**UNITEDSTATESSECURITIES 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 3, 2004** |
|           |   |   |
| **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** |

 

**1-800CONTACTS, INC.**

(Exact name of registrantas 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, 3rd  Floor  Draper, UT**           |   | **84020**                             |
| (Address of  principal executive offices)                        |   | (Zip Code)                            |
|                                                             |   |                                  |
| **(801) 924-9800**                                               |
| (Registrant’s  telephone number, including area code)       |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.

ý Yes        o No

 

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

ý Yes        o No

 

As of May 5, 2004, theRegistrant had 13,285,501 shares of Common Stock, par value $0.01 per share,outstanding.

 

 

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**1-800 CONTACTS, INC.**

 

**INDEX**

 
| **PART I.**                              | **FINANCIAL INFORMATION**                                                                                           |   |
|------------------------------------------|---------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.  Financial  Statements |                                                                                                                |
|                                     | Condensed  Consolidated Balance Sheets as of January 3, 2004 and  April 3, 2004                           |   |
|                                     | Condensed  Consolidated Statements of Operations for the Quarters Ended  March 29, 2003 and April 3, 2004 |   |
|                                     | Condensed  Consolidated Statements of Cash Flows for the Quarters Ended  March 29, 2003 and April 3, 2004 |   |
|                                     | 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.                                  | Changes in  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 and Reports  on Form 8-K                                                                                   |   |

 

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**PART 1.  FINANCIAL INFORMATION**

**Item1.  Financial Statements**

 

**1-800 CONTACTS, INC.CONDENSED CONSOLIDATED BALANCESHEETS(in thousands)(unaudited)**
|                                                       |   | **January 3,  2004** |   | **April 3,  2004** |   |
|------------------------------------------------------------|--------|---------------------------|--------|-------------------------|--------|
| **ASSETS**                                                 |   |                      |   |                    |   |
| CURRENT  ASSETS:                                           |   |                      |   |                    |   |
| Cash                                                       |   | $                         | 1,075  |                    | $      | 957 |   |
| Accounts  receivable                                       |   | 944                       |   | 1,160                   |   |
| Inventories,  net                                          |   | 24,127                    |   | 26,574                  |   |
| Prepaid  income taxes                                      |   | 797                       |   | 797                     |   |
| Deferred  income taxes                                     |   | 548                       |   | 1,023                   |   |
| Other  current assets                                      |   | 1,752                     |   | 2,932                   |   |
| Total  current assets                                      |   | 29,243                    |   | 33,443                  |   |
| PROPERTY  AND EQUIPMENT, net                               |   | 13,183                    |   | 16,518                  |   |
| DEFERRED  INCOME TAX ASSETS                                |   | 710                       |   | 804                     |   |
| GOODWILL                                                   |   | 33,853                    |   | 33,990                  |   |
| DEFINITE-LIVED  INTANGIBLE ASSETS, net                     |   | 9,207                     |   | 17,113                  |   |
| OTHER  ASSETS                                              |   | 735                       |   | 672                     |   |
| Total  assets                                              |   | $                         | 86,931 |                    | $      | 102,540 |   |
|                                                       |   |                      |   |                    |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**             |   |                      |   |                    |   |
| CURRENT  LIABILITIES:                                      |   |                      |   |                    |   |
| Current  portion of long-term debt                         |   | 3,381                     |   | 1,122                   |   |
| Current  portion of capital lease obligations              |   | 191                       |   | 176                     |   |
| Accounts  payable                                          |   | 8,558                     |   | 9,668                   |   |
| Accrued  liabilities                                       |   | 4,847                     |   | 7,071                   |   |
| Total  current liabilities                                 |   | 16,977                    |   | 18,037                  |   |
| LONG-TERM  LIABILITIES:                                    |   |                      |   |                    |   |
| Line  of credit                                            |   | —                    |   | 15,555                  |   |
| Long-term  debt, less current portion                      |   | 14,683                    |   | 9,114                   |   |
| Capital  lease obligations, less current portion           |   | 64                        |   | 127                     |   |
| Deferred  income tax liabilities                           |   | —                    |   | 3,324                   |   |
| Total  long-term liabilities                               |   | 14,747                    |   | 28,120                  |   |
| STOCKHOLDERS’  EQUITY:                                |   |                      |   |                    |   |
| Common  stock, 13,113 and 13,285 outstanding, respectively |   | 131                       |   | 133                     |   |
| Additional  paid-in capital                                |   | 42,346                    |   | 45,749                  |   |
| Retained  earnings                                         |   | 12,834                    |   | 10,628                  |   |
| Accumulated  other comprehensive loss                      |   | (104                      | )      | (127                    | )      |
| Total  stockholders’ equity                           |   | 55,207                    |   | 56,383                  |   |
| Total  liabilities and stockholders’ equity           |   | $                         | 86,931 |                    | $      | 102,540 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPE****RATIONS**

**(inthousands, except per share amounts)**

**(unaudited)**

 
|                                               |   | **Quarter  Ended**       |   |
|----------------------------------------------------|--------|--------------------------|--------|
|                                               |   | **March 29,  2003** |   | **April 3,  2004** |   |
| NET  SALES                                         |   | $                        | 46,662 |   | $ | 50,849 |   |
| COST  OF GOODS SOLD                                |   | 30,560                   |   | 31,553 |   |
| Gross  profit                                      |   | 16,102                   |   | 19,296 |   |
|                                               |   |                     |   |   |   |
| OPERATING  EXPENSES:                               |   |                     |   |   |   |
| Advertising                                        |   | 3,794                    |   | 8,815 |   |
| Legal  and professional                            |   | 1,621                    |   | 1,840 |   |
| Research  and development                          |   | 1,803                    |   | 892 |   |
| Purchased  in-process research and development     |   | —                   |   | 83 |   |
| Other  operating                                   |   | 8,649                    |   | 9,882 |   |
| Total  operating expenses                          |   | 15,867                   |   | 21,512 |   |
| INCOME  (LOSS) FROM OPERATIONS                     |   | 235                      |   | (2,216 | ) |
| OTHER  EXPENSE, net                                |   | (500                     | )      | (356 | ) |
| LOSS  BEFORE BENEFIT (PROVISION)  FOR INCOME TAXES |   | (265                     | )      | (2,572 | ) |
| BENEFIT  (PROVISION) FOR INCOME TAXES              |   | (223                     | )      | 366 |   |
| NET  LOSS                                          |   | $                        | (488   | ) | $ | (2,206 | ) |
|                                               |   |                     |   |   |   |
| PER  SHARE INFORMATION:                            |   |                     |   |   |   |
| Basic  and diluted net loss per common share       |   | $                        | (0.04  | ) | $ | (0.17 | ) |

 

See accompanyingnotes to condensed consolidated financial statements.

 

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CAS****H FLOWS**

**(unaudited)**

**(in thousands)**

 
|                                                                                       |   | **Quarter  Ended**       |   |
|--------------------------------------------------------------------------------------------|--------|--------------------------|--------|
|                                                                                       |   | **March 29,  2003** |   | **April 3,  2004** |   |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                     |   |                     |   |   |   |
| Net loss                                                                                   |   | $                        | (488   | ) | $ | (2,206 | ) |
| Adjustments  to reconcile net loss to net cash provided by (used in) operating activities: |   |                     |   |   |   |
| Depreciation  and amortization                                                             |   | 1,407                    |   | 1,676 |   |
| Amortization  of debt issuance costs and discounts                                         |   | 40                       |   | 147 |   |
| Purchased  in-process research and development                                             |   | —                   |   | 83 |   |
| Unrealized  foreign currency exchange loss (gain)                                          |   | 137                      |   | (77 | ) |
| Loss  on disposal of property and equipment                                                |   | 6                        |   | 73 |   |
| Deferred  income taxes, net of effects of acquisition                                      |   | (172                     | )      | (366 | ) |
| Changes  in operating assets and liabilities, net of effects of acquisitions:              |   |                     |   |   |   |
| Inventories                                                                                |   | 5,605                    |   | (2,051 | ) |
| Other  current assets                                                                      |   | (760                     | )      | (831 | ) |
| Accounts  receivable                                                                       |   | (88                      | )      | (190 | ) |
| Accounts  payable                                                                          |   | (3,038                   | )      | 318 |   |
| Accrued  liabilities                                                                       |   | 2,912                    |   | 1,627 |   |
| Income  taxes payable / prepaid income taxes                                               |   | 395                      |   | — |   |
| Net  cash provided by (used in) operating activities                                       |   | 5,956                    |   | (1,797 | ) |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                     |   |                     |   |   |   |
| Purchase  of property and equipment                                                        |   | (732                     | )      | (1,381 | ) |
| Proceeds  from sale of property and equipment                                              |   | 33                       |   | — |   |
| Purchase  of intangible assets                                                             |   | (23                      | )      | (692 | ) |
| Cash  paid for acquisitions                                                                |   | (6,904                   | )      | (3,776 | ) |
| Deposits  and other                                                                        |   | (379                     | )      | 109 |   |
| Net  cash used in investing activities                                                     |   | $                        | (8,005 | ) | $ | (5,740 | ) |

 

5

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|                                             |   | **Quarter  Ended**       |   |
|--------------------------------------------------|--------|--------------------------|--------|
|                                             |   | **March 29,  2003** |   | **April 3,  2004** |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:           |   |                     |   |   |   |
| Proceeds  from exercise of common stock options  |   | $                        | 439    |   | $ | 123 |   |
| Net  borrowings on line of credit                |   | 2,765                    |   | 15,555 |   |
| Principal  payments on capital lease obligations |   | (109                     | )      | (82 | ) |
| Debt  issuance costs                             |   | —                   |   | (179 | ) |
| Principal  payments on long-term debt            |   | (745                     | )      | (7,983 | ) |
| Net  cash provided by financing activities       |   | 2,350                    |   | 7,434 |   |
| EFFECT  OF FOREIGN EXCHANGE RATES ON CASH        |   | (6                       | )      | (15 | ) |
| NET  INCREASE (DECREASE) IN CASH                 |   | 295                      |   | (118 | ) |
| CASH  AT BEGINNING OF PERIOD                     |   | 259                      |   | 1,075 |   |
| CASH  AT END OF PERIOD                           |   | $                        | 554    |   | $ | 957 |   |
|                                             |   |                     |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:             |   |                     |   |   |   |
| Cash  paid for interest                          |   | $                        | 208    |   | $ | 264 |   |

 

SUPPLEMENTAL DISCLOSURESOF NONCASH INVESTING AND FINANCING ACTIVITIES:

 

During the first quarter of 2003, the Companypurchased certain assets and assumed certain liabilities of Lens Express andLens 1st.  The purchase considerationincluded cash of $6,904, common stock with a fair value of $19,859 and assumedoperating liabilities of $4,099 (see Note 6).

 

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 Note 6).

 

See accompanying notes to condensed consolidatedfinancial statements.

 

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**1-800CONTACTS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIA****L 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.  Certaininformation and disclosures normally included in financial statements preparedin accordance with accounting principles generally accepted in the UnitedStates of 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 3, 2004.

 

The results of operationsfor the 2004 interim period are not necessarily indicative of the results thatmay be expected for the full fiscal year 2004. On May 4, 2004, the Company announced its results of operations for thequarter ended April 3, 2004.  TheCompany announced basic and diluted net loss per common share of ($0.16) basedon a preliminary purchase price allocation to the underlying assets acquired inthe purchase of VisionTec (see Note 6). Subsequent to that announcement, the following modifications have beenmade to the Company’s financial position and results of operations (inthousands):

 
|                                         |   | **April 3,  2004** |   | **April 3,  2004**       |   |
|----------------------------------------------|--------|--------------------|--------|--------------------------|--------|
|                                         |   | **as  announced**  |   | **as  reported in 10-Q** |   |
| Deferred income  tax assets                  |   | $                  | 1,789  |                     | $      | 1,827 |   |
| Definite-lived  intangible assets, net       |   | 14,281             |   | 17,113                   |   |
| Deferred income  tax liabilities             |   | —             |   | 3,324                    |   |
| Stockholders’  equity                   |   | 56,415             |   | 56,383                   |   |
|                                         |   |               |   |                     |   |
| Loss from  operations                        |   | (2,268             | )      | (2,216                   | )      |
| Benefit for  income taxes                    |   | 451                |   | 366                      |   |
| Net loss                                     |   | (2,173             | )      | (2,206                   | )      |
| Basic and  diluted net loss per common share |   | $                  | (0.16  | )                        | $      | (0.17 | ) |

 

# **NOTE 2.  INVENTORIES**

# ** **

Inventories are recorded at the lower of cost (usingthe first-in, first-out method) or market.  Inventories consisted of the following (in thousands):

 
|                           |   | **January 3,  2004** |   | **April 3,  2004** |   |
|--------------------------------|--------|---------------------------|--------|-------------------------|--------|
| Purchased  contact lenses      |   | $                         | 20,943 |                    | $      | 22,445 |   |
| Manufactured  inventories:     |   |                      |   |                    |   |
| Raw  materials                 |   | 429                       |   | 570                     |   |
| Work  in process               |   | 2,681                     |   | 3,476                   |   |
| Finished  goods contact lenses |   | 74                        |   | 83                      |   |
| Total                          |   | $                         | 24,127 |                    | $      | 26,574 |   |

 

Provision is made to reduce excess and obsoleteinventories to their estimated net realizable values.  As of January 3, 2004 and April 3, 2004, reserves forexcess and obsolete inventories were $623,000 and $638,000, respectively.

 

**NOTE3.  NET INCOME (LOSS) PER COMMON SHARE**

 

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 or other common stock equivalents were exercisedor converted into common stock.  Thecomputation of Diluted EPS does not assume exercise or conversion of securitiesthat would have an antidilutive effect on net income (loss) per common share.For the quarters ended March 29, 2003 and April 3, 2004, options topurchase 1,207,482 and 1,400,481 shares of common stock were not included inthe computation of Diluted EPS 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 March 29, 2003** |   | **Quarter  Ended April 3, 2004** |   |
|-------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                    |   | **Net Loss**                           |   | **Shares**                            |   | **Per-Share  Amount** |   | **Net  Loss** |   | **Shares** |   | **Per-Share  Amount** |   |
|                    |   |                                   |   |                                  |   |   |   |   |   |   |   |   |   |
| Basic EPS               |   | $                                      | (488   | )                                     | 11,985 |   | $ | (0.04 | ) | $ | (2,206 | ) | 13,188 |   | $ | (0.17 | ) |
| Effect of stock options |   | —                                 |   | —                                |   | — |   | — |   | — |   | — |   |
| Diluted EPS             |   | $                                      | (488   | )                                     | 11,985 |   | $ | (0.04 | ) | $ | (2,206 | ) | 13,188 |   | $ | (0.17 | ) |

 

**NOTE 4.  COMPREHENSIVE LOSS**

 

Comprehensive lossfor the quarters ended March 29, 2003 and April 3, 2004 consists ofthe following components (in thousands):

 

 
|                                      |   | **Quarter  Ended**       |   |
|-------------------------------------------|--------|--------------------------|--------|
|                                      |   | **March 29,  2003** |   | **April 3,  2004** |   |
| Net  loss                                 |   | $                        | (488   | ) | $ | (2,206 | ) |
| Foreign  currency translation gain (loss) |   | 140                      |   | (22 | ) |
| Comprehensive  loss                       |   | $                        | (348   | ) | $ | (2,228 | ) |

 

The foreign currencytranslation gain (loss) results primarily from changes in exchange ratesrelative to the U.S. dollar from the translation of the Company’s Singapore andUnited Kingdom subsidiaries’ financial statements.

 

**NOTE 5.  STOCK-BASEDCOMPENSATION**

 

The Company appliesAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees,” 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.

 

UnderStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” compensation expense is recognized for the fair market valueof each option as estimated on the date of grant using the Black-Scholesoption-pricing model.  SFASNo. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,”amends SFAS No. 123, to provide alternative methods of transition for avoluntary change to the fair market value based method of accounting forstock-based employee compensation.  In

 

8

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addition, SFAS No. 148amends the disclosure requirements of SFAS No. 123 to require new prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. The Company has elected to adopt the “disclosureonly” provisions of SFAS No. 148.

 

If compensation expensefor all stock options had been determined consistent with SFAS No. 123, theCompany’s net loss and basic and diluted net loss per common share would havebeen as follows (in  thousands, exceptper share amounts):

 

9

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|                                          |   | **Quarter  Ended**       |   |
|-----------------------------------------------|--------|--------------------------|--------|
|                                          |   | **March 29,  2003** |   | **April 3,  2004** |   |
| Net  loss:                                    |   |                     |   |   |   |
| As  reported                                  |   | $                        | (488   | ) | $ | (2,206 | ) |
| Fair-value  based compensation, net of tax    |   | (278                     | )      | (416 | ) |
| Pro  forma                                    |   | $                        | (766   | ) | $ | (2,622 | ) |
|                                          |   |                     |   |   |   |
| Basic  and diluted net loss per common share: |   |                     |   |   |   |
| As  reported                                  |   | $                        | (0.04  | ) | $ | (0.17 | ) |
| Pro  forma                                    |   | $                        | (0.06  | ) | $ | (0.20 | ) |

 

The weighted average pershare fair value of options granted during the quarters ended March 29,2003 and April 3, 2004 was $11.98 and $12.59, 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**       |   |
|--------------------------|--------|--------------------------|--------|
|                     |   | **March 29,  2003** |   | **April 3,  2004** |   |
| Risk-free  interest rate |   | 2.9                      | %      | 3.0 | % |
| Expected  dividend yield |   | 0.0                      | %      | 0.0 | % |
| Volatility               |   | 78.0                     | %      | 68.0 | % |
| Expected  life           |   | 5 years                  |   | 5 years |   |

 

**NOTE 6.  RECENTACQUISITIONS**

 

***Lens Express and Lens 1st***

 

On January 30, 2003,the Company completed the acquisition of certain assets and the assumption ofcertain liabilities of Lens Express LLC and Camelot Ventures/CJ, L.L.C. d/b/aLens 1st (collectively, the “Seller”), two leading U.S. mail order contact lensretailers. The assets acquired included databases, customer information, websites and Internet addresses or domain names, telephone numbers, certainspecified contracts and intellectual property rights. In addition, acquiredassets included certain property, equipment, inventories, receivables andprepaid expenses. With the exception of specifically identified liabilities,the Company did not assume the liabilities of the Seller. The liabilitiesassumed by the Company included certain of the Seller’s identified contracts,accounts payable, accrued liabilities, certain customer program obligations andseverance obligations as of January 30, 2003.

 

The consideration paid bythe Company consisted of approximately $7.0 million in cash (including$0.5 million in transaction costs), 900,000 shares of restricted common stockof the Company with a fair value of $19.9 million and the assumption ofapproximately $4.1 million of the aforementioned liabilities. The 900,000shares of restricted common stock were subject to a lock-up period of12 months after the acquisition date of January 30, 2003.  In connection with the acquisition, theCompany entered into a registration rights agreement granting the Sellercertain piggyback registration rights with respect to the 900,000 shares ofrestricted common stock.  The followingsets forth the consideration paid by the Company (in thousands, except pershare amounts):

 

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| Cash                                                |   | $      | 6,500  |   |
|-----------------------------------------------------|--------|--------|--------|--------|
| Restricted  shares (900 shares at $22.07 per share) |   | 19,859 |   |
| Acquisition  expenses                               |   | 512    |   |
| Accounts  payable                                   |   | 3,575  |   |
| Accrued  expenses                                   |   | 524    |   |
| Total  purchase consideration                       |   | $      | 30,970 |   |

 

For purposes of computingthe purchase price, the value of the restricted common stock was determined bytaking the average closing price of the Company’s common stock as quoted onNasdaq for the two days before, the day of and the two days following theannouncement of the signing of a letter of intent to acquire Lens Express andLens 1st.  This average price was thenreduced by a 15 percent discount (as determined by a third party appraisal) dueto the restriction provisions associated with the common shares issued.

 

The following table setsforth the allocation of the purchase price to the tangible and intangibleassets acquired (in thousands):

 
| Accounts  receivable    |   | $      | 178    |   |
|-------------------------|--------|--------|--------|--------|
| Inventories             |   | 2,740  |   |
| Other  assets           |   | 76     |   |
| Property  and equipment |   | 572    |   |
| Customer  databases     |   | 5,100  |   |
| Goodwill                |   | 22,304 |   |
| Total                   |   | $      | 30,970 |   |

 

The unaudited pro formainformation below sets forth summary results of operations as if theacquisition of Lens 1st and Lens Express (acquired January 30, 2003) hadtaken place at the beginning of fiscal 2003, after giving effect to certainadjustments, including amortization of intangibles, depreciation, interestexpense and other adjustments directly attributable to the transactions.  The following pro forma information for thefirst quarter of fiscal year 2003 has been prepared for comparative purposesonly and does not purport to be indicative of what would have occurred had theacquisitions occurred at the beginning of fiscal 2003 or of results which mayoccur in the future (in thousands, except per share amounts):

 
|                                         |   | **Quarter  Ended  March 29, 2003** |   |
|----------------------------------------------|--------|-----------------------------------------|--------|
|                                         |   |                                    |   |
| Net  sales                                   |   | $                                       | 50,072 |   |
| Net  loss                                    |   | (374                                    | )      |
| Basic  and diluted net loss per common share |   | $                                       | (0.03  | ) |

 

***VisionTec (subsequently renamed ClearLab UK)***

 

On March 13, 2003, the Companysigned a letter of intent with VisionTec, a developer and manufacturer ofcontact lenses based in the United Kingdom, and certain of itsshareholders.  The Company agreed to payVisionTec a non-refundable sum equal to $1.5 million to be used by the entityfor research and development activities relating to contact lenses.  Of the total, $0.7 million was paid onMarch 14, 2003, and the remaining $0.8 million was paid on June 13,2003.    In addition, the Company wasgranted a six-month option to either: (1) acquire all of the shares of commonstock of the entity; or, (2) acquire from the entity a worldwide license tomanufacture, market, sell or otherwise use or exploit specific technologydeveloped by the entity.  As considerationfor this option, the Company paid $0.1 million to VisionTec on March 14,2003.  In the event that the Company didnot exercise the option to 

 

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purchasethe shares of the VisionTec, the Company agreed to pay the entity an additional$0.8 million.  The Company alsoreimbursed VisionTec and its shareholders approximately $0.2 million for legaland financial expenses incurred by the entity in connection with the agreement.

 

On September 12, 2003, the Companyexercised the option to acquire all of the shares of common stock ofVisionTec.  During the period betweenSeptember 12, 2003 and the closing of the acquisition on February 24,2004, the Company continued to pay certain fees and expenses of the entityrelated to the entity’s research and development activities.   The Company paid approximately $2.1 millionto VisionTec from September 12, 2003 through January 3, 2004 and $0.5million from January 3, 2004 through February 24, 2004, for suchresearch and development activities.

 

In connection with the agreement, andthe transactions discussed above, the Company has expensed a total ofapproximately $3.9 million from March 13, 2003 through January 3,2004  (inclusive of the $0.2 million incosts) related to these research and development initiatives and $0.5 millionin the first quarter ended April 3, 2004.

 

On February 24, 2004, the Companycompleted the acquisition of the stock of VisionTec (subsequently renamedClearLab UK).  The transaction wasaccomplished as a purchase of all of the stock of the entity.  The consideration paid includedapproximately $3.8 million in cash (including $0.6 million in transactioncosts) and 155,084 shares of the Company’s common stock with a fair value ofapproximately $3.2 million.  Inaddition, the Company has agreed to pay a per unit royalty on sale of contactlenses to the former shareholders of VisionTec for a period of ten years.

 

The Company has agreed to file a registration statementwith the Securities and Exchange Commission (“SEC”) covering the resale ofthese shares by the former stockholders of VisionTec.

 

The following sets forth the consideration paid by theCompany (in thousands, except share amounts):

 
| Cash                                                     |   | $     | 3,200  |   |
|----------------------------------------------------------|--------|-------|--------|--------|
| Restricted  shares (155,084 shares at $20.634 per share) |   | 3,200 |   |
| Acquisition  expenses                                    |   | 576   |   |
| Total  purchase consideration                            |   | $     | 6,976  |   |

 

The following table sets forth the preliminary allocationof the purchase price to the net tangible and intangible assets acquired (inthousands):

 
| Current  assets                                 |   | $      | 629    |   |
|-------------------------------------------------|--------|--------|--------|--------|
| Property,  equipment and other long term assets |   | 2,914  |   |
| Core  technologies                              |   | 4,791  |   |
| Patent                                          |   | 3,355  |   |
| Purchased  in-process research and development  |   | 83     |   |
| Current  liabilities                            |   | (1,523 | )      |
| Deferred  income tax liability                  |   | (3,273 | )      |
| Total                                           |   | $      | 6,976  |   |

 

Core Technologies andpatents are definite-lived intangible assets that are being amortized overtwelve years.

 

**NOTE 7.  COMMON STOCKTRANSACTIONS**

 

During the quarter endedApril 3, 2004, employees exercised stock options to purchase 16,772 sharesof common stock for a total of approximately $123,000.  The Company recorded an increase inadditional paid-in capital of approximately $82,000 as a result of the incometax benefit related to these stock option exercises.

 

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During the quarterended April 3, 2004, the Company granted nonqualified stock options topurchase 105,978 shares of common stock to employees and directors of theCompany.  The exercise price of theoptions was $22.00 per share, which was not less than the quoted fair marketvalue at the grant date. The options vest equally over a four-year period andexpire in five years.

 

OnFebruary 24, 2004, the Company completed the acquisition of VisionTec andissued 155,084 shares of the Company’s common stock with a fair value ofapproximately $3.2 million (see Note 6). The restricted stock is required to be registered with the Securities and Exchange Commission (“SEC”) on FormS-3 or another form suitable for the registration of such stock under theSecurities Act.

 

**NOTE 8.  DEBT OBLIGATIONS**

 

EffectiveFebruary 27, 2004, the Company executed a restated loan agreement with itsexisting U.S. bank, providing for a revolving credit facility for borrowings ofup to $28 million through June 1, 2004, and reducing thereafter on thefirst day of each September, December, March and June by $0.4 millionuntil the maturity date of February 27, 2007.  Additionally, theagreement provides for letters of credit up to a maximum of $15 millionoutstanding or payable at any time.  If the maximum leverage ratio, asdefined in the restated loan agreement, is greater than 2.5, then the amountsoutstanding on the revolving credit facility together with the amount of alloutstanding letters of credit can at no time exceed the Company’s book value ofinventory. As of April 3, 2004, the Company was subject to thisrestriction and could only borrow up to $26.6 million, which is the book valueof its inventory as of April 3, 2004. Outstanding borrowings on the revolving credit facility bear interest ata floating rate equal to the lender’s prime interest rate plus a margin or thelender’s LIBOR rate plus a margin. Interest based on the lender’s prime rate is the prime rate plus 0.75 percentuntil July 31, 2004, and thereafter is adjusted quarterly, ranging betweenprime plus 0.0 percent and prime plus 1.25 percent, depending on the Company’smaximum leverage ratio.  Interest based on the lender’s LIBOR rate is theLIBOR rate for the applicable period plus 2.75 percent until July 31,2004, and thereafter is adjusted quarterly, ranging between LIBOR plus 2.0percent and LIBOR plus 3.25 percent, depending on the Company’s maximumleverage ratio.  Interest is payable monthly.  As of April 3, 2004 the Company’s outstanding borrowings onthe credit facility, including bank overdrafts, were $15.6 million.  Of this amount, $12.0 million bore interestat the lender’s LIBOR rate plus 2.75 percent (3.84% at April 3, 2004) andthe remaining $3.6 million bore interest at the lender’s prime rate plus 0.75percent (4.75% at April 3, 2004).  The facility requires the paymentof an unused credit fee which is also determined by the Company’s maximumleverage ratio.  The unused credit feeis payable quarterly at 0.5 percent until July 31, 2004, and thereafter isadjusted quarterly, ranging from 0.38 percent to 0.5 percent, depending on theCompany’s maximum leverage 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 in alldomestic subsidiaries and 65 percent ownership interests in foreignsubsidiaries directly owned by the Company.   The new loan agreementincludes various financial covenants including a capital expenditure limit, amaximum leverage ratio, a minimum working capital requirement, a minimum fixedcharge coverage ratio and a minimum net worth requirement.  The new loanagreement does not permit the Company or its subsidiaries to dissolve, sell,dispose or merge all of its assets or acquire all the assets of any entitywithout the written consent of the U.S. bank, unless the transaction meets thedefinition of a “Permitted Acquisition Basket”, as defined in theagreement.  The new loan agreement also places a limit on the amount theCompany can loan to any entity, outside the normal course of business. Additionally, the agreement does not permit the Company to declare or pay anycash dividends, to repurchase its stock or to perform other similar equity transactionsprior to December 31, 2005; thereafter, such transactions are subject toother terms.  This agreement defines several customary events of defaultincluding any material adverse change or any event that occurs which may causea material adverse change in the Company’s or its subsidiaries’condition.  This restated loan agreement succeeds and replaces theCompany’s prior loan agreement executed July 22, 2002.  Alloutstanding balances associated with the July 22, 2002 loan agreement werepaid with proceeds from this new loan agreement.

 

The Company’s Singaporebank term loan contains various financial covenants including minimums on networth and shareholders’ funds of the Singapore operations.   As of April 3, 2004, the Company wasin compliance with all applicable covenants. 1-800 CONTACTS, INC. has guaranteed this term loan.

 

 

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Cross defaultclauses exist such that if the Company were in default on its U.S. debt, theCompany would also be in default on its Singapore debt.  If the Company were in default on itsSingapore bank term loan, the Company would also be in default on its notepayable to the parent of IGEL and its restated loan agreement with its U.S. bank.

 

**NOTE 9.  COMMITMENTS AND CONTINGENCIES**

 

***Legal Matters***

 

The sale anddelivery of contact lenses are governed by both Federal and state laws andregulations, including the recently enacted federal Fairness to Contact LensConsumer Act (“FCLCA”).    The FCLCArequires that contact lenses only be sold to consumers based on a validprescription.  Satisfying thisprescription requirement obligates the seller either to obtain a copy of theprescription itself or to verify the prescription by direct communication withthe customer’s prescriber.  Consistentwith this requirement, the Company’s current operating practice is to requireall customers to provide either a valid copy of their prescription or thecontact information for their prescriber so that the Company can verify theirprescription by direct communication with their prescriber.  If the Company does not have a valid copy ofthe customer’s prescription, the Company directly communicates to thecustomer’s prescriber the precise prescription information received from thecustomer and informs the prescriber that it will proceed with the sale based onthis prescription information unless the prescriber advises it within eightbusiness 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 thecustomer’s order.  On the other hand, ifthe prescriber either advises the Company that the prescription is valid or failsto properly respond within the communicated time period, the Company’s practiceis to complete the sale based on the prescription information communicated tothe prescriber, as expressly permitted by the FCLCA.  The Company retains copies of the written prescriptions that itreceives and maintains records of its communications with the customer’sprescriber.

 

On April 7, 1999,the Kansas Board of Examiners in Optometry (“KBEO”) commenced a civil actionagainst the Company. The action was filed in the District Court of ShawneeCounty, Kansas, Division 6. The complaint was amended on May 28, 1999. Theamended complaint alleges that “on one or more occasions” the Company soldcontact lenses in the state of Kansas without receipt of a prescription. The amendedcomplaint seeks an order enjoining the Company from further engaging in thealleged activity. The amended complaint does not seek monetary damages. TheCompany filed an answer to the amended complaint and, at the request of theCourt, filed a motion for summary judgment. In November 2000, the Courtissued an order denying the summary judgment motion, finding that there werefactual issues regarding whether the KBEO can meet the requirements necessaryto obtain injunctive relief, and whether the Kansas law violates the CommerceClause of the United States Constitution. On June 18, 2002, the courtgranted a summary judgment motion in favor of the KBEO. However, the court madeno findings of any violations of Kansas law. Further, the court based itsdecision on a Kansas optometry law that has been repealed and amended by theKansas legislature. To preserve the issues for appeal, on July 2, 2002,the Company filed a motion to alter or amend judgment, asking the court toreverse its decision, and to enter summary judgment in favor of defendant, orto dismiss the KBEO’s lawsuit as moot based on the new law. The court deniedthe motion on September 12, 2002, finding that no new evidence had beenpresented to persuade the court to change its prior ruling. The court made nonew findings of fact and did not change its conclusions of law. OnOctober 11, 2002, the Company filed its Notice of Appeal with the KansasCourt of Appeals; the Docketing Statement was filed on October 30, 2002.All pleadings were timely filed and an oral argument was held onAugust 27, 2003. On November 7, 2003, the Kansas Court of Appealsreversed the trial court’s order that entered summary judgment in favor of theBoard. The Appellate court remanded the case back to the trial court for furtherproceedings. Thus, as a result of the Appellate court’s order, there was noinjunction against the Company as of November 7, 2003. Following receiptof the Appellate Court’s order, the parties each submitted proposed orders tothe trial court. The Board asked the court to re-enter summary judgment in itsfavor, and to reinstate the injunction. The Company asked the court to dismissthe case, based either on the lack of any basis for injunctive relief, orbecause the case is now moot based on changes to Kansas law which took effectwhile the case was pending on appeal, or based on the recent passage of theFCLCA which took effect on February 4, 2004.  By order dated April 30, 2004, the trial court reinstatedthe injunction prohibiting the Company from selling contact lenses without avalid prescription under

 

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K.S.A. 65-1504b unlessand until a determination is made that the Fairness to Contact Lens ConsumersAct (“FCLCA”) preempts its enforcement.  Since the FCLCA was enacted lastyear, the Company has continued to adhere to the prescription verificationprocedures set forth in this new federal law.  To the extent K.S.A.65-1504 continues to have any application at all, the Company believes that bycomplying with the FCLCA it does not run afoul of K.S.A. 65-1504 and thereforeintends to continue adhering to the prescription verification procedures setforth in the FCLCA.  The KBEO thus far has not contended thatK.S.A. 65-1504 can or does require the Company to employ anystricter prescription verification procedures than those set forth in theFCLCA.  However, should this change, the Company is preparedto vigorously contest any such claim or interpretation.

 

From time to time theCompany is involved in other legal matters generally incidental to itsbusiness.

 

It is the opinion ofmanagement, after consultation with legal counsel, that, except for legal andprofessional fees that the Company incurs from time to time, the ultimatedispositions of these matters will not have a material impact on the financialposition, liquidity, or results of operations of the Company.  However, there can be no assurance that theCompany will be successful in its efforts to satisfactorily resolve thesematters and the ultimate outcome could result in a material negative impact onthe Company’s financial position, liquidity, or results of operations.

 

***Advertising Commitments***

 

As of April 3, 2004,the Company had entered into certain noncancelable commitments with variousadvertising companies that will require the Company to pay approximately $12.8million for advertising during the remainder of 2004.

 

**NOTE10.  SEGMENT INFORMATION**

 

As a result of the acquisitionof IGEL (ClearLab International) in the third quarter of fiscal 2002 and therecently acquired VisionTec (ClearLab UK), the Company has two operatingsegments.  These operating segmentsrepresent components of the Company for which separate financial information isavailable and evaluated regularly by management in determining resourceallocation and performance assessment. The Company’s U.S. segment includes the operations of 1-800 CONTACTS andthe operations from the Lens Express and Lens 1st acquisitions.  The Company’s International segment includesthe operations of ClearLab International and ClearLab UK; both of which aredevelopers and manufacturers of contact lenses.  Operating segment information for the first quarter endedMarch 29, 2003 and April 3, 2004 is as follows (in thousands):

 
|                                          |   | **Quarter Ended**       |   |
|-----------------------------------------------|--------|-------------------------|--------|
|                                          |   | **March 29, 2003** |   | **April 3, 2004** |   |
|                                          |   | **U.S.**                |   | **International** |   | **Total** |   | **U.S.** |   | **International** |   | **Total** |   |
| Net sales                                     |   | $                       | 45,131 |   | $ | 1,531 |   | $ | 46,662 |   | $ | 49,451 |   | $ | 1,398 |   | $ | 50,849 |   |
| Gross profit                                  |   | 15,748                  |   | 354 |   | 16,102 |   | 18,930 |   | 366 |   | 19,296 |   |
| Purchased in-process research and development |   | —                  |   | — |   | — |   | — |   | 83 |   | 83 |   |
| Income (loss) from operations                 |   | 611                     |   | (376 | ) | 235 |   | (1,149 | ) | (1,067 | ) | (2,216 | ) |
|                                               |        |                         |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Identifiable segment assets areas follows (in thousands):

 
|                   |   | **January 3, 2004** |   | **April 3, 2004** |   |
|------------------------|--------|--------------------------|--------|------------------------|--------|
|                   |   | **U.S.**                 |   | **International**      |   | **Total** |   | **U.S.** |   | **International** |   | **Total** |   |
| Long-lived assets, net |   | $                        | 30,615 |                   | $      | 25,628 |   | $ | 56,243 |   | $ | 30,802 |   | $ | 36,819 |   | $ | 67,621 |   |
| Total assets           |   | 56,274                   |   | 30,657                 |   | 86,931 |   | 59,005 |   | 43,535 |   | 102,540 |   |
|                        |        |                          |        |                        |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 2.****           *Management’sDiscussion and Analysis of**Financial Condition and Results of Operations***

 

**Overview**

 

The Company is a leadingdirect marketer of replacement contact lenses and also conducts contact lensmanufacturing and development operations in Singapore and the United Kingdom.  The Company sells all of the popular brandsof contacts lenses, including those manufactured by Johnson & JohnsonVision Care, CIBA Vision, Bausch & Lomb, Ocular Sciences and CooperVision.

 

***International Operations (ClearLab)*.**  On July 24, 2002, the Company completedthe acquisition of certain net assets and the majority of the businessoperations of IGEL (subsequently renamed ClearLab International), a developerand manufacturer of contact lenses based in Singapore.  ClearLabInternational is the principal marketing organization for the Company’sinternational wholesale manufacturing business, focusing on the marketing ofcontact lens products to major retailers and distributors, as well as providingcontract manufacturing capacity for other contact lens manufacturers. ClearLab International manufactures a wide range of frequent replacementspherical and toric lenses and is focused on developing new lens materials.

 

On February 24,2004, the Company acquired VisionTec, a developer and manufacturer of dailycontact lenses based in the United Kingdom.  VisionTec has developed amethod for low cost, high quality production of daily disposable contact lensesusing a unique proprietary material.  VisionTec has subsequently beenrenamed ClearLab UK Ltd (“ClearLab UK”).  The business will operate as aresearch and development and a manufacturing affiliate of ClearLabInternational.  The Company has recently completed the testing of ClearLabUK’s manufacturing capabilities, shipped its first daily disposable contactlenses and is currently expanding its production capabilities.  The Company will increase its productofferings to the international markets throughout fiscal 2004 from itsproduction facilities in Singapore and in the U.K.

 

ClearLab International’sand ClearLab UK’s development and manufacturing capabilities also provide theCompany with greater access to future contact lens products for the U.S. retailmarket.  This is critical to theCompany’s strategy should the Company’s access to contact lenses from the majorcontact lens manufacturers be disrupted, curtailed or otherwise negativelyimpacted, or if the manufacturers do not provide the Company with contactlenses at competitive pricing and with competitive marketing support.

 

***Johnson & Johnson Vision Care Agreement.***  In December 2002, the Company announcedthat it had reached an agreement with Johnson & Johnson Vision Care tobecome an authorized retailer of Johnson & Johnson Vision Care contactlenses.  The Company modified itsoperating systems in connection with this agreement. The Company implementednew prescription verification procedures for Johnson & Johnson Vision Careby geographic region based on time zone. The Company began this implementation in February 2003 andcompleted it in April 2003. The Company began buying direct from Johnson& Johnson Vision Care during March 2003.

 

This direct relationshipwith Johnson & Johnson Vision Care has lowered the Company’s productacquisition costs and allowed it to offer rebates and other incentives notpreviously available to its customers who wear Johnson & Johnson VisionCare lenses. The Company has also been able to reduce its inventory investmentby purchasing a more balanced mix of products at lower prices than it hashistorically been able to obtain through indirect sources. This agreement alsoresolved long-standing disputes.

 

***Cole NationalMarketing Agreement.*** On June 30, 2003, the Company and Cole National Corporation(“Cole”) announced that they had signed an agreement under which the Company’scustomers can receive discounted eye exams and value pricing on eyeglasses,sunglasses and other vision products that the Company does not sell from anetwork of doctors contracted with Cole Managed Vision and associated with morethan 1,500 Pearle Vision, Pearle VisionCare, Sears Optical and Target Opticalstores in the U.S.  Subsequent to thefirst fiscal quarter of 2004, the Company and Cole extended this agreementthrough March 31, 2005.  Under thisagreement, Cole is offering its network of doctors to the Company to be usedfor contacts lens exam referrals and the Company retains the contact lensbusiness of customers referred to Cole stores.

 

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As part of the agreement,the Company and Cole have also worked together on a variety of cross-marketingprograms and promotions of their respective products in select testmarkets.  The goal of thesecross-marketing programs is to find other ways that the Company and Cole canhelp create value together.

 

***Lens Express / Lens1st****.*  On January 30, 2003, the Companyacquired certain assets and assumed certain liabilities of Lens Express LLC andCamelot Ventures/CJ, L.L.C. d/b/a Lens 1st (collectively, the“Seller”), two leading U.S. mail order contact lens retailers. The assetsacquired included databases, customer information, web sites and Internetaddresses or domain names, telephone numbers, certain specified contracts andintellectual property rights. In addition, acquired assets included certainproperty, equipment, inventories, receivables and prepaid expenses. With theexception of specifically identified liabilities, the Company did not assumethe liabilities of the Seller. The liabilities assumed by the Company includedcertain of the Seller’s identified contracts, accounts payable, accruedliabilities, certain customer program obligations and severance obligations asof January 30, 2003.

 

During the first quarterof fiscal 2004, the Company completed the consolidation of a majority of theoperating facilities acquired from Lens 1st into its principaloperating facilities in Utah.

 

***Supplier Agreements.*** During the latterpart of 2003, the Company reached agreements with its top three vendors forimproved pricing and marketing support. This support will come in the form of cooperative marketing and rebateprograms designed to promote the manufacturer’s products and build sales.  As part of its ongoing relationship with itssuppliers, the Company periodically reviews its specific marketing plans andnegotiates cooperative marketing programs with these vendors.

 

# **Regulatory Considerations**

 

***Fairness to Contact Lens Consumer Act*.**  In November 2003, Congress passed theFairness to Contact Lens Consumer Act (“FCLCA”), which establishes a nationaluniform standard for both eye care practitioners and direct marketers withregard to releasing and verifying consumer contact lens prescriptions as wellas other requirements relating to the sale of contact lenses.  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 alsorequires all eye care practitioners to respond to direct marketers’ requests toverify consumer prescriptions and provides that their failure to respond withineight business hours shall result in the prescription being presumed valid,thereby eliminating the ability of eye care practitioners to impede sales bydirect marketers simply by ignoring or refusing to respond to their requests toverify prescriptions  The FCLCA alsoprovides that prescriptions will be valid for a minimum of at least one year(absent some special medical reason justifying a shorter period) and that the timefor expiration shall not begin to run until the eye care practitioner has giventhe patient a copy of his or her prescription. It also directs the Federal Trade Commission (“FTC”) topromulgate implementing rules and to conduct a study examining the strength ofcompetition in the market for contact lenses and to submit a report to Congresswithin twelve months. This FTC study will specifically address, among otherthings, the use of doctor exclusive brands (i.e., contact lenses available onlyfor sale from an eye care practitioner) and other practices that impedecompetition.

 

The FCLCA also requiresthat contact lenses only be sold to consumers based on a validprescription.  Satisfying thisprescription requirement obligates the seller either to obtain a copy of theprescription itself or to verify the prescription by direct communication withthe customer’s prescriber.  Consistentwith this requirement, the Company’s current operating practice is to requireall customers to provide either a valid copy of their prescription or thecontact information for their prescriber so that the Company can verify theirprescription by direct communication with their prescriber.  If the Company does not have a valid copy ofthe customer’s prescription, the Company directly communicates to thecustomer’s prescriber the precise prescription information received from thecustomer and informs the prescriber that it will proceed with the sale based onthis prescription information unless the prescriber advises it within eightbusiness 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 thecustomer’s order.  On the other hand, ifthe prescriber either advises the Company that the prescription is valid orfails to respond properly within the required time period, the Company’spractice is to complete the sale based on the prescription informationcommunicated to 

 

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the prescriber, asexpressly permitted by the FCLCA.  TheCompany retains copies of the written prescriptions that it receives andmaintains records of its communications with the customer’s prescriber.

 

Net sales for fiscal 2003and the first quarter of fiscal 2004 were negatively impacted by canceledorders due to the Company’s prescription verification procedures, including,most significantly, those implemented as part of the Johnson & JohnsonVision Care agreement in 2003, and the revisions to the Company’s prescriptionverification procedures made on February 4, 2004 in response to the FCLCA.The Company is taking steps to recover these canceled orders principally by offeringto its customers who do not hold a valid prescription for contact lensesreferrals for contact lens exams from a Cole doctor under the Coleagreement.  The Company is uncertain asto the ultimate impact its revised prescription verification procedures willhave on future net sales, and the Company is uncertain as to the number ofcanceled orders that can subsequently be recovered through its doctor networkreferral program with Cole.

 

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# **Results of Operations**

 

The Company’s fiscal yearconsists of a 52/53-week period ending on the Saturday nearest toDecember 31. Fiscal 2004 is a 52-week year and will end on January 1,2005.

 

The following tablepresents the Company’s results of operations expressed as a percentage of netsales for the periods indicated:
|                                               |   | **Quarter  Ended**       |   |
|----------------------------------------------------|--------|--------------------------|--------|
|                                               |   | **March 29,  2003** |   | **April 3,  2004** |   |
| NET  SALES                                         |   | 100.0                    | %      | 100.0 | % |
| COST  OF GOODS SOLD                                |   | 65.5                     |   | 62.0 |   |
| Gross  profit                                      |   | 34.5                     |   | 38.0 |   |
|                                               |   |                     |   |   |   |
| OPERATING  EXPENSES:                               |   |                     |   |   |   |
| Advertising                                        |   | 8.1                      |   | 17.3 |   |
| Legal  and professional                            |   | 3.5                      |   | 3.6 |   |
| Research  and development                          |   | 3.9                      |   | 1.8 |   |
| Purchased  in-process research and development     |   | —                   |   | 0.2 |   |
| Other  operating                                   |   | 18.5                     |   | 19.4 |   |
| Total  operating expenses                          |   | 34.0                     |   | 42.3 |   |
| INCOME  (LOSS) FROM OPERATIONS                     |   | 0.5                      |   | (4.3 | ) |
| OTHER  EXPENSE, net                                |   | (1.1                     | )      | (0.7 | ) |
| LOSS  BEFORE BENEFIT (PROVISION)  FOR INCOME TAXES |   | (0.6                     | )      | (5.0 | ) |
| BENEFIT  (PROVISION) FOR INCOME TAXES              |   | (0.5                     | )      | 0.7 |   |
| NET  LOSS                                          |   | (1.1                     | )%     | (4.3 | )% |

 

***Net sales***.  Net sales for the quarter ended April 3, 2004 increased 9% to$50.8 million from $46.7 million for the quarter ended March 29,2003.  Net sales, exclusive of theCompany’s international operations (ClearLab), for the first quarter of fiscal2004 were $49.4 million compared to $45.2 million for the first quarter offiscal 2003.  The increase in net salesis mainly due to increased advertising and manufacturer rebate programsinstituted during the quarter for select products.  Net sales were negatively impacted by more than $10 million dueto a substantial increase in the number and percentage of orders the Companycanceled as a result of the prescription verification procedures implemented aspart of the Johnson & Johnson Vision Care agreement during the periodFebruary through April 2003 and the revisions to the Company’sprescription verification procedures instituted on February 4, 2004 incompliance with the FCLCA (see “Federal Regulation”).  The Company’s cancellation rate after implementation of the newverification system was approximately 20% versus the 17% the Companyanticipated.

 

The Company has takensteps to minimize these canceled orders, including continued development of adoctor network through the Cole agreement and the establishment of a doctornetwork department to help obtain the necessary prescription information thatis required to complete an order.  TheCompany is uncertain of the ultimate long-term impact that these prescriptionverification procedures required by the new FCLCA and the Company’s efforts torecover the canceled sales will have on future net sales.

 

***Gross profit.***  Gross profit as a percentage of net salesincreased to 38% for the quarter ended April 3, 2004 from 34.5% for thequarter ended March 29, 2003. During the first quarter of fiscal 2004, the majority of the grossprofit improvement was due to the Company continuing to realize the expectedbenefits of a decrease in wholesale prices paid for Johnson & JohnsonVision Care products.  DuringMarch 2003, the Company began buying directly 

 

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from Johnson &Johnson Vision Care.  The Company didnot realize the full benefits of purchasing from Johnson & Johnson VisionCare during the first quarter of fiscal 2003 due to significant amounts ofJohnson & Johnson Vision Care inventory held by the Company prior to makingdirect purchases from them.  During thelatter part of 2003, the Company reached agreement with Johnson & JohnsonVision Care for additional pricing improvements.

 

The Company expects grossprofit as a percentage of net sales to increase slightly during the remainderof fiscal 2004 as it realizes the full benefit of the improved pricingarrangement it negotiated from vendors during the latter part of fiscal 2003.

 

***Advertising expense. ***Advertising expense for the quarter endedApril 3, 2004 increased $5 million to $8.8 million, from the quarter endedMarch 29, 2003.  As a percentage ofnet sales, advertising expense increased to 17.3% for the first quarter offiscal 2004 from 8.1% for the first quarter of fiscal 2003.  A majority of the increase was for theCompany’s television advertising campaign. The Company expects total advertising expense incurred will be between$25 million and $30 million for all of fiscal 2004.  However, if opportunities present themselves, the Company mayincrease advertising 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 3, 2004 increased $0.2 million, or 13.5%, from the quarterended March 29, 2003.  As apercentage of net sales, legal and professional fees increased to 3.6% for thefirst quarter of fiscal 2004 from 3.5% for the first quarter of fiscal2003.  Although the Fairness to ContactLens Consumer Act (“FCLCA”) became effective February 4, 2004, the Companyinvested considerable effort during the quarter preparing comments for theFederal Trade Commission, which has the responsibility to finalize rulesrelated to the FCLCA.  The Companysubmitted its comments to the proposed rules during the first fiscal quarter offiscal 2004.  The Company expects toreduce expenditures on legal and professional fees by approximately $2 millionin fiscal 2004 versus expenditures in fiscal 2003, which would be reflected ina reduction in legal and professional fees in subsequent quarters based oncurrent plans.  However, the Companywill continue to support legal and legislative initiatives that it believeswill benefit contact lens wearers and the industry, including the continuedimplementation of the FCLCA.

 

***Research and development expenses.***  Research and development expenses for thequarter ended April 3, 2004 decreased to $0.9 million, or 1.8% of netsales, from $1.8 million, or 3.9% of net sales, from the quarter endedMarch 29, 2003.  The Company’s U.S.operations funded $0.5 million during the first fiscal quarter of 2004 forresearch and development activities performed by VisionTec prior to theCompany’s acquisition of the entity on February 24, 2004.  During the first quarter of fiscal 2003, theCompany’s U.S. operations expensed approximately $1.7 million for research anddevelopment activities performed by VisionTec. The Company expects total consolidated research and development expensesof approximately $2 million in fiscal 2004.

 

***Other operating expenses.***  Other selling, general and administrativeexpenses for the quarter ended April 3, 2004 increased $1.2 million, or14.3%, from the quarter ended March 29, 2003.  As a percentage of net sales, other operating expenses increasedto 19.4% for the first quarter of fiscal 2004 from 18.5% for the first quarterof fiscal 2003.  ClearLab accounted forapproximately $0.3 million of the increase for the first quarter of fiscal2004.  The Company also incurredapproximately $0.2 million in costs related to the consolidation of theoperations of Lens 1st  toUtah and $0.1 million in incremental amortization related to the intangibleassets.  The Company’s other operatingand payroll costs also increased by approximately $0.5 million as the Companycontinued to enhance its operating infrastructure and its management team tomeet the demands of the business and the requirements of the FCLCA.

 

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.  However, the Company expects savings of 

 

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approximately $1 millionin its operating expenses during the balance of fiscal 2004 directly related tothe consolidation of the majority of the operating facilities acquired fromLens 1st into its principal operating facilities in Utah.

 

***Other expense, net.***  Other expense decreased to approximately$0.4 million for the quarter ended April 3, 2004 from approximately $0.5million for the quarter ended March 29, 2003.  For the first quarter of fiscal 2004, other expense consistedmainly of interest expense, resulting from the use of the revolving creditfacility and debt related to the acquisition of VisionTec (ClearLab UK, Ltd.)and ClearLab International. This interest expense was offset slightly by anunrealized foreign exchange transaction gain of approximately $0.1 million,relating primarily to an intercompany loan to ClearLab International. For thefirst quarter of fiscal 2003, other expense consisted mainly of interestexpense and an unrealized foreign exchange transaction loss incurred by the Company.  The unrealized loss related primarily to theintercompany loan to ClearLab International.

 

***Income taxes. ***TheCompany’s effective U.S. income tax rate for the quarter ended April 3,2004 is 39% compared to 42% for the quarter ended March 29, 2003.  The Company records quarterly income taxesat the effective tax rate expected for the year.  The decrease in the effective income tax rate results from theestimated annual decrease in permanent nondeductible expenses, including thoserelating to the Company’s lobbying efforts. ClearLab International and ClearLab UK are taxed separately in their taxjurisdictions of Singapore and the United Kingdom.  During the first quarter of fiscal 2004, the Company did notrecord a tax benefit for the loss from the operations of ClearLab Internationaland ClearLab UK due to the uncertainty with respect to the realization of taxbenefits in Singapore and the United Kingdom. As of the first quarter of fiscal 2004, the Company provided a valuationallowance for the full amount of the deferred income tax assets in Singaporeand the United Kingdom.   The Company’sestimated effective U.S. income tax rate may change as facts and circumstanceschange.

 

**Liquidityand Capital Resources**

 

The Company’s principalsources of liquidity have been cash provided by operating activities andproceeds from debt financings.  TheCompany’s principal uses of cash have been to meet debt service requirements,finance acquisitions, finance capital expenditures, fund working capital needsand repurchase common stock.  TheCompany anticipates that, with the exception of repurchases of common stock,these uses will continue to be the principal demands on its cash in the future.

 

The Company believes thatits cash on hand, together with cash generated from operating activities andthe borrowings available through the credit facility, will be sufficient tosupport planned operations through the foreseeable future.  Should the Company’s plans or expectationschange, the Company may be required to seek additional sources of funds andthere can 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.

 

As a result of regulatory requirements, the Company’s liquidity,capital resources, and results of operations may be negatively impacted in thefuture if the Company incurs increased costs (including legal fees) or fines,is prohibited from selling its products or experiences losses of a substantialportion of the Company’s customers for whom the Company is unable to obtain orverify a prescription due to the enforcement of requirements by regulatoryagencies.

 

**Acquisition of VisionTec (ClearLabUK) -** During fiscal 2003, the Company paid $3.9 million forresearch and development activities performed by ClearLab UK on the Company’sbehalf and an additional $0.5 million in January 2004.  On February 24, 2004, the Companyacquired all of the stock of ClearLab UK.  The consideration paid included approximately $3.8 in cash (including$0.6 million in transaction costs) and 155,084 shares of the Company’s commonstock with a fair value of approximately $3.2 million.  In addition, the Company has agreed to pay aper unit royalty to the former shareholders of ClearLab UK for a period of tenyears. The Company financed the cash portion of this acquisition with its revolvingcredit facility from its U.S. bank.

 

The Company will continueto pursue and fund the research and development activities of ClearLab UK.  ClearLab UK began to manufacture products ina test environment in late 2003, and the Company will expand its 

 

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manufacturingcapabilities in fiscal 2004 to market the ClearLab UK productsinternationally.  The establishment ofmanufacturing operations will require investments in capital expenditures andworking capital in 2004.  In addition,the Company anticipates incurring other infrastructure costs including thehiring of additional employees during 2004 as this entity continues to developcontact lens technologies and commercialize products.

 

**Renewed Loan Agreement**- Effective February 27, 2004, the Company executed a restated loanagreement with its existing U.S. bank, providing for a revolving creditfacility for borrowings of up to $28 million through June 1, 2004, andreducing thereafter on the first day of each September, December, March andJune by $0.4 million until the maturity date of February 27,2007.  Additionally, the agreement provides for letters of credit up to amaximum of $15 million outstanding or payable at any time.  If the maximumleverage ratio, as defined in the restated loan agreement, is greater than 2.5,then the amounts outstanding on the revolving credit facility together with theamount of all outstanding letters of credit can at no time exceed the Company’sbook value of inventory. As of April 3, 2004, the Company was subjectto this restriction and could only borrow up to $26.6 million, which is thebook value of its inventory as of April 3, 2004.  Outstanding borrowings on the revolving credit facility bearinterest at a floating rate equal to the lender’s prime interest rate plus amargin or the lender’s LIBOR rate plus a margin.  Interest based on the lender’s prime rate is the prime rate plus0.75 percent until July 31, 2004, and thereafter is adjusted quarterly,ranging between prime plus 0.0 percent and prime plus 1.25 percent, dependingon the Company’s maximum leverage ratio.  Interest based on the lender’sLIBOR rate is the LIBOR rate for the applicable period plus 2.75 percent untilJuly 31, 2004, and thereafter is adjusted quarterly, ranging between LIBORplus 2.0 percent and LIBOR plus 3.25 percent, depending on the Company’smaximum leverage ratio.  Interest is payable monthly.  As of April 3, 2004 the Company’soutstanding borrowings on the credit facility were $15.6 million.  $12.0 million bore interest at the lender’sLIBOR rate plus 2.75 percent (3.84% at April 3, 2004).  The remaining $3.6 million bore interest atthe lender’s prime rate plus 0.75 percent (4.75% at April 3, 2004). The facility requires the payment of an unused credit fee which is also determinedby the Company’s maximum leverage ratio. The unused credit fee is payable quarterly at 0.5 percent untilJuly 31, 2004, and thereafter is adjusted quarterly, ranging from 0.38percent to 0.5 percent, depending on the Company’s maximum leverage 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 in alldomestic subsidiaries and 65 percent ownership interest in foreign subsidiariesdirectly owned by the Company.   The new loan agreement includesvarious financial covenants including a capital expenditure limit, a maximumleverage ratio, a minimum working capital requirement, a minimum fixed chargecoverage ratio and a minimum net worth requirement.  The new loanagreement also does not permit the Company or its subsidiaries to dissolve,sell, dispose or merge all of its assets or acquire all the assets of anyentity without the written consent of the U.S. bank, unless the transactionmeets the definition of a “Permitted Acquisition Basket”, as defined in theagreement.  The new loan agreement also places a limit on the amount theCompany can loan to any entity, outside the normal course of business. Additionally, the agreement does not permit the Company to declare or pay anycash dividends, to repurchase its stock, or to perform other similar equitytransactions prior to December 31, 2005; thereafter such transactions aresubject to other terms.  This agreement defines several customary eventsof default including any material adverse change or any event that occurs whichmay cause a material adverse change in the Company’s or its subsidiaries’condition.  This restated loan agreement succeeds and replaces theCompany’s prior loan agreement executed July 22, 2002.  Alloutstanding balances associated with the July 22, 2002 loan agreement werepaid with proceeds from this new loan agreement.

 

***Cash flows from operating activities.***  For the quarters ended April 3, 2004and March 29, 2003, net cash (used in) provided by operating activitieswas approximately ($1.8 million) and $6.0 million, respectively.  In the first quarter of fiscal 2004 , cashwas used primarily for increases in inventories, other current assets and tofund the net loss, partially offset by an increase in accrued liabilities andaccounts payable.  In the first quarterof fiscal 2003, cash was provided primarily by a decrease in inventories and anincrease in accrued liabilities partially offset by a decrease in accountspayable.

 

***Cash flows from investing activities.***  The Company used approximately $5.7 millionand $8.0 million for investing activities in the quarters ended April 3,2004 and March 29, 2003, respectively. 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 .  In thefirst quarter of fiscal 2003, the Company paid 

 

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approximately$6.9 million in cash (including $0.4 million in transaction costs) inconnection with the acquisition of Lens Express and Lens 1st.

 

Capital expenditures forinfrastructure improvements for the first quarters of fiscal 2004 and 2003 wereapproximately $1.4 million and $0.7 million, respectively.  Of those amounts, approximately $0.8 millionand $0.3 million related to the international operations, respectively.  The Company anticipates additional capitalexpenditures in fiscal 2004 for infrastructure as it continues to expand andimprove operating facilities, telecommunications systems and managementinformation systems in order to handle future operations of both its U.S. andinternational operations.

 

***Financing activities.***  During the quarters ended April 3, 2004and March 29, 2003, net cash provided by financing activities wasapproximately  $7.4 million and $2.4million, respectively.  In the firstquarter of 2004, the Company had net borrowings on its credit facility ofapproximately $15.6 million and made principal payments on debt obligations andcapital lease obligations of approximately $8.1 million.  In the fiscal 2003 period, the Company hadnet borrowings on its credit facility of approximately $2.8 million and madeprincipal payments on debt obligations and capital lease obligations ofapproximately $0.9 million.  In both thefirst quarters of fiscal 2004 and 2003, these amounts were offset by proceedsfrom the exercise of common stock options.

 

The Company’s Board of Directors has authorized the repurchase of up to3,000,000 shares of the Company’s Common Stock.  A purchase of the full 3,000,000 shares would equal approximately23 percent of the total shares issued as of January 3, 2004.  The repurchase of common stock is subject tomarket conditions and is accomplished through periodic purchases at prevailingprices on the open market, by block purchases or in privately negotiatedtransactions.  From inception of itsauthorized repurchase programs through April 3, 2004, the Company hadrepurchased 1,706,500 shares for a total cost of approximately $22.1 million.  No shares were repurchased by the Companyduring fiscal 2003 or the first quarter of fiscal 2004 and the Company iscurrently prohibited by its restated loan agreement from purchasing anyadditional shares until January 1, 2006. As of April 3, 2004, no shares remain in treasury as these shareswere used to acquire ClearLab International and Lens 1st/Lens Express.

 

EffectiveFebruary 27, 2004, the Company executed a restated loan agreement with itsexisting U.S. bank providing for a revolving credit facility for borrowings ofup to $28 million through June 1, 2004 and reducing thereafter on thefirst day of each September, December, March and June by $0.4 millionuntil the maturity date of February 27, 2007.  All amounts outstanding under the Company’s prior revolving creditfacility and U.S. term loan were paid off with proceeds from this new creditfacility.

 

At April 3, 2004, the Company had an unsecured, non-interest bearing note to ClearLab International’s chief technology officer with a principal balance of SGD$2,500,000 (USD$1,486,000). The note payable is discounted at 7%.  Payments are due in equal monthly installments through July 2007.

 

At April 3, 2004,the Company had a term loan payable to a Singapore bank with a principalbalance of SGD$8,360,000 (USD$4,967,000) that bears interest at 6.75% and issecured by substantially all of the assets of ClearLab International.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2003 through December 2007.  This note also contains various financialcovenants including minimums on net worth and shareholders’ funds.  As of April 3, 2004, the Company was incompliance these covenants.  1-800CONTACTS, INC. has guaranteed this term loan.

 

At April 3, 2004,the Company also had a note payable to the former parent of ClearLab Internationalwith a principal balance of SGD$6,892,000 (USD$4,095,000) that bears interestat 6% and has a subordinated position to the term loan payable to the Singaporebank.  The note payable is discounted at7%.  Interest payments are duemonthly.  Principal payments are due inmonthly installments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed thisnote.

 

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 default on its Singapore bank term loan,the Company would also be in default on its note payable.

 

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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 acquisition of ClearLab International and VisionTec (ClearLab UK, Ltd.).  As of April 3, 2004, the present valueof future minimum lease payments was approximately USD$0.3 million with amajority of payments scheduled through fiscal 2004.

 

**Contractual Obligations and Commitments**

 

Subsequent toJanuary 3, 2004, there have been no material changes to the Company’scontractual obligations and commitments, outside the normal course of business,other than the renewed loan agreement with the Company's existing bank.

 

**Critical Accounting Policies**

 

Accounting polices thatrequire significant judgments and estimates include revenue recognition(including sales returns and allowances); realizability of inventories;realizability of deferred income tax assets; accounting for businesscombinations including assessment of realizability of long-lived assets;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 endedJanuary 3, 2004.  Judgments andestimates are based on historical experience as well as relevant facts andcircumstances known at each reporting date. Actual results may differ 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,persuasive evidence of an arrangement exists and the sales price is fixed ordeterminable.  Net sales consist ofproduct sales less provisions for sales returns and allowances, whichprovisions are made at the time of sale. The Company accrues an estimated amount for sales returns and allowancesbased on historical information, adjusted for current economic trends.  To the extent actual returns and allowancesvary from historical experience, revisions to the allowances may be required.

 

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.  As of April 3, 2004, theCompany determined that no impairment existed. All of the goodwill and a significant portion of the other long-livedassets were generated from the Company’s recent acquisitions of ClearLabInternational, ClearLab UK, Ltd., Lens Express and Lens 1st. Ifforecasts and assumptions used to support the realizability of long-livedassets change in the future, significant impairment charges could result thatwould adversely affect the Company’s results of operations and financialposition.

 

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 oftaxable income change in future periods, it may become necessary to change thevaluation allowance, which could affect the Company’s results of operations inthe period such determination is made. The Company records an income tax provision or benefit at a rate that isbased on expected results for the fiscal year. If future changes in market conditions cause actual results to be moreor less favorable, adjustments to the effective income tax rate on a quarterlybasis 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 

 

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impact on its financialposition, liquidity, or results of operations. 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.

 

**Forward-Looking Statements**

 

Except for thehistorical information contained herein, the matters discussed in this Form10-Q are forward-looking statements within the meaning of Section 21E ofthe Securities 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 similarexpressions are intended to identify forward-looking statements.  The Company undertakes no obligation torevise any of these forward-looking statements to reflect events orcircumstances after the date hereof.

 

*FactorsThat May Affect Future 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;

 

•                                          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 inventory from a limited number ofsuppliers, with a single manufacturer accounting for 46%, 35%, and 23% of theCompany’s inventory purchases in fiscal 2001, 2002, and 2003,respectively.  In addition, theCompany’s top three suppliers accounted for 70 percent, 63 percent, and 59percent of the Company’s inventory purchased in fiscal 2001, 2002, and 2003,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;

 

•                                          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;

 

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•                                          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 a viable, high qualitycontact lens for sale to consumers that meets all federal regulatoryrequirements;

 

•                                          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, CIBAVision and Cole.

 

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

 

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

 

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**Item 3.****          *****Quantitative and Qualitative Disclosures******AboutMarket Risk***

 

***Interest Rate Risk.***** **As of April 3, 2004, the Company was exposed to changes in interestrates relating to its renewed credit facility and other debt obligations.  The renewed credit facility bears interestat a variable rate based on the U.S. prime rate or LIBOR. The Company’soutstanding borrowings on the credit facility, including bank overdrafts, wereapproximately $15.6 million as of April 3, 2004. 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 ofApril 3, 2004, the face amounts of the outstanding borrowings on thesefixed rate debt obligations were approximately $9.4 million.

 

***Foreign CurrencyRisk.***  The Companyfaces foreign currency risks primarily as a result of its acquired Singaporeoperations, its recently acquired United Kingdom operations and theintercompany balances between its U.S. and these international operations.  The functional currency of the Company’sSingapore operations is the Singapore dollar, however, most of the sales of theSingapore operations and some of the expenses are denominated in U.S.dollars.  The Company has debt and otherlong-term obligations of approximately $10.9 million that are denominated inSingapore dollars and mature over the next six years.  Fluctuations in exchange rates between the U.S. dollar and theSingapore dollar could lead to additional currency exchange losses or gains onthe intercompany balances and transactions denominated in currencies other thanthe functional currency.  If the U.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 May5, 2004 the exchange rate has fluctuated approximately 3.6 percent (weakeningof the U.S. dollar).

 

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, as well, to currency exchange losses or gains on anyintercompany balances and transactions denominated in currencies other than thefunctional currency.  From the date ofthe VisionTec (ClearLab UK, Ltd.) acquisition, February 24, 2004, throughMay 5, 2004, the exchange rate has fluctuated approximately 3.9 percent(strengthening of U.S. dollar).

 

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.****                                                          *****Controlsand Procedures***

 

***(a)**Evaluationof disclosure controls and procedures*.**  The Company’s Chief Executive Officer and Chief FinancialOfficer, after evaluating the effectiveness of the Company’s disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) asof the end of the period covered by this report (the “Evaluation Date”), haveconcluded that, as of the Evaluation Date, the Company’s disclosure controlsand procedures were adequate and effective to ensure that material informationrelating to the Company and its consolidated subsidiaries would be made knownto them by others within 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, nor were there any significant deficiencies or material weaknesses insuch disclosure controls and procedures requiring corrective actions.  As a result, no corrective actions weretaken.

 

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**PART II.****                                                OTHER INFORMATION**

 

**Item 1.****                                                          *****LegalProceedings***

 

See notes tocondensed consolidated financial statements.

 

**Item 2.****                                                           *Changesin Securities and Use of Proceeds***

 

On February 24, 2004, the Companycompleted the acquisition of the stock of VisionTec (subsequently renamedClearLab UK).  The transaction wasaccomplished as a purchase of all of the stock of the entity.  The consideration paid includedapproximately $3.8 million in cash (including $0.6 million in transactioncosts) and 155,084 shares of the Company’s common stock with a fair value ofapproximately $3.2 million.  In addition,the Company has agreed to pay a per unit royalty to the former shareholders ofVisionTec for a period of ten years.

 

The shares were sold without registration under theSecurities Act upon reliance on the Company's determination that none of theformer stockholders of Vision Tec were U.S. Persons (as that term is defined inRegulation S promulgated under the Securities Act).  The Company has agreed to file a registration statement coveringthe resale of these shares by the former stockholders of Vision Tec.

 

**Item 3.****                                                           *Defaultsupon Senior Securities***

 

None.

 

**Item 4.****                                                           *Submissionof Matters to a Vote of Secur**ityHolders***

 

None.

** **

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

 

From time to timethe Company 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.

 

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**Item 6.****                                                          *****Exhibitsand Reports on Form 8-K***

 

**(A) Exhibits**

 
| **Exhibit No.** |   | **Description  of Exhibit**                                                             |
|-----------------|--------|-----------------------------------------------------------------------------------------|
|            |   |                                                                                    |
| 31.1            |   | Certification Required  Pursuant to Section 302 of the Sarbanes-Oxley Act of2002.  |
| 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. |

 

**(B) Reports on Form 8-K**

 

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*                 Current Report onForm 8-K filed February 24, 2004, filing of Press Release AnnouncingOperating and Financial Results for the fourth quarter and fiscal year endedJanuary 3, 2004.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                      | **1-800 CONTACTS, INC.** |
|---------------------------|--------------------------|
|                      |                     |
|                      |                     |   |
| Dated:  May 13, 2004 | 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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