and capital leaseobligations of approximately $8.1 million.  In both the first quarters of fiscal 2005 and 2004, these amounts wereoffset by proceeds from the exercise of common stock options.

 

At April 2, 2005, the Company had an unsecured, non-interest bearing note to ClearLab International’s chief technology officer with a principal balance of SGD$1,750,000 (USD$1,060,000). The note payable is discounted at 7%.  Payments are due in equal monthly installments through July 2007.

 

At April 2, 2005 the Company had a termloan payable to a Singapore bank with a principal balance of SGD$7,110,000(USD$4,306,000) that bears interest at 6.75% and is secured by substantiallyall of the assets of ClearLab International. Interest payments are due monthly. Principal payments are due in monthly installments through December 2007.  This note also contains various financialcovenants including minimums on net worth and shareholders’ funds.  As of April 2,2005, the Company was in compliance with these covenants.  1-800 CONTACTS, INC. has guaranteed this termloan.

 

At April 2, 2005, the Company also had anote payable to the former parent of ClearLab International with a principalbalance of SGD$6,892,000 (USD$4,175,000) that bears interest at 6% and has asubordinated position to the term loan payable to the Singapore bank.  The note payable is discounted at 7%.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed thisnote.

 

The Company leasesvarious manufacturing and other equipment from financing companies undercapital lease arrangements.  All of theequipment is maintained at the Singapore and United Kingdom facilities.  The majority of the leases were assumed inconnection with the Company’s acquisitions of ClearLab International andClearLab UK.  As of April 2, 2005, the present value offuture minimum lease payments was approximately $0.1 million with paymentsscheduled through fiscal 2009.

 

**Contractual Obligations andCommitments**

 

Subsequent to January 1,2005, there have been no material changes to the Company’s contractualobligations and commitments, outside the normal course of business.

 

**New Accounting Pronouncements**

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”),which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”)and supercedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees.” SFAS 123R requires all share-based payments to

 

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employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values beginning with the first annual periodafter January 1, 2006, with early adoption encouraged. The pro formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. The Company is required toadopt SFAS 123R in the first fiscal quarter 2006, beginning January 1,2006. Under SFAS 123R, the Company must determine the appropriate fairvalue model to be used for valuing share-based payments, the amortizationmethod for compensation cost and the transition method to be used at date ofadoption. The transition methods include prospective and retroactive adoptionoptions. Under the retroactive option, prior periods may be restated either asof the beginning of the year of adoption or for all periods presented. Theprospective method requires that compensation expense be recorded for allunvested stock options at the beginning of the first quarter of adoption ofSFAS 123R, while the retroactive methods would record compensation expensefor all unvested stock options beginning with the first period restated. TheCompany is evaluating the requirements of SFAS 123R and expects that theadoption of SFAS 123R will have a material impact on its consolidatedresults of operations and earnings per share. The Company has not yetdetermined the method of adoption or the effect of adopting SFAS 123R.

 

**Critical Accounting Policies**

 

Accounting polices thatrequire significant judgments and estimates include revenue recognition(including sales returns and allowances and customer rebates); realizability ofinventories; realizability of deferred income tax assets; accounting forbusiness combinations including assessment of realizability of long-livedassets; stock-based compensation; and legal and regulatory contingencies.  A description of the Company’s significantaccounting policies is included in the notes to the consolidated financialstatements included in the Company’s Form 10-K for the fiscal year ended January 1,2005.  Judgments and estimates are basedon historical experience as well as relevant facts and circumstances known ateach reporting date.  Actual results maydiffer from these estimates.

 

Sales are generallyrecognized when products are shipped and the customer takes ownership andassumes risk of loss, collection of the related receivable is probable, persuasiveevidence of an arrangement exists and the sales price is fixed ordeterminable.  U.S. Retail net salesconsist of product sales less a provision for sales returns and allowances andestimated customer rebates.  The Companyaccrues an estimated amount for unclaimed customer rebates and sales returnsand allowances based on historical information, adjusted for economictrends.  To the extent actual rebates,returns and allowances vary from historical experience; revisions to theallowances may be required.  ClearLab netsales consist of product sales less a provision for sales returns andallowances. The Company provides its customers with standard industry paymentterms and performs ongoing credit evaluations of its customers and provides fordoubtful accounts to the extent determined necessary based on historical dataand current economic trends.  ClearLabnet sales also include license fees from the Company’s Japanese licenseagreement.  Cash payments received fromthis license are recognized systematically over the periods that the fees areearned by the Company.

 

In assessing therealizability of inventories, the Company makes judgments as to future demandrequirements and product expiration dates. The inventory requirements change based on projected customer demand,which changes due to fluctuations in market conditions and product life cycles.

 

The Company hassignificant long-lived tangible and intangible assets consisting of property,plant and equipment, goodwill and definite-lived intangibles.  These assets are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountsof such assets may not be recoverable. In addition, the Company performs an impairment test related to goodwillat least annually.  An impairmentanalysis related to long-lived tangible and definite-lived intangible assetsrequires the assessment of expected future undiscounted cash flows over theremaining useful life of the asset.  Animpairment analysis of goodwill requires the use of a fair-value basedanalysis.  All of the goodwill and asignificant portion of the other long-lived assets were generated from theCompany’s acquisitions of ClearLab International, ClearLab UK and Lens1st/LensExpress.  If forecasts and assumptionsused to support the realizability of long-lived assets change in the future,significant impairment charges could result that would adversely affect theCompany’s results of operations and financial position.

 

Deferred income taxassets are assessed for recoverability and valuation allowances are provided asnecessary to reduce deferred income tax assets to amounts expected to berealized.  Should expectations of taxableincome change in future periods, it may become necessary to change thevaluation allowance, which could affect the

 

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Company’s results ofoperations in the period such determination is made.  The Company records an income tax provisionor benefit at a rate that is based on expected results for the fiscalyear.  If future changes in marketconditions cause actual results to be more or less favorable, adjustments tothe effective income tax rate on a quarterly basis could be required.

 

The Company recordsliabilities for legal and regulatory matters when the contingency is bothprobable and reasonably estimable.  TheCompany is involved in several legal and regulatory matters.  The Company, after consultation with legalcounsel, believes that the ultimate dispositions of these matters will not havea material impact on its financial position, liquidity or results ofoperations.  However, there can be noassurance that the Company will be successful in its efforts to satisfactorilyresolve these matters and the ultimate outcome could result in a material negativeimpact on the Company’s financial position, liquidity or results of operations.

 

**Forward-Looking Statements**

 

Except for the historicalinformation contained herein, the matters discussed in this Form 10-Q areforward-looking statements within the meaning of Section 21E of theSecurities Exchange Act of 1934, as amended, and Section 27A of theSecurities Act of 1933, as amended. These forward-looking statements involve risks and uncertainties andoften depend on assumptions, data or methods that may be incorrect orimprecise.  The Company’s futureoperating results may differ materially from the results discussed in, orimplied by, forward-looking statements made by the Company.  Factors that may cause such differencesinclude, but are not limited to, those discussed below and the other risksdetailed in the Company’s other reports filed with the Securities and ExchangeCommission.  Words such as “believes,” “anticipates,”“expects,” “future,” “intends,” “would,” “may,” and similar expressions are intendedto identify forward-looking statements. The Company undertakes no obligation to revise any of theseforward-looking statements to reflect events or circumstances after the datehereof.

 

*Factors That May AffectFuture Results*

 

•                                          TheCompany may encounter unforeseen difficulties in managing its future growth;

 

•                                          Asignificant portion of the Company’s sales may be found not to comply withstate laws and regulations concerning the delivery and sale of contact lenses;

 

•                                          Becausethe Company does not manufacture most of the contact lenses that it sells, theCompany cannot ensure that all of the contact lenses it sells meet all federalregulatory requirements;

 

•                                          Itis possible that the FDA could consider certain of the contact lenses theCompany sells to be misbranded or adulterated;

 

•                                          TheCompany, through a wholly owned subsidiary, is registered as an initialdistributor/importer with the FDA.  TheCompany’s failure to comply with certain regulatory responsibilities andrequirements could result in enforcement by the FDA;

 

•                                          TheCompany currently purchases a portion of its products from unauthorizeddistributors and is not an authorized distributor for some of the products thatit sells;

 

•                                          TheCompany obtains a large percentage of its retail inventory from a limitednumber of suppliers, with a single manufacturer accounting for 35%, 23% and 44%of the Company’s inventory purchases in fiscal 2002, 2003 and 2004,respectively.  In addition, the Company’stop three suppliers accounted for 63%, 59% and 83% of the Company’s inventorypurchased in fiscal 2002, 2003 and 2004, respectively;

 

•                                          TheCompany may continue to incur significant legal and professional fees relatedto its legal matters and its efforts to proactively influence the industry onbehalf of itself and consumers;

 

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•                                          TheCompany’s quarterly results are likely to vary based upon the level of salesand marketing activity in any particular quarter;

 

•                                          TheCompany is dependent on its telephone, Internet and management informationsystems for the sale and distribution of contact lenses;

 

•                                          Theretail sale of contact lenses is highly competitive; certain of the Company’scompetitors are large, national optical chains that have greater resources thanthe Company;

 

•                                          Thedemand for contact lenses could be substantially reduced if alternativetechnologies to permanently correct vision gain in popularity;

 

•                                          TheCompany does not have any property rights in the 1-800 CONTACTS telephonenumber or the Internet addresses that it uses;

 

•                                          Increasesin the cost of shipping, postage or credit card processing could harm theCompany’s business;

 

•                                          TheCompany’s business could be harmed if it is required to collect state sales taxon the sale of all products;

 

•                                          TheCompany faces an inherent risk of exposure to product liability claims in theevent that the use of the products it manufacturers or sells results inpersonal injury;

 

•                                          TheCompany conducts its retail operations through a single distribution facility;

 

•                                          TheCompany’s success is dependent, in part, on continued use of the Internet;

 

•                                          Governmentregulation and legal uncertainties relating to the Internet and online commercecould negatively impact the Company’s business operations;

 

•                                          Changingtechnology could adversely affect the operation of the Company’s website;

 

•                                          TheCompany may not be able to develop and manufacture viable, high quality contactlenses for sale to consumers that meets all federal regulatory requirements;

 

•                                          TheCompany may not be able to fully integrate the operations of its acquisitionsinto its business;

 

•                                          Consumeracceptance of the Company’s manufactured products may not meet the Company’sexpectations;

 

•                                          TheCompany’s intellectual property rights may be challenged;

 

•                                          TheCompany may encounter legal, regulatory and government agency oversight riskswith foreign operations;

 

•                                          TheCompany may not be able to establish a sufficient network of eye carepractitioners to prescribe the products manufactured by the Company;

 

•                                          TheCompany may not be able to adequately manage its foreign currency risk;

 

•                                          TheCompany may incur unforeseen costs or not realize all of the anticipatedbenefits from its relationships with Johnson & Johnson Vision Care,CIBA Vision and Menicon;

 

•                                          TheCompany may be required to reduce the carrying value of its intangible assetsif events and circumstances indicate the remaining balance of intangible assetsmay not be recoverable;

 

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•                                          TheCompany may incur an increase in order cancellations due to the prescriptionverification requirements of the Fairness to Contact Lens Consumers Act;

 

•                                          TheCompany may not be able to complete its milestones and obligations in a timelymanner under the Japanese license agreement; and

 

•                                          TheCompany may not receive the amount of license fees and royalties that itpresently anticipates under the Japanese license agreement.

 

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***Item3.******   Quantitativeand Qualitative Disclosures About Market Risk***

 

***Interest RateRisk.***** **As of April 2, 2005, the Company was exposed to changes in interestrates relating to its renewed credit facility and other debt obligations.  The renewed credit facility bears interest ata variable rate based on the U.S. prime rate or LIBOR. The Company’soutstanding borrowings on the credit facility, including bank overdrafts, wereapproximately $8.4 million as of April 2, 2005. The remainder of theCompany’s interest bearing debt obligations, including capital leaseobligations, is denominated in Singapore dollars and British pounds and bearsinterest at a fixed rate.  As of April 2,2005, the face amounts of the outstanding borrowings on these fixed rate debtobligations were approximately $8.6 million.  Ifinterest rates were to change by a full percentage point, the net impact oninterest expense would be approximately $0.1 million per year.

 

***Foreign Currency Risk.***  The Company faces foreign currency risksprimarily as a result of its acquired Singapore and United Kingdom operationsand the intercompany balances between its U.S. and these internationaloperations which are denominated in U.S. dollars.  The functional currency of the Company’sSingapore operations is the Singapore dollar. The Company has debt and other long-term obligations of approximately$9.6 million that are denominated in Singapore dollars and mature over the nextfive years.  Fluctuations in exchangerates between the U.S. dollar and the Singapore dollar could lead to additionalcurrency exchange losses or gains on the intercompany balances and transactionsdenominated in currencies other than the functional currency. For the firstquarter of fiscal 2005, the Company recorded a foreign currency transactionloss of approximately $0.1 million on the intercompany balances between theU.S. and Singapore operations.  If theU.S. dollar weakens relative to the Singapore dollar, additional funds may berequired to meet these obligations if the debt cannot be adequately servicedfrom the Singapore operations.  From thedate of the ClearLab International acquisition, July 24, 2002, through May 4,2005 the exchange rate has fluctuated approximately 6.5 percent (weakening ofthe U.S. dollar).   If the Singaporedollar were to weaken against the U.S. dollar by 10 percent, the Company wouldrecord a $1.8 million dollar foreign currency loss on the intercompany balancesthat exist as of April 2, 2005.

 

The functional currency of the Company’s UnitedKingdom operations is the British pound. Fluctuations in exchange rates between the U.S. dollar and the Britishpound could lead to currency exchange losses or gains on any intercompanybalances and transactions denominated in currencies other than the functionalcurrency.  For the first quarter offiscal 2005, the Company recorded a foreign currency transaction loss ofapproximately $0.2 million on the intercompany balances between the U.S. andUnited Kingdom operations.  From the dateof the ClearLab UK acquisition, February 24, 2004, through May 4,2005, the exchange rate has fluctuated approximately 1.4 percent (weakening ofthe U.S. dollar).  If the British poundwere to weaken against the U.S. dollar by 10 percent, the Company would recorda $0.9 million dollar foreign currency loss on the intercompany balances thatexist as of April 2, 2005.

 

The Company has not entered into any foreign currencyderivative financial instruments; however, it may choose to do so in the futurein an effort to manage or hedge its foreign currency risk.

 

**Item 4.****   *****Controls and Procedures***

 

***(a) Evaluation of disclosure controls andprocedures*.**  TheCompany’s Chief Executive Officer and Chief Financial Officer, after evaluatingthe effectiveness of the Company’s disclosure controls and procedures (asdefined in Exchange Act Rules 13a-14 and 15d-14) as of the end of theperiod covered by this report (the “Evaluation Date”), have concluded that, asof the Evaluation Date, the Company’s disclosure controls and procedures wereadequate and effective to ensure that material information relating to theCompany and its consolidated subsidiaries would be made known to them by otherswithin those entities.

 

***(b) Changes in internal controls.***  There were no significant changes in theCompany’s internal controls or in other factors that could significantly affectthe Company’s disclosure controls and procedures subsequent to the EvaluationDate.  As a result, no corrective actionswere taken.

 

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The Company’s management,including its Chief Executive Officer and Chief Financial Officer, does notexpect that the Company’s disclosure controls and procedures or its internalcontrols will prevent all error and all fraud. A control system, no matter howwell conceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the control system are met. Further, the design of acontrol system must reflect the fact that there are resource constraints, andthe benefits of controls must be considered relative to their costs. Because ofthe inherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the Company have been detected.

 

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**PART II.****                OTHERINFORMATION**

 

**Item 1.****                                                        *Legal Proceedings***

 

See notes to condensed consolidated financial statements.

 

**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***

 

None.

 

**Item 5.****                                                        *Other Information***

 

From time to time theCompany receives notices, inquiries, or other correspondence from states orother regulatory bodies charged with overseeing the sale of contactlenses.  The Company’s practice is toreview such notices with legal counsel to determine the appropriate response ona case-by-case basis.  It is the opinionof management, after discussion with legal counsel, that the Company is takingthe appropriate steps to address the various notices received.

 

**Item 6.****                   Exhibits**

 

**(A) Exhibits**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                             |
|----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|
| 3.1 (i)              |       | Restated Certificate of  Incorporation of the Company. (1)                                                                             |
| 3.1 (ii)             |       | Restated By-Laws of the  Company. (1)                                                                                                  |
| 4.1                  |       | Form of  certificate representing shares of Common Stock, $0.1 par value per share.  (2)                                          |
| 10.1                 |       | Sublease agreement  between the Company and UCN, Inc., dated March 2, 2005, with  respect to the Company’s call center. |
| 31.1                 |       | Certification Required  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                |
| 31.2                 |       | Certification Required  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                |
| 32.1                 |       | Certification Required  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                |
| 32.2                 |       | Certification Required  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                |

 

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(1)                                  Incorporatedby reference to the Company’s Quarterly Report on Form 10-Q for thequarterly period ended April 4, 1998 (Commission File No. 0-23633).

 

(2)                                  Incorporatedby reference to the same numbered exhibit to the Company’s RegistrationStatement on Form S-1 (Registration No. 333-41055).

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
| ** **                | **1-800 CONTACTS, INC.** |
|---------------------------|--------------------------|
|                      |                     |   |
|                      |                     |   |
| Dated: May 12,  2005 | By:                      | /s/ Jonathan C. Coon |   |
|                      | Name:                    | Jonathan C. Coon |
|                      | Title:                   | Chief Executive Officer |
|                      |                     |   |
|                      | By:                      | /s/ Brian W. Bethers |   |
|                      | Name:                    | Brian W. Bethers |
|                      | Title:                   | President and Chief  Financial Officer |
|                           |                          |  |  |  |

 

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