**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

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**FORM 10-Q**

**(Mark one)**

**x**                              QUARTERLY REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the quarterly period ended September 30, 2006**

**                                       or                                       **

**o**                                 TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the transitionperiod from                              to                              .**

**Commission filenumber:         0-23633**

**1-800 CONTACTS, INC.**

(Exact name of registrant as specified in its charter)

| **Delaware**                              | ** ** | **87-0571643**                        |
|-------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)           |       |                                  |
|                                      |       |                                  |
| **66 E.  Wadsworth Park Drive,**          | ** ** | ** **                            |
| **Draper,  UT**                           | ** ** | **84020**                             |
| (Address of  principal executive offices) |       | (Zip Code)                            |

 

**(801) 316-5000**

(Registrant’s telephonenumber, including area code)

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports) and (2) has been subject to suchfiling requirements for the past 90 days.

x  Yes              o  No

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer (asdefined in Rule 12b-2 of the Exchange Act).

Large accelerated filer  o              Acceleratedfiler  x              Non-acceleratedfiler  o

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

o  Yes              xNo

As of November 2, 2006, the Registrant had 14,026,345shares of Common Stock, par value $0.01 per share, outstanding.

 

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**1-800CONTACTS, INC.**

**INDEX**
| **PART I.**  | **FINANCIAL  INFORMATION**                                                                                                        |   |   |
|--------------|-----------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1.      | Financial  Statements (unaudited)                                                                                                 |   |   |
|         | Condensed  Consolidated Balance Sheets as of December 31, 2005 and September 30, 2006                                             |   |   |
|         | Condensed  Consolidated Statements of Operations for the Quarter and Three Quarters  ended October 1, 2005 and September 30, 2006 |   |   |
|         | Condensed  Consolidated Statements of Cash Flows for the Three Quarters ended October 1,  2005 and September 30, 2006             |   |   |
|         | 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  1A.    | Risk Factors                                                                                                                      |   |   |
| Item 2.      | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                 |   |   |
| Item 3.      | Defaults  Upon Senior Securities                                                                                                  |   |   |
| Item 4.      | Submission  of Matters to a Vote of Security Holders                                                                              |   |   |
| Item 5.      | Other Information                                                                                                                 |   |   |
| Item 6.      | Exhibits                                                                                                                          |   |   |

 

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**PART 1.FINANCIAL INFORMATION**

**Item1.  Financial Statements**

**1-800 CONTACTS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| **ASSETS**                                                | ** ** | ** **            | ** ** | ** **             | ** ** |
| CURRENT ASSETS:                                           |       |                  |       |                   |       |
| Cash                                                      |       | $                     | 1,481      |                   | $          | 1,538 |   |
| Accounts  receivable, net                                 |       | 3,451                 |       | 3,483                  |       |
| Other  receivables                                        |       | 1,738                 |       | 2,150                  |       |
| Inventories, net                                          |       | 21,458                |       | 21,988                 |       |
| Deferred income  taxes                                    |       | 1,624                 |       | 1,955                  |       |
| Other current  assets                                     |       | 3,792                 |       | 3,001                  |       |
| Total current  assets                                     |       | 33,544                |       | 34,115                 |       |
| PROPERTY AND EQUIPMENT,  net                              |       | 29,705                |       | 31,791                 |       |
| DEFERRED INCOME TAXES                                     |       | 1,087                 |       | 1,007                  |       |
| GOODWILL                                                  |       | 35,405                |       | 36,742                 |       |
| DEFINITE-LIVED  INTANGIBLES, net                          |       | 13,847                |       | 11,958                 |       |
| OTHER ASSETS                                              |       | 1,357                 |       | 1,253                  |       |
| Total assets                                              |       | $                     | 114,945    |                   | $          | 116,866 |   |
|                                                      |       |                  |       |                   |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**            | ** ** | ** **            | ** ** | ** **             | ** ** |
| CURRENT LIABILITIES:                                      |       |                  |       |                   |       |
| Line of credit                                            |       | $                     | —     |                   | $          | 27,216 |   |
| Current portion  of long-term debt                        |       | 1,633                 |       | 2,404                  |       |
| Current portion  of capital lease obligations             |       | 58                    |       | 25                     |       |
| Income taxes  payable                                     |       | 567                   |       | 703                    |       |
| Accounts payable                                          |       | 12,063                |       | 11,191                 |       |
| Accrued  liabilities                                      |       | 8,197                 |       | 10,156                 |       |
| Unearned revenue                                          |       | 3,299                 |       | 2,053                  |       |
| Total current  liabilities                                |       | 25,817                |       | 53,748                 |       |
| LONG-TERM LIABILITIES:                                    |       |                  |       |                   |       |
| Line of credit                                            |       | 23,746                |       | —                 |       |
| Long-term debt,  net of current portion                   |       | 6,440                 |       | 4,816                  |       |
| Capital lease  obligations, net of current portion        |       | 83                    |       | 46                     |       |
| Unearned  revenue, net of current portion                 |       | 973                   |       | —                 |       |
| Other long-term  liabilities                              |       | 669                   |       | 848                    |       |
| Total long-term  liabilities                              |       | 31,911                |       | 5,710                  |       |
| STOCKHOLDERS’ EQUITY                                 |       |                  |       |                   |       |
| Common stock,  13,340 and 13,370 issued, respectively     |       | 133                   |       | 134                    |       |
| Additional  paid-in capital                               |       | 47,876                |       | 50,334                 |       |
| Treasury stock  at cost, 0 and 1,187 shares, respectively |       | —                |       | (18                    | )          |
| Retained  earnings                                        |       | 9,613                 |       | 7,221                  |       |
| Accumulated  other comprehensive loss                     |       | (405                  | )          | (263                   | )          |
| Total  stockholders’ equity                          |       | 57,217                |       | 57,408                 |       |
| Total liabilities and  stockholders’ equity          |       | $                     | 114,945    |                   | $          | 116,866 |   |

 

See accompanying notes tocondensed consolidated financial statements.

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**1-800 CONTACTS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**
| ** **                                         | ** ** | **Quarter Ended** | ** ** | **Three Quarters Ended** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|------------------------------------|------------|
| ** **                                         | ** ** | **October 1**     | ** ** | **September 30,**             | ** ** | **October 1** | ** ** | **September 30,** | ** ** |
| ** **                                         | ** ** | **2005**               | ** ** | **2006**                           | ** ** | **2005** | ** ** | **2006** | ** ** |
| NET SALES                                          |       | $                      | 60,858     |                               | $          | 64,329 |   | $ | 182,506 |   | $ | 190,975 |   |
| COST OF GOODS  SOLD                                |       | 37,706                 |       | 40,427                             |       | 113,178 |   | 119,963 |   |
|                                               |       |                   |       |                               |       |   |   |   |   |
| Gross profit                                       |       | 23,152                 |       | 23,902                             |       | 69,328 |   | 71,012 |   |
|                                               |       |                   |       |                               |       |   |   |   |   |
| SELLING, GENERAL  AND ADMINISTRATIVE EXPENSES:     |       |                   |       |                               |       |   |   |   |   |
| Advertising                                        |       | 6,606                  |       | 3,977                              |       | 20,264 |   | 11,663 |   |
| Legal and professional                             |       | 1,210                  |       | 1,307                              |       | 3,400 |   | 3,555 |   |
| Research and development                           |       | 426                    |       | 1,388                              |       | 2,292 |   | 4,353 |   |
| Other selling, general and administrative          |       | 13,538                 |       | 16,657                             |       | 37,359 |   | 46,258 |   |
|                                               |       |                   |       |                               |       |   |   |   |   |
| Total selling, general and administrative expenses |       | 21,780                 |       | 23,329                             |       | 63,315 |   | 65,829 |   |
|                                               |       |                   |       |                               |       |   |   |   |   |
| INCOME FROM  OPERATIONS                            |       | 1,372                  |       | 573                                |       | 6,013 |   | 5,183 |   |
|                                               |       |                   |       |                               |       |   |   |   |   |
| OTHER INCOME  (EXPENSE), net                       |       | (755                   | )          | (55                                | )          | (2,562 | ) | 610 |   |
|                                               |       |                   |       |                               |       |   |   |   |   |
| INCOME BEFORE  PROVISION FOR INCOME TAXES          |       | 617                    |       | 518                                |       | 3,451 |   | 5,793 |   |
|                                               |       |                   |       |                               |       |   |   |   |   |
| PROVISION FOR  INCOME TAXES                        |       | (1,191                 | )          | (2,053                             | )          | (3,801 | ) | (8,185 | ) |
| NET LOSS                                           |       | $                      | (574       | )                                  | $          | (1,535 | ) | $ | (350 | ) | $ | (2,392 | ) |
|                                               |       |                   |       |                               |       |   |   |   |   |
| PER SHARE  INFORMATION:                            |       |                   |       |                               |       |   |   |   |   |
| Basic and  diluted net loss per common share       |       | $                      | (0.04      | )                                  | $          | (0.11 | ) | $ | (0.03 | ) | $ | (0.18 | ) |

 

See accompanying notes tocondensed consolidated financial statements.

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(in thousands)**

**(unaudited)**
| ** **                                                                       | ** ** | **Three Quarters Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                       | ** ** | **October 1,**                | ** ** | **September 30,** | ** ** |
| ** **                                                                       | ** ** | **2005**                           | ** ** | **2006** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                           |       |                               |       |   |   |
| Net loss                                                                         |       | $                                  | (350       | ) | $ | (2,392 | ) |
| Adjustments to reconcile net loss to net cash provided  by operating activities: |       |                               |       |   |   |
| Depreciation and amortization                                                    |       | 6,572                              |       | 7,575 |   |
| Amortization of debt issuance costs and discounts                                |       | 138                                |       | 171 |   |
| Foreign currency exchange loss (gain)                                            |       | 1,390                              |       | (2,026 | ) |
| Stock-based compensation                                                         |       | 79                                 |       | 1,649 |   |
| Tax benefits from share-based payment exercises                                  |       | —                             |       | (34 | ) |
| Loss on sale of property and equipment                                           |       | 519                                |       | 168 |   |
| Deferred income taxes                                                            |       | (1,463                             | )          | (253 | ) |
| Changes in operating assets and liabilities:                                     |       |                               |       |   |   |
| Accounts receivable, net                                                         |       | (1,193                             | )          | 342 |   |
| Inventories, net                                                                 |       | (6,025                             | )          | 74 |   |
| Other receivables                                                                |       | 315                                |       | (412 | ) |
| Other current assets                                                             |       | (1,047                             | )          | 1,046 |   |
| Income taxes payable                                                             |       | (1,245                             | )          | 153 |   |
| Accounts payable                                                                 |       | 5,917                              |       | (1,190 | ) |
| Accrued liabilities                                                              |       | 4,656                              |       | 1,770 |   |
| Unearned revenue                                                                 |       | (3,110                             | )          | (2,379 | ) |
| Net cash provided by operating activities                                        |       | 5,153                              |       | 4,262 |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                           |       |                               |       |   |   |
| Purchase of property and equipment                                               |       | (9,549                             | )          | (5,514 | ) |
| Proceeds from sale of property and equipment                                     |       | 27                                 |       | — |   |
| Purchase of definite-lived intangible assets                                     |       | (610                               | )          | — |   |
| Deposits and other                                                               |       | (2,121                             | )          | (470 | ) |
| Net cash used in  investing activities                                           |       | $                                  | (12,253    | ) | $ | (5,984 | ) |

 

5

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| ** **                                              | ** ** | **Three Quarters Ended** | ** ** |
|---------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                              | ** ** | **October 1,**                | ** ** | **September 30,** | ** ** |
| ** **                                              | ** ** | **2005**                           | ** ** | **2006** | ** ** |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                  |       |                               |       |   |   |
| Proceeds from exercise of stock options                 |       | $                                  | 381        |   | $ | 110 |   |
| Purchase of treasury stock                              |       | —                             |       | (18 | ) |
| Excess tax benefits from share-based payment  exercises |       | —                             |       | 34 |   |
| Net borrowings on line of credit                        |       | 5,045                              |       | 3,470 |   |
| Principal payments on capital lease obligations         |       | (35                                | )          | (77 | ) |
| Principal payments on long-term debt                    |       | (1,261                             | )          | (1,386 | ) |
| Net cash provided by financing activities               |       | 4,130                              |       | 2,133 |   |
| EFFECT OF  FOREIGN EXCHANGE RATES ON CASH               |       | 91                                 |       | (354 | ) |
|                                                    |       |                               |       |   |   |
| NET INCREASE  (DECREASE) IN CASH                        |       | (2,879                             | )          | 57 |   |
| CASH AT  BEGINNING OF PERIOD                            |       | 3,105                              |       | 1,481 |   |
| CASH AT END OF  PERIOD                                  |       | $                                  | 226        |   | $ | 1,538 |   |
|                                                    |       |                               |       |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                    |       |                               |       |   |   |
| Cash paid for interest                                  |       | $                                  | 807        |   | $ | 1,294 |   |
| Cash paid for income taxes                              |       | 6,510                              |       | 8,275 |   |

 

SUPPLEMENTAL DISCLOSURESOF NONCASH INVESTING AND FINANCING ACTIVITIES:

As part of theacquisition of ClearLab International in 2002, the Company entered into anagreement to issue 270,000 options to purchase shares of 1-800 CONTACTS, INC.common stock in three equal tranches. The second tranche of 90,000 options vested on July 24, 2006.  The Company used the Black-Scholesoption-pricing model to determine the fair-value of these options, as of thevesting date.  Using this method, thevested options were valued at approximately $0.7 million and the Companyrecorded this amount as additional purchase consideration, increasing goodwill.

See accompanying notes to condensed consolidatedfinancial statements.

6

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**1-800 CONTACTS, INC.**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

# **NOTE 1. PRESENTATION OF CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

The accompanyingcondensed consolidated financial statements have been prepared by 1-800CONTACTS, INC. (“the Company”), without audit, pursuant to the rules andregulations of the Securities and Exchange Commission.  Certain information and disclosures normallyincluded in financial statements prepared in accordance with U.S. generallyaccepted accounting principles have been condensed or omitted pursuant to suchrules and regulations.  These condensedconsolidated financial statements reflect all adjustments (consisting only ofnormal recurring adjustments), which in the opinion of management, are necessaryto present fairly the results of operations of the Company for the periodspresented.  It is suggested that thesecondensed consolidated financial statements be read in conjunction with theaudited financial statements and the notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2005.

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenue and expenses during the reporting period.  Actual results could differ from these estimates.

# **NOTE 2. INVENTORIES**

Inventories are recordedat the lower of cost (using the first-in, first-out method) or marketvalue.  Elements of cost in the Company’smanufactured inventories generally include raw materials, direct labor,manufacturing overhead and freight-in.  Inventories consisted of the following (in thousands):

|                                           | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| Purchased  contact lenses and accessories |       | $                     | 13,554     |                   | $          | 11,195 |   |
| Manufactured  inventories:                |       |                  |       |                   |       |
|  Raw materials                       |       | 1,322                 |       | 808                    |       |
|  Work in  process                    |       | 1,894                 |       | 1,177                  |       |
|  Finished  goods contact lenses      |       | 4,688                 |       | 8,808                  |       |
| Total                                     |       | $                     | 21,458     |                   | $          | 21,988 |   |

 

Provision is made toreduce excess and obsolete inventories to their estimated net realizablevalues.  As of December 31, 2005 andSeptember 30, 2006, reserves for excess and obsolete inventories wereapproximately $2.2 million and $1.2 million, respectively.

**NOTE 3.  NET INCOME (LOSS) PER COMMON SHARE**

Basic net loss per commonshare (“Basic EPS”) excludes dilution and is computed by dividing net loss bythe weighted-average number of common shares outstanding during theperiod.  Diluted net loss per commonshare (“Diluted EPS”) reflects the potential dilution that could occur if stockoptions or other common stock equivalents were exercised or converted intocommon stock using the treasury stock method. The computation of Diluted EPS does not assume exercise or conversion ofsecurities that would have an antidilutive effect on net loss per commonshare.  Additionally, the Company has notreflected performance based unvested stock awards in Diluted EPS since theperformance conditions were not satisfied as of September 30, 2006.  Forthe quarter and three quarters ended October 1, 2005, options to purchase1,278,569 and 974,339 shares of common stock, respectively, as well as 36,794and 33,461 shares of unvested common stock, respectively, were not included inthe computation of Diluted EPS because the effect would be antidilutive.  For the quarter and three

7

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quarters ended September30, 2006, options to purchase 1,182,481 and 1,193,640 shares of common stock, respectively,as well as 687,066 and 685,696 shares of unvested common stock, respectively, werenot included in the computation of Diluted EPS because the effect would beantidilutive.

The following is areconciliation of the numerator and denominator used to calculate Basic andDiluted EPS (in thousands, except per share amounts): 
| ** **                       | ** ** | **Quarter Ended October 1, 2005** | ** ** | **Quarter Ended September 30, 2006** | ** ** |
|----------------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                       | ** ** | **Net  Loss**                                         | ** ** | **Shares**                                               | ** ** | **Per-Share  Amount** | ** ** | **Net  Loss** | ** ** | **Shares** | ** ** | **Per-Share  Amount** | ** ** |
|                             |       |                                                  |       |                                                     |       |   |   |   |   |   |   |   |   |
| Basic  EPS                       |       | $                                                     | (574       | )                                                        | 13,329     |   | $ | (0.04 | ) | $ | (1,535 | ) | 13,366 |   | $ | (0.11 | ) |
| Effect  of stock options         |       |                                                  |       | —                                                   |       |   |   |   |   | — |   |   |   |
| Effect  of unvested stock awards |       |                                                  |       | —                                                   |       |   |   |   |   | — |   |   |   |
| Diluted EPS                      |       | $                                                     | (574       | )                                                        | 13,329     |   | $ | (0.04 | ) | $ | (1,535 | ) | 13,366 |   | $ | (0.11 | ) |

 
| ** **                       | ** ** | **Three Quarters Ended October 1, 2005** | ** ** | **Three Quarters Ended September 30, 2006** | ** ** |
|----------------------------------|------------|-------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Net  Loss**                                                     | ** ** | **Shares**                                                           | ** ** | **Per-Share  Amount** | ** ** | **Net  Loss** | ** ** | **Shares** | ** ** | **Per-Share  Amount** | ** ** |
|                             |       |                                                              |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Basic  EPS                       |       | $                                                                 | (350       | )                                                                    | 13,315     |   | $ | (0.03 | ) | $ | (2,392 | ) | 13,357 |   | $ | (0.18 | ) |
| Effect  of stock options         |       |                                                              |       | —                                                               |       |   |   |   |   | — |   |   |   |
| Effect  of unvested stock awards |       |                                                              |       | —                                                               |       |   |   |   |   | — |   |   |   |
| Diluted EPS                      |       | $                                                                 | (350       | )                                                                    | 13,315     |   | $ | (0.03 | ) | $ | (2,392 | ) | 13,357 |   | $ | (0.18 | ) |

 

**NOTE4.  COMPREHENSIVE LOSS**

Comprehensive loss for the quarter and three quartersended October 1, 2005 and September 30, 2006 consisted of the followingcomponents (in thousands):
| ** **                                | ** ** | **Quarter Ended**    | ** ** | **Three Quarters Ended** | ** ** |
|-------------------------------------------|------------|---------------------------|------------|------------------------------------|------------|
| ** **                                | ** ** | **October 1,  2005** | ** ** | **September 30,  2006**       | ** ** | **October 1,  2005** | ** ** | **September 30,  2006** | ** ** |
| Net loss                                  |       | $                         | (574       | )                                  | $          | (1,535 | ) | $ | (350 | ) | $ | (2,392 | ) |
| Foreign currency  translation gain (loss) |       | (127                      | )          | 31                                 |       | (487 | ) | 142 |   |
| Comprehensive loss                        |       | $                         | (701       | )                                  | $          | (1,504 | ) | $ | (837 | ) | $ | (2,250 | ) |

 

The foreign currency translation gain (loss) resultedfrom changes in exchange rates relative to the U.S. dollar from the translationof the Company’s Singapore and United Kingdom subsidiaries’ financialstatements.

**NOTE5.  STOCK-BASED COMPENSATION**

Effective January 1,2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”)No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS No. 123R”), whichrequires stock-based compensation to be measured based on the fair value of theaward on the date of grant and recognized over the period during which serviceis required in exchange for the award. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SABNo. 107”) relating to SFAS No. 123R.  TheCompany has applied the provisions of SAB No. 107 in its adoption of SFAS No.123R.

8

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Prior to January 1, 2006,the Company applied Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations (“APB 25”), andadopted the disclosure-only provisions of Statement of Financial AccountingStandards No. 123 (“SFAS No. 123”), “Accounting for Stock-Based Compensation.”  Under APB 25, no compensation expense wasrecognized in net income for grants of employee stock options prior to 2006.

SFASNo. 123R applies to all of the Company’s outstanding unvested share-basedpayment awards as of January 1, 2006 and all awards made thereafter.  All of the Company’s stock-based awards,which are stock options and restricted stock awards, are classified as equityinstruments.  In accordance with SFASNo. 123R, the Company elected to use the modified prospective transition methodand therefore, financial statements prior to adoption  of SFAS No. 123R remain unchanged. Under thistransition method, compensation cost for the quarter and three quarters endedSeptember 30, 2006 includes amounts associated with (i) unvested stock optionsgranted prior to January 1, 2006, (ii) restricted stock awards granted prior toJanuary 1, 2006 and (iii) restricted stock awards granted during the currentfiscal year. Compensation cost recognized in fiscal 2006 for unvested optionsas of January 1, 2006 was based on the grant-date fair value estimated inaccordance with the original provisions of SFAS No. 123.  The following discusses certain otherelections and assumptions the Company made as a result of adoptingSFAS No. 123R:

·                  *Black-ScholesModel. *For the Company’s pro formadisclosures under SFAS No. 123, it used the Black-Scholes option pricingmodel. Upon the adoption of SFAS No. 123R, the Company has elected tocontinue to use the Black-Scholes option pricing model to compute the fairvalue of options granted on or after January 1, 2006.

·                  *Forfeitures.*Forfeitures under SFAS No. 123were recognized when they occurred. SFAS No. 123R, however, requiresforfeitures to be estimated at the grant date. Accordingly, compensation costis recognized based on the number of awards expected to vest. There may beadjustments in future periods if actual forfeitures differ from the Company’sestimates.  The Company’s forfeiturerates are based upon historical experience.

·                  *Short-cut Method.*TheCompany has elected to use the short-cut method in accordance with FSP 123R-3in measuring its APIC pool available to absorb tax deficiencies recognized insubsequent periods from the exercise of unqualified stock options and vestingof restricted stock awards.  Under theshort-cut method, the Company has determined that it has no APIC pool as ofJanuary 1, 2006.  Accordingly, realizedtax deficiencies in excess of tax benefits related to fully vested awards as ofJanuary 1, 2006 will be recorded as additional income tax expense in the perioddetermined.

Prior to the adoption of SFAS No. 123R, theCompany presented tax benefits resulting from share-based compensation asoperating cash flows in the consolidated statements of cash flows.  SFAS No. 123R requires that cash flowsresulting from tax deductions in excess of compensation cost recognized in thefinancial statements be classified as financing cash flows. However, under theshort-cut method, for all vested awards as of January 1, 2006, any realized taxbenefits are recorded as financing cash flows and an increase to additionalpaid in capital.   Approximately $6,000of excess tax benefits were generated for the quarter ended September 30, 2006and approximately $34,000 of excess tax benefits have been generated for thethree quarters ended September 30, 2006.

Stock-based expense recorded during fiscal 2006includes expense, recognized over the applicable vesting periods, for newrestricted stock share-based awards and for restricted stock and stock optionshare-based awards granted prior to, but not yet vested, as of January 1,2006.  As a result of adopting SFAS No. 123R, the stock-basedcompensation expense for employees and non-employee directors for the quarterand three quarters ended September 30, 2006 totaled approximately $0.6 millionand $1.6 million, respectively.  The total income tax benefit related tostock-based expense during the quarter and three quarters ended September 30,2006 was approximately $0.2 million and $0.6 million, respectively.  The impact on Basic and Diluted EPS for thequarter and three quarters ended September 30, 2006 was a decrease ofapproximately $0.03 and $0.08 per share, respectively.  In addition, prior to the adoption of SFASNo. 123R, the Company presented the tax benefit from the exercise ofcommon stock option exercises as a component of cash flows from operatingactivities.  Upon the adoption of SFAS No. 123R, tax benefitsresulting from tax deductions in excess of the compensation cost recognized forthose options are classified as a component of cash flows from financingactivities.  For the three quarters ended September 30, 2006, this new 

9

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classification resulted in a decrease of approximately$34,000 in cash flows from operating activities and an increase ofapproximately $34,000 in cash flows from financing activities, compared to cashflows from stock-based compensation presented under APB 25.

***Stock –Based Award Plans***

***Stock Options.***TheCompany has established a stock incentive plan that provides for the issuanceof a maximum of 1,940,000 shares of common stock to officers, employees,directors and consultants. The plan allows for the issuance of incentive stockoptions, nonqualified stock options and restricted stock. Incentive andnonqualified stock options are granted at not less than 100 percent of thefair market value of the underlying common stock on the date of grant. As ofSeptember 30, 2006, 32,186 shares were available for future granting.

Prior to the establishment of the stock incentive plan,the Company issued nonqualified stock options to various key employees, aconsultant and a director of the Company.

All options granted through January 1, 2000 vestequally over a three-year period and expire ten years from the date of grant.The stock options issued as a portion of the consideration for the assignmentof certain technologies and intellectual property in conjunction with theacquisition of ClearLab International in 2002 and other options issued to thechief technology officer of ClearLab International vest equally at the end ofthe third, fourth and fifth years and expire ten years from the date of grant.All other options granted subsequent to January 1, 2000, vest equally overa four-year period and expire  betweenfive and  ten years from the date ofgrant.

Stock options remainedoutstanding under various plans as of January 1, 2006.******There have been no options granted from these plansduring fiscal 2006, and the Company does not currently plan to grant any stockoptions during the remainder of fiscal 2006. Under SFAS No. 123, pro-forma expense for stock options wascalculated using a straight-line vesting schedule over the vesting period ofapproximately four years.  Had the Company used the fair value basedaccounting method for stock option expense prescribed by SFAS No. 123, theCompany’s net income and earnings per share for the quarter and three quartersended October 1, 2005 would have been reduced to the pro-forma amountsillustrated as follows (in thousands, except per share amounts):
| ** **                                                                         | ** ** | **Quarter Ended**        | ** ** | **Three Quarters Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------------------|------------|
| ** **                                                                         | ** ** | **October 1, 2005** | ** ** | **October 1, 2005**      | ** ** |
| Net loss:                                                                          |       |                          |       |                               |       |
| As reported                                                                        |       | $                             | (574       | )                                  | $          | (350 | ) |
| Add: Stock-based  compensation expense included in reported net income, net of tax |       | 22                            |       | 49                                 |       |
| Deduct:  Fair-value based compensation, net of tax                                 |       | (155                          | )          | (727                               | )          |
| Pro forma                                                                          |       | $                             | (707       | )                                  | $          | (1,028 | ) |
|                                                                               |       |                          |       |                               |       |
| Basic and diluted net  loss per common share:                                      |       |                          |       |                               |       |
| As reported                                                                        |       | $                             | (0.04      | )                                  | $          | (0.03 | ) |
| Pro forma                                                                          |       | $                             | (0.05      | )                                  | $          | (0.08 | ) |

 

10

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The Company’s stock option activity during the firstthree quarters of fiscal 2006 is as follows (in thousands, except option pricesand years):
| ** **                                                 | ** ** | ** **         | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|------------------------------------------------------------|------------|--------------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                                                 | ** ** | ** **         | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                                                 | ** ** | ** **         | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                                                 | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                                                 | ** ** | **Options**        | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Value**     | ** ** |
|                                                       |       |               |       |         |       |                  |       |          |       |
| Options  outstanding at December 31, 2005                  |       | 1,243              |       | $            | 20.90      |                  |       |          |       |   |
| Exercised                                                  |       | (15                | )          | 7.48         |       |                  |       |          |       |
| Forfeited                                                  |       | (36                | )          | 23.58        |       |                  |       |          |       |
| Expired                                                    |       | (10                | )          | 24.17        |       |                  |       |          |       |
| Options  outstanding at September 30, 2006                 |       | 1,182              |       | $            | 20.96      |                  | 3.71       |          | $          | 1,938 |   |
|                                                       |       |               |       |         |       |                  |       |          |       |
| Options  vested and expected to vest at September 30, 2006 |       | 1,162              |       | 20.86        |       | 3.72                  |       | $             | 1,938      |   |
|                                                       |       |               |       |         |       |                  |       |          |       |
| Options exercisable at September 30, 2006                  |       | 1,047              |       | $            | 20.24      |                  | 3.78       |          | $          | 1,937 |   |

 

The total intrinsic value of options exercised duringthe three quarters ended September 30, 2006 totaled approximately $0.1million.  The total intrinsic value ofoptions exercised during the three quarters ended October 1, 2005 totaledapproximately $0.4 million.   The weightedaverage fair value of stock option grants was $11.30 for the first three quartersof fiscal 2005.  No stock options weregranted during the first three quarters of fiscal 2006.

The fair value of options granted during the firstthree quarters of fiscal 2005 was estimated using the Black-Scholes optionvaluation model that used the assumptions noted in the table below. Expectedvolatility and expected dividend yield are based on actual historicalexperience of the Company’s common stock. The expected life represents theperiod of time that options granted are expected to be outstanding. Therisk-free rate is based on the U.S. Treasury security with terms equal to theexpected time of exercise as of the grant date.
|                          | ** ** | **Three Quarters Ended** | ** ** |
|--------------------------|------------|------------------------------------|------------|
| ** **               | ** ** | **October 1, 2005**      | ** ** |
| Risk-free  interest rate |       | 3.7                                | %          |
| Expected  dividend yield |       | 0.0                                | %          |
| Volatility               |       | 65.5                               | %          |
| Expected life            |       | 5 years                            |       |

 

For the quarter and three quarters ended September 30,2006, stock option expense was recognized on a straight-line basis over thefour-year vesting period.  Approximately$0.2 million and $0.8 million, respectively, was charged to expense in thequarter and three quarters ended September 30, 2006 related to stock options.The Company has applied a weighted average forfeiture assumption of15.03% in the calculation of such expense.

As of September 30, 2006, there was approximately $0.8million of unrecognized compensation cost related to non-vested stock options,which is expected to be recognized over a weighted-average period ofapproximately one year.

Cash received from option exercises during the threequarters ended September 30, 2006 was approximately $0.1 million. The total taxbenefit generated from options granted prior to December 31, 2005, which wereexercised during the three quarters ended September 30, 2006, was approximately$28,000, which was credited to additional paid-in capital.

11

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***Restricted ShareAwards****. *During the first fiscal quarter of2006, the Company’s Board of Directors approved a grant of 599,096 shares ofrestricted common stock to various employees and executives of the Company.  The restricted share grants were valued atthe closing stock price on the date of the grant, March 27, 2006, which was$13.14.  The restricted share grantsinclude both time-vesting and performance-vesting restricted shares.  The time-vesting shares (273,451 awards) vest20% per year beginning November 30, 2006 and ending November 30, 2010.  The performance-vesting shares (325,645awards) vest upon achievement of certain operational milestones - such as obtainingsources for “doctors only” lenses on competitive terms, development of certaincontact lens products and the achievement of an eight quarter cumulativefinancial target of at least $81 million consolidated earnings before taxes byor before the end of fiscal 2010.  Both the time-vesting and the performance-vesting shares are subject tovarious change in control provisions involving the Company and its subsidiariesthat may result in the accelerated vesting of unvested shares, as well asconversion of unvested shares into a cash amount at the time of a change incontrol.

The Company also granted50,000 shares of restricted common stock to its five non-employeedirectors.  These grants vest equally, atannual intervals, over a three-year period ending March 27, 2009; the vestingof these awards will be accelerated upon a change in control of theCompany.  These restricted share grantsmade to non-employee directors were also valued at the closing stock price onthe date of the grant, March 27, 2006, which was $13.14.  An additional 2,500 shares of restrictedcommon stock were granted to one non-employee director.  This restricted share grant was valued at theclosing stock price on the date of the grant, March 29, 2006, which was $13.28,and vested on July 28, 2006.

During the quarter endedSeptember 30, 2006, the Company granted an aggregate of 16,178 shares ofrestricted common stock to various employees of the Company.  The restricted share grants were valued atthe closing stock price on the date of each grant which ranged from $13.93 to$15.44.  These restricted share grantsinclude both time-vesting and performance-vesting restricted shares; thetime-vesting shares vest equally over a four-year period and theperformance-vesting shares have similar vesting provisions as those discussedabove with respect to Company employees.

The Company’s activity relating to restricted shareawards during the first three quarters of fiscal 2006 was as follows (inthousands, except fair values):
| ** **                     | ** ** | **Number of Restricted** | ** ** | **Weighted Average  Grant Date Fair** | ** ** |
|--------------------------------|------------|------------------------------------|------------|------------------------------------------------------|------------|
| ** **                     | ** ** | **Share Awards**              | ** ** | **Value Per Award**                        | ** ** |
| Unvested at December  31, 2005 |       | 36                                 |       | $                                                    | 17.82      |   |
| Granted                        |       | 652                                |       | 13.14                                                |       |
| Vested                         |       | (4                                 | )          | 22.69                                                |       |
| Unvested at April 1,  2006     |       | 684                                |       | $                                                    | 13.51      |   |
| Vested                         |       | (2                                 | )          | 18.84                                                |       |
| Forfeited and expired          |       | (1                                 | )          | 13.14                                                |       |
| Unvested at July 1,  2006      |       | 681                                |       | $                                                    | 13.49      |   |
| Granted                        |       | 16                                 |       | 14.81                                                |       |
| Vested                         |       | (9                                 | )          | 13.52                                                |       |
| Forfeited and expired          |       | (1                                 | )          | 13.14                                                |       |
| Unvested at September 30, 2006 |       | 687                                |       | $                                                    | 13.52      |   |

 

For the quarter and three quarters ended September 30,2006, approximately $0.4 million and $0.8 million, respectively, was charged toexpense relating to the amortization of the time-vested restricted shareawards.  At September 30, 2006,unrecognized compensation expense, including estimated forfeitures related totime-vested restricted share awards totaled approximately $3.9 million and willbe recognized over a weighted average period of 3.93 years.  No restricted share awards vested during thequarter and three quarters ended October 1, 2005.  The fair value of restricted share awardsthat vested during the quarter and three quarters ended September 30, 2006totaled approximately $138,000 and $219,000, respectively.  Total tax benefit generated from vestedrestricted share awards 

12

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as of January 1, 2006 for the quarter ended September30, 2006, was approximately $6,000, which was credited to additional paid-incapital.

Expense related to performance-vesting shares will berecognized once it is determined “probable” that the operational milestoneswill be met.  At the time the achievementof these operational milestones are considered “probable”, the Company willrecord a cumulative catch-up for the amount of expense that should have beenrecognized from the date of the grant to the date it was determined achievementwas probable and recognize the remaining expense on a straight-line basisthrough the estimated date of achievement. Total gross compensation expense, excluding any estimate of forfeituresrelated to the performance-vesting shares, will be approximately $4.3 million.

**NOTE6.  DEBT OBLIGATIONS**

The Company has a loanagreement with a U.S. bank providing for a revolving credit facility. OnJanuary 13, 2006, the Company entered into a modified agreement whichmodified this loan agreement effective as of December 30, 2005. Themodified loan agreement provides for borrowings of up to $30 million, $35million, or $40 million, depending on the Company’s minimum fixed coverageratio assessed on a quarterly basis, as defined in the agreement.  Accordingly, as of September 30, 2006, theCompany’s borrowing capacity under the line was $40 million; subsequent to thethird quarter of fiscal 2006, the borrowing capacity was reduced to $35million.  Additionally, the agreementprovides for letters of credit up to a maximum of $15 million outstandingor payable at any time. The amount of any letters of credit outstanding isdeducted from the amount available for borrowing. The maturity date of the loanagreement is February 27, 2007, as such; the amounts due under the line ofcredit are reported as current liabilities in the condensed consolidatedbalance sheet as of September 30, 2006. The Company is in the process of extending this loan agreement to extendthe maturity date and provide for borrowings of up to $40 million during theterm of the extension.  The extension isexpected to be completed before the end of fiscal 2006.

Outstanding borrowings onthe revolving credit facility bear interest at a floating rate equal to thelender’s prime interest rate plus a margin or the lender’s LIBOR rate plus amargin. The interest rate is adjusted quarterly and ranges between prime minus0.25 percent and prime plus 0.25 percent or between the applicableLIBOR rate plus 1.75 percent and the applicable LIBOR rate plus2.25 percent, depending on the Company’s maximum leverage ratio, asdefined in the agreement. As of September 30, 2006, the prime rate margin is 0percent and the LIBOR rate margin is 2.00 percent. Interest is payablemonthly. As of September 30, 2006, the Company’s outstanding borrowings on thecredit facility, including bank overdrafts, were $27.2 million. Of thisamount, $12.5 million bore interest at the lender’s LIBOR rate plus2.00 percent (7.33% at September 30, 2006) and the remaining $14.7 millionbore interest at the lender’s prime rate plus 0 percent (8.25% atSeptember 30, 2006). The facility requires the quarterly payment of an unusedcredit fee which ranges from 0.25 percent to 0.38 percent, dependingon the Company’s maximum leverage ratio. There were no outstanding letters of credit as of September 30, 2006.

Outstanding balances on the credit facility aresecured by substantially all of the Company’s U.S. assets, subsidiary debtinstruments, 100 percent ownership interests in all domestic subsidiariesand 65 percent ownership interests in foreign subsidiaries directly ownedby the Company. The modified loan agreement includes various financialcovenants including a capital expenditure limit, a maximum leverage ratio and aminimum fixed charge coverage ratio. The modified loan agreement does notpermit the Company or its subsidiaries to dissolve, sell, dispose or merge allof their assets or acquire all of the assets of any entity without the writtenconsent of the U.S. bank, unless the transaction meets the definition of a “PermittedAcquisition Basket”, as defined in the agreement. The modified loan agreementalso places a limit on the amount the Company can loan to any entity, outsidethe normal course of business. Additionally, the modified agreement allows theCompany to declare or pay cash dividends, to repurchase its stock or to performother similar equity transactions if such transactions would not exceed $15million in any fiscal year and subject to other terms. This agreement definesseveral customary events of default including any material adverse change orany event that occurs which may cause a material adverse change in the Company’sor its subsidiaries’ condition.

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As of September 30, 2006, theCompany had an unsecured, non-interest bearing note to ClearLabInternational’s chief technology officer with a principal balance ofSGD$625,000 (USD$394,000). The note payable is discounted at 7%.  Payments are due in equal monthlyinstallments through July 2007.

As of September30, 2006, the Company had a term loan payable to a Singapore bank with aprincipal balance of SGD$4,110,000 (USD$2,591,000) that bears interest at 6.75%and is secured by substantially all of the assets of ClearLabInternational.  Interest payments are duemonthly.  Principal payments are due inmonthly installments through December 2007. This note also contains various financial covenants including minimumson net worth and shareholders’ funds. 1-800 CONTACTS, INC. has guaranteed this term loan.

As of September 30, 2006, the Company also had a notepayable to the former parent of ClearLab International with a principal balanceof SGD$6,892,000 (USD$4,345,000) that bears interest at 6% and has asubordinated position to the term loan payable to the Singapore bank.  The note payable is discounted at 7%.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed thisnote.

The Company’s Singapore bank term loan containsvarious financial covenants including minimums on net worth and shareholders’funds of the Singapore operations. 1-800 CONTACTS, INC. has guaranteedthis term loan.

Cross default clauses exist such that if the Companywere in default on its U.S. debt, the Company would also be in default on itsSingapore debt. If the Company were in default on its Singapore bank term loan,the Company would also be in default on its note payable to the former parentof ClearLab International and its loan agreement with its U.S. bank.

**NOTE7.  COMMITMENTS AND CONTINGENCIES**

***Legaland Regulatory Matters***

The sale and delivery of contact lenses are governedby both federal and state laws and regulations, including the federal Fairnessto Contact Lens Consumers Act (“FCLCA”). The FCLCA requires a seller, prior toselling contact lenses to a consumer, to either (i) obtain an actual copy ofthe consumer’s prescription or (ii) verify the consumer’s prescription bydirect communication with the customer’s prescriber. Consistent with thisrequirement, the Company’s current operating practice is to require allcustomers to provide either a valid copy of their prescription or the contactinformation for their prescriber so that the Company can verify theirprescription by direct communication with their prescriber. If the Company doesnot have a valid copy of the customer’s prescription, the Company directlycommunicates to the customer’s prescriber the precise prescription informationreceived from the customer and, in accordance with the FCLCA, informs theprescriber that it will proceed with the sale based on this prescriptioninformation unless the prescriber advises it within eight business hours thatsuch prescription information is expired or otherwise invalid. If theprescriber properly advises the Company within this time period that thecustomer’s prescription is expired or otherwise invalid, the Company’s practiceis to cancel the customer’s order. On the other hand, if the prescriber eitheradvises the Company that the prescription is valid or fails to respond properlywithin the required time period, the Company’s practice is to complete the salebased on the prescription information communicated to the prescriber, asexpressly permitted by the FCLCA. The Company retains copies of the writtenprescriptions that it receives and maintains records of its communications withthe customer’s prescriber. The FCLCA provides for several means of directcommunication with eye care practitioners, and the Company may alter itsprescription verification procedures from time to time in keeping with theFCLCA and FTC guidelines.

From time to time, the Company is involved in legalmatters generally incidental to its business. It is the opinion of management,after discussion with legal counsel, that except for legal and professionalfees that the Company incurs from time to time, the ultimate dispositions ofall of these matters will not have a material impact on the financial position,liquidity or results of operations of the Company. However, there can be noassurance that the Company will be successful in its efforts to satisfactorilyresolve these matters, and the ultimate outcome could result in a materialnegative impact on the Company’s financial position, liquidity or results ofoperations.

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***AdvertisingCommitments***

As of September 30, 2006,the Company had entered into certain noncancelable commitments with variousadvertising companies that will require the Company to pay approximately $0.8million and $2.8 million for advertising during the remainder of 2006 and in2007, respectively.

**NOTE8.  SEGMENT INFORMATION**

The Company has two operating segments. These operating segments representcomponents of the Company for which separate financial information is availableand are evaluated regularly by management in determination of resourceallocation and performance assessment. The Company’s U.S. Retail segmentincludes the operations of 1-800 CONTACTS, a direct marketer of replacementcontact lenses. The Company’s International segment includes the operations ofClearLab International and ClearLab UK, which are developers, marketers,manufacturers and distributors of contact lenses.  The U.S. Retail segment includesrevenue from the Company’s optical retail store agreement and the Internationalsegment includes revenue from the Japanese license and royalty agreement.   Operating segment information for thequarter and three quarters ended October 1, 2005 and September 30, 2006 is asfollows (in thousands):
| ** **                                                             | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total**  | ** ** |
|------------------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|------------------|------------|------------|------------|
| **Quarter  Ended October 1, 2005**                                     |       |                 |       |              |       |             |       |       |       |
| ** **                                                             | ** ** | ** **           | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| Net  sales (International segment includes intersegment sales of $917) |       | $                    | 55,791     |              | $          | 5,984            |       | $          | (917       | ) | $ | 60,858 |   |
| Gross  profit                                                          |       | 21,928               |       | 1,841             |       | (617             | )          | 23,152     |       |
| Research  and development                                              |       | —               |       | 426               |       | —           |       | 426        |       |
| Other  selling, general and administrative expense                     |       | 10,998               |       | 2,540             |       | —           |       | 13,538     |       |
| Income (loss) from operations                                          |       | $                    | 3,367      |              | $          | (1,378           | )          | $          | (617       | ) | $ | 1,372 |   |

 
| ** **                                         | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total**  | ** ** |
|----------------------------------------------------|------------|----------------------|------------|-------------------|------------|------------------|------------|------------|------------|
| **Quarter  Ended September 30, 2006**              |       |                 |       |              |       |             |       |       |       |
| ** **                                         | ** ** | ** **           | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| Net  sales                                         |       | $                    | 59,189     |              | $          | 5,140            |       | $          | —     |   | $ | 64,329 |   |
| Gross  profit                                      |       | 22,968               |       | 934               |       | —           |       | 23,902     |       |
| Research  and development                          |       | —               |       | 1,388             |       | —           |       | 1,388      |       |
| Other  selling, general and administrative expense |       | 12,762               |       | 3,895             |       | —           |       | 16,657     |       |
| Income (loss) from operations                      |       | $                    | 5,125      |              | $          | (4,552           | )          | $          | —     |   | $ | 573 |   |

 
| ** **                                                               | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total**  | ** ** |
|--------------------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|------------------|------------|------------|------------|
| **Three  Quarters Ended October 1, 2005**                                |       |                 |       |              |       |             |       |       |       |
| ** **                                                               | ** ** | ** **           | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| Net  sales (International segment includes intersegment sales of $1,291) |       | $                    | 168,924    |              | $          | 14,873           |       | $          | (1,291     | ) | $ | 182,506 |   |
| Gross  profit                                                            |       | 66,972               |       | 3,147             |       | (791             | )          | 69,328     |       |
| Research  and development                                                |       | —               |       | 2,292             |       | —           |       | 2,292      |       |
| Other  selling, general and administrative expense                       |       | 31,870               |       | 5,489             |       | —           |       | 37,359     |       |
| Income (loss) from operations                                            |       | $                    | 12,159     |              | $          | (5,355           | )          | $          | (791       | ) | $ | 6,013 |   |

 

15

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| ** **                                         | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total**  | ** ** |
|----------------------------------------------------|------------|----------------------|------------|-------------------|------------|------------------|------------|------------|------------|
|                                               |       |                 |       |              |       |             |       |       |       |
| **Three  Quarters Ended September 30, 2006**       |       |                 |       |              |       |             |       |       |       |
| ** **                                         | ** ** | ** **           | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| Net  sales                                         |       | $                    | 176,096    |              | $          | 14,879           |       | $          | —     |   | $ | 190,975 |   |
| Gross  profit                                      |       | 69,366               |       | 1,393             |       | 253              |       | 71,012     |       |
| Research  and development                          |       | 10                   |       | 4,343             |       | —           |       | 4,353      |       |
| Other  selling, general and administrative expense |       | 37,044               |       | 9,214             |       | —           |       | 46,258     |       |
| Income (loss) from operations                      |       | $                    | 17,886     |              | $          | (12,956          | )          | $          | 253        |   | $ | 5,183 |   |

 

The following reconciles total segment income from operations to incomebefore provision for income taxes for the quarter and three quarters endedOctober 1, 2005 and September 30, 2006 as follows (in thousands):
| ** **                                              | ** ** | **Quarter Ended**        | ** ** |
|---------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                              | ** ** | **October 1, 2005** | ** ** | **September 30, 2006** | ** ** |
| Income  from operations                                 |       | $                             | 1,372      |   | $ | 573 |   |
| Interest  expense, net                                  |       | (347                          | )          | (542 | ) |
| Foreign  currency exchange transaction gain (loss), net |       | (330                          | )          | 509 |   |
| Other,  net                                             |       | (78                           | )          | (22 | ) |
| Income before provision for income taxes                |       | $                             | 617        |   | $ | 518 |   |

 
| ** **                                              | ** ** | **Three Quarters Ended** | ** ** |
|---------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                              | ** ** | **October 1, 2005**      | ** ** | **September 30, 2006** | ** ** |
| Income  from operations                                 |       | $                                  | 6,013      |   | $ | 5,183 |   |
| Interest  expense, net                                  |       | (995                               | )          | (1,388 | ) |
| Foreign  currency exchange transaction gain (loss), net |       | (1,390                             | )          | 2,026 |   |
| Other,  net                                             |       | (177                               | )          | (28 | ) |
| Income before provision for income taxes                |       | $                                  | 3,451      |   | $ | 5,793 |   |

 

Identifiable segment assets areas follows (in thousands):
|                        | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total**  | ** ** |
|------------------------|------------|----------------------|------------|-------------------|------------|------------|------------|
| **December 31, 2005**  |       |                 |       |              |       |       |       |
| ** **             | ** ** | ** **           | ** ** | ** **        | ** ** | ** ** | ** ** |
| Long-lived assets, net |       | $                    | 35,130     |              | $          | 43,827     |       | $ | 78,957 |   |
| Total  assets          |       | 54,758               |       | 60,187            |       | 114,945    |       |
|                        |            |                      |            |                   |            |            |            |  |  |  |

 
|                        | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total**  | ** ** |
|------------------------|------------|----------------------|------------|-------------------|------------|------------|------------|
| **September 30, 2006** |       |                 |       |              |       |       |       |
| ** **             | ** ** | ** **           | ** ** | ** **        | ** ** | ** ** | ** ** |
| Long-lived assets, net |       | $                    | 33,235     |              | $          | 47,256     |       | $ | 80,491 |   |
| Total  assets          |       | 52,392               |       | 64,474            |       | 116,866    |       |
|                        |            |                      |            |                   |            |            |            |  |  |  |

 

**NOTE9.  RECENTLY ISSUED ACCOUNTING STANDARDS**

In June 2006, the Financial Accounting StandardsBoard (FASB) issued Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes,” which defines the threshold for recognizing the benefits of taxreturn positions in the financial statements as “more-likely-than-not” to besustained by the taxing authority. A tax position that meets the “more-likely-than-not”criterion shall be measured at the largest amount of benefit that is more than50% likely of being realized upon ultimate settlement. InterpretationNo. 48 applies to all tax positions accounted for under SFAS No. 109,“Accounting for Income Taxes.” Interpretation No. 48 is effective forfiscal years beginning after 

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December 15, 2006.Upon adoption, the Company will adjust its financial statements to reflect onlythose tax positions that are more-likely-than-not to be sustained as of theadoption date. Any adjustment will be recorded directly to the beginningretained earnings balance in the period of adoption and reported as a change inaccounting principle. The Company is currently analyzing the effects ofadopting Interpretation No. 48.

In September 2006, the FASB issued Statement ofFinancial Accounting Standard No. 157, “Fair Value Measurements” (“FAS 157”).FAS 157 provides a definition of fair value, establishes acceptable methods ofmeasuring fair value and expands disclosures for fair value measurements. Theprinciples apply under accounting pronouncements which require measurement offair value. The Company does not expect the adoption of FAS 157 to have amaterial impact on its financial statements.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements” (“SAB 108”). SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thecurrent year’s financial statements are materially misstated. SAB 108 permitsregistrants to record the cumulative effect of initial adoption by recordingthe necessary “correcting” adjustments to the carrying values of assets andliabilities as of the beginning of that year with the offsetting adjustmentrecorded to the opening balance of retained earnings only if material under thedual method. SAB 108 is effective for fiscal years ending on or afterNovember 15, 2006. The Company is currently analyzing the effects ofadopting SAB 108.

In June 2006, the Emerging Issues Task Force (“EITF”)reached a consensus on EITF Issue No. 06-03 (“EITF 06-03”), “How TaxesCollected from Customers and Remitted to Governmental Authorities Should BePresented in the Income Statement (That Is, Gross versus Net Presentation).”  EITF 06-03 provides that the presentation oftaxes assessed by a governmental authority that is directly imposed on arevenue-producing transaction between a seller and a customer on either a grossbasis (included in revenues and costs) or on a net basis (excluded fromrevenues) is an accounting policy decision that should be disclosed.  The provisions of EITF 06-03 will becomeeffective as of December 31, 2006.  TheCompany does not expect the adoption of EITF 06-03 to have a material impact onits consolidated financial statements.

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

**Overview**

TheCompany is a direct marketer of replacement contact lenses and is also amanufacturer, developer and distributor of its own branded and private labelcontact lenses through its operations in Singapore and the United Kingdom.  The Company’s U.S. Retail operations sellalmost all of the popular brands of contacts lenses, including thosemanufactured by Johnson & Johnson Vision Care, CIBA Vision, Bausch &Lomb and CooperVision.  ClearLab is theCompany’s international contact lens development, manufacturing anddistribution business.

OnJuly 26, 2006 ClearLab introduced its AquaSoft Singles product.  The Company engaged an investment bankingfirm to evaluate a broad range of strategic alternatives in an effort tocapitalize on the value of ClearLab and this new product. The first round ofthis strategic review of ClearLab has been completed.  Based on this review, the Company is now committedto a separation of ClearLab from the U.S. Retail business and expects toannounce terms related to this separation by the end of March 2007.  The Company has also undergone an extensivereview of  ClearLab’s manufacturingoperations.  Subject to any consultation thatmay be necessary under United Kingdom law, the Company is evaluating aconsolidation of  ClearLab’smanufacturing, research and development operations which are currently carriedout in the Singapore and United Kingdom manufacturing facilities.  Should the Company commence with thisconsolidation of ClearLab’s operations, it may incur significant restructuringcharges and its financial condition and results of operations could beadversely affected.

***Japanese License and Royalty Agreement.***  In December 2004, the Company signed anagreement which grants Menicon Co., LTD (Menicon), Japan’s largest independentcontact lens manufacturer, exclusive rights to develop, manufacture and marketcertain disposable contact lenses and related intellectual property inJapan.  Under the terms of the agreement,Menicon licenses from the Company different types of intellectual property,including contact lens material, manufacturing technology and relatedknowledge.  As of the third quarter offiscal 2006, the Company has received a total of $10 million under theagreement; the Company will receive an additional $3 million of guaranteedpayments under this agreement through December 31, 2007.

TheCompany had been recognizing the guaranteed portion of the license fees fromthis agreement on a straight-line basis, limited by the amount of cashreceived, over the period of the Company’s continued involvement in meeting itsobligations, estimated to be through June 2007.  During the third quarter of fiscal 2006, dueto delays in its initial estimated timeline in completing its obligations underthe agreement, the Company determined that the estimated period for meeting itsobligations should be through December 2007 rather than June 2007 and hasaccounted for the change in estimate prospectively and will recognize theunrecognized revenue through December 2007. Revenue recognized under this agreement for the quarter and threequarters ended September 30, 2006 was $1.0 million and $4.0 million,respectively.

***Optical Retail Store Agreement. ***During thelatter part of 2004, the Company entered into an agreement with a regionaloptical retail chain in Utah. Under the terms of the agreement, the companieseffectively combined their contact lens business in Utah and began jointlyserving these customers in December 2004. The objective of this agreement wasto partner with an optical retailer to create a seamless experience forconsumers that will include exams as well as in-store, phone and onlineservice.

Underthe agreement, the Company fulfilled substantially all orders taken at theretail optical chain for contact lenses and both parties share in the operatingresults of the combined contact lens business based on a certain allocationpercentage. However, during the term of the agreement, the Company guaranteedthat the retail chain would receive at least $0.5 million of annual earningsunder the arrangement. Additionally, the Company committed to purchaseapproximately $0.3 million per year in inventory from the retail chain’s sourceof supply. Under the arrangement, the Company recorded gross revenues for allorders fulfilled and recorded selling, general and administrative expense forthe retail chain’s share of the net operating results.

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Thisagreement expired in January 2006; however, both parties continued tooperate their contact lens businesses under the arragement described above throughOctober 2006.  The Company has decidednot to renew this agreement. The Company is deferring any decision to launch anational network with optical retail stores until a resolution can be found toindustry practices relating to “doctors only” lenses.

***Doctor Referral Network.******  ***The Company iscurrently expanding its national doctor referral network with select opticalretail chains and independent practitioners and had agreements in place with nearly1,000 locations for referrals in its network as of September 30, 2006. Underthis referral program, when a current or potential customer needs a new contactlens prescription, the Company can facilitate the process of obtaining an eyeexamination through this network of providers. This process minimizes theinterruptions in product consumption for the consumer and improves the Company’sability to capture new customers and retain its current customers.

TheCompany is developing this referral program under the brand name ProNet. ProNetwill serve as the division of the Company dedicated to the national doctorreferral network. The Company launched a website in support of the ProNet brandduring March 2006. This website serves as a tool to assist ProNet inrecruiting providers and communicating with the optical community.

***Supplier Agreements.******  ***TheCompany has agreements with its top two vendors for improved pricing andmarketing support. This support comes in the form of cooperative marketing andrebate programs designed to promote the manufacturer’s products and buildsales. As part of its ongoing relationship with its suppliers, the Companyperiodically reviews its specific marketing plans and negotiates cooperativemarketing programs and product pricing.

# **RegulatoryConsiderations**

***Fairness to Contact Lens Consumers Act. *** In November 2003, Congress passed the Fairness toContact Lens Consumers Act (“FCLCA”), which establishes a national uniformstandard for both eye care practitioners and direct marketers with regard toreleasing and verifying consumer contact lens prescriptions as well as otherrequirements 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 of theirprescription as soon as they have been fitted for contact lenses, whether the patientsask for it or not.  It also directscontact lens sellers to contact eye care practitioners to request verificationof consumer prescriptions before shipping all orders (if the prescription isnot already on file), and it provides that a practitioner’s failure to respondwithin eight business hours shall result in the prescription being presumedvalid, thereby eliminating the ability of eye care practitioners to impedesales by direct marketers simply by ignoring or refusing to respond to theirrequests to verify prescriptions.  TheFCLCA also provides that prescriptions will be valid for a minimum of at leastone year (absent some special medical reason justifying a shorter period).  It also directed the Federal TradeCommission (“FTC”) to conduct a study examining the strength of competition inthe market for contact lenses and to submit a report to Congress within twelvemonths of the FCLCA effective date. The FTC completed and published this studyon February 15, 2005, with no recommendations for further changes in federallaw.

Satisfyingthe prescription verification requirement of the FCLCA obligates a contact lensseller either to obtain a copy of the prescription itself or to verify theprescription by direct communication with the customer’s prescriber. 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 the customer’sprescriber the precise prescription information received from the customer andinforms the prescriber that it will proceed with the sale based on thisprescription information unless the prescriber advises it within eight businesshours that such prescription information is expired or otherwise invalid.  If the prescriber properly advises theCompany within this time period that the customer’s prescription is expired orotherwise invalid, the Company’s practice is to cancel the customer’sorder.  On the other hand, if theprescriber either advises the Company that the prescription is valid or failsto respond properly within the required time period, the Company’s practice isto complete the sale based on the prescription information communicated to theprescriber, as expressly permitted by the FCLCA.  The Company retains copies of the writtenprescriptions that it receives and maintains records of its communications withthe

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customer’sprescriber.  The FCLCA provides forseveral means of direct communication with eye care practitioners, and theCompany may alter its prescription verification procedures from time to time inkeeping with the FCLCA and FTC guidelines.

**Resultsof Operations**

TheCompany’s fiscal year consists of a 52/53-week period ending on the Saturdaynearest to December 31. The Company’s 2006 fiscal year is a 52-week year andwill end on December 30, 2006.

TheCompany has two operating segments referred to below.  The Company’s domestic segment is representedby operations within the U.S. and is referred to as “U.S. Retail” by theCompany, whereas the Company’s international segment is represented byoperations in both Singapore and the U.K. and is referred to as “ClearLab” bythe Company.

Thefollowing table presents the Company’s results of operations expressed as apercentage of net sales for the periods indicated:
| ** **                                            | ** ** | **Quarter Ended** | ** ** | **Three Quarters Ended** | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|------------------------------------|------------|
| ** **                                            | ** ** | **October 1,**    | ** ** | **September 30,**             | ** ** | **October 1,** | ** ** | **September 30,** | ** ** |
| ** **                                            | ** ** | **2005**               | ** ** | **2006**                           | ** ** | **2005** | ** ** | **2006** | ** ** |
| NET SALES                                             |       | 100.0                  | %          | 100.0                              | %          | 100.0 | % | 100.0 | % |
| COST OF GOODS SOLD                                    |       | 62.0                   |       | 62.8                               |       | 62.0 |   | 62.8 |   |
| Gross profit                                          |       | 38.0                   |       | 37.2                               |       | 38.0 |   | 37.2 |   |
|                                                  |       |                   |       |                               |       |   |   |   |   |
| SELLING, GENERAL &  ADMINISTRATIVE EXPENSES:      |       |                   |       |                               |       |   |   |   |   |
| Advertising                                           |       | 10.9                   |       | 6.2                                |       | 11.1 |   | 6.1 |   |
| Legal and  professional                               |       | 2.0                    |       | 2.0                                |       | 1.9 |   | 1.9 |   |
| Research and  development                             |       | 0.7                    |       | 2.2                                |       | 1.3 |   | 2.3 |   |
| Other selling,  general & administrative          |       | 22.2                   |       | 25.9                               |       | 20.4 |   | 24.2 |   |
| Total selling, general  & administrative expenses |       | 35.8                   |       | 36.3                               |       | 34.7 |   | 34.5 |   |
| INCOME FROM OPERATIONS                                |       | 2.2                    |       | 0.9                                |       | 3.3 |   | 2.7 |   |
| OTHER INCOME (EXPENSE),  net                          |       | (1.2                   | )          | (0.1                               | )          | (1.4 | ) | 0.3 |   |
| INCOME BEFORE PROVISION  FOR INCOME TAXES             |       | 1.0                    |       | 0.8                                |       | 1.9 |   | 3.0 |   |
| PROVISION FOR INCOME  TAXES                           |       | (2.0                   | )          | (3.2                               | )          | (2.1 | ) | (4.3 | ) |
| NET LOSS                                              |       | (1.0                   | )%         | (2.4                               | )%         | (0.2 | )% | (1.3 | )% |

 

***Net sales***. Net sales for the quarter ended September 30, 2006 increased 5.7% to $64.3million from $60.9 million for the quarter ended October 1, 2005.  For the three quarters ended September 30,2006, net sales increased 4.6% to $191.0 million from $182.5 million for the threequarters ended October 1, 2005.  Netsales for the Company’s U.S. Retail operations, for the third quarter of fiscal2006 and the first three quarters of fiscal 2006, were $59.2 million and $176.1million, respectively, an increase from the prior year periods of 6.1% and 4.2%,respectively.  U.S. Retail net salesincreased primarily from an increase in sales on the Internet, due mainly toupgrades the Company made to its website during fiscal 2005 and from targetedonline marketing programs.  The Companyis also receiving benefit from its record level of brand awareness.

Duringthe quarter and three quarters ended September 30, 2006, the Company spentapproximately $4.0 million and $11.7 million, respectively, on advertising.  During the quarter and three quarters ended October1, 2005, the Company spent approximately $6.6 million and $20.3 million,respectively, on advertising.  TheCompany’s reduction in advertising spending during the first three quarters offiscal 2006 from the first three quarters of fiscal

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2005 is consistentwith the Company’s strategy to spend less on advertising in fiscal 2006 as theCompany focuses on addressing the threat of ‘doctors only’ lenses.  The Company expects that U.S. Retail netsales will continue to be impacted by the decrease in advertising spending duringthe fourth quarter of fiscal 2006. Additionally, U.S. Retail net sales growth continues to be constrained bylost sales related to certain ‘doctors only’ contact lenses that the Companycannot obtain in order to fill orders for customers who wish to purchase theproduct from the Company.

Net sales for ClearLab for the third quarter of fiscal2006 and the first three quarters of fiscal 2006 were $5.1 million and $14.9million, respectively.  Net sales forClearLab for the third quarter of fiscal 2005 and the first three quarters offiscal 2005 were $6.0 million and $14.9 million, respectively.  ClearLab’s results for the thirdquarter and first three quarters of fiscal 2006 included $1.0 million and $4.0million, respectively, in license fees from the Company’s Japanese licenseagreement, compared to $1.0 million and $3.0 million in the third quarter andfirst three quarters of fiscal 2005, respectively.  For the quarter and first three quarters offiscal 2005, ClearLab net sales included approximately $0.9 million and $1.3million, respectively, in intercompany sales to the Company’s U.S. Retailbusiness.  ClearLab recorded no intercompanysales to the U.S. Retail business in the first three quarters of fiscal2006.  ClearLab’s sales have beennegatively impacted by sales delays to external customers due to product andpackaging improvements, including the introduction of ClearLab’s new lensdesign and manufacturing process improvements.

***Gross profit.*** Consolidated gross profit as a percentage of net sales decreased to 37.2%for the quarter ended September 30, 2006 from 38.0% for the quarter ended October1, 2005.  For the three quarters ended September30, 2006, consolidated gross profit as a percentage of net sales decreased to 37.2%from 38.0% for the three quarters ended October 1, 2005.

Grossprofit as a percentage of net sales for the Company’s U.S. Retail operations decreasedto 38.8% in the third quarter of fiscal 2006 from 39.3% in the third quarter offiscal 2005.  Gross profit as apercentage of net sales for the Company’s U.S. Retail operations decreasedslightly to 39.4% from 39.6% for the three quarters ended September 30, 2006and October 1, 2005, respectively.  Thisdecrease from the prior year was due largely to increases in select productcosts and shipping rates.  The Companyexpects the U.S. Retail gross profit margin for the fourth quarter of fiscal2006 to approximate the margin achieved for the third quarter of fiscal 2006.

Grossprofit as a percentage of net sales for ClearLab was 18.2% and 9.4% for the thirdquarter and three quarters ended September 30, 2006, respectively.  Gross profit as a percentage of net sales forClearLab was 30.8% and 21.1% for the third quarter and three quarters ended October1, 2005, respectively.  The decrease ingross profit for the quarter ended September 30, 2006 related mainly to thedecrease in intercompany sales to the Company’s U.S Retail business. The grossprofit margin for the three quarters ended September 30, 2006 was also impactedby provisions of approximately $1.2 million recorded on certain inventory inthe second quarter of fiscal 2006.  Themajority of this inventory was produced prior to the introduction of a newdaily lens design.

***Advertisingexpense. ***Advertisingexpense for the quarter ended September 30, 2006 decreased to $4.0 million from$6.6 million for the quarter ended October 1, 2005.  As a percentage of net sales, advertisingexpense for the third quarter of fiscal 2006 decreased to 6.2% from 10.9% forthe third quarter of fiscal 2005.  Forthe three quarters ended September 30, 2006, advertising expense as apercentage of sales decreased to 6.1% from 11.1% for the first three quartersof fiscal 2005.  The Company expects thatfiscal 2006 advertising expenses will be approximately $14 million, a decreaseof approximately $11 million from fiscal 2005 as it continues to focus itsresources towards legislative and public relations initiatives. If, however,opportunities present themselves, the Company may increase advertising spendingabove currently planned levels.  TheCompany’s experience has been that increases in advertising expenditures have adirect impact on the growth of net sales not only in the current period butalso in future periods.

TheCompany expenses all advertising costs when the advertising first takes place.As a result, quarter-to-quarter comparisons are impacted within and betweenquarters by the timing of television, radio and Internet advertisements and bythe mailing of the Company’s printed advertisements. The volume of mailings andother advertising may vary in different quarters and from year to yeardepending on the Company’s assessment of prevailing market opportunities.

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***Legaland professional fees. ***Legaland professional fees for the quarter ended September 30, 2006 increased $0.1 million,from the third quarter ended October 1, 2005.  As a percentage of net sales, legal andprofessional fees remained constant at 2.0% for the third quarter of fiscal2006 compared to the third quarter of fiscal 2005.  For the three quarters ended September 30,2006, legal and professional fees increased by $0.2 million to $3.6 millionfrom the three quarters ended October 1, 2005. As a percentage of net sales, legal and professional fees remained constantat 1.9% for the first three quarters of fiscal 2006 compared to the first threequarters of fiscal 2005.

During the first threequarters of fiscal 2006, the Company continued to incur professional fees forSarbanes-Oxley compliance, and other internal control initiatives, as well asongoing legal, lobbying and regulatory initiatives. The Company will continueto focus its efforts on compliance with federal rules and regulations aswell as continue to support legal and legislative initiatives that it believeswill benefit contact lens wearers.

***Research and development expenses.***  Research and development expenses for thequarter ended September 30, 2006 increased to $1.4 million, or 2.2% of netsales, from $0.4 million, or 0.7% of net sales, from the quarter ended October1, 2005.  For the three quarters ended September30, 2006, research and development expenses were $4.4 million, or 2.3% of netsales, up from $2.3 million, or 1.3% of net sales, for the three quarters endedOctober 1, 2005.  During the first three quartersof fiscal 2006, the Company continued to fund research and development effortsfor ClearLab’s operations.

Totalfiscal 2006 research and development costs will be dependent on progress withresearch and development efforts relating to expanding ClearLab’s productoffering and developing its intellectual property, including it’s recentlyintroduced AquaSoft Singles product.

***Otherselling, general and administrative expenses.***  Other selling, general and administrativeexpenses for the quarter ended September 30, 2006 increased approximately $3.1million to $16.7 million from the quarter ended October 1, 2005.  As a percentage of net sales, other selling,general and administrative expenses for the third quarter of fiscal 2006 alsoincreased to 25.9%, from 22.2% for the third quarter of fiscal 2005. As apercentage of net sales, other selling, general and administrative expenses forthe three quarters ended September 30, 2006 increased to 24.2% from 20.4% forthe three quarters ended October 1, 2005, as such expenses increased byapproximately $8.9 million for the same period. The results for the third quarter of fiscal 2006 include approximately $0.2million of expense related to stock options granted prior to fiscal 2006 andapproximately $0.4 million of expense related to the restricted stock grants,compared to approximately $35,000 of expense related to restricted stock grantsin the third quarter of fiscal 2005. Likewise, the results for the first three quarters of fiscal 2006include approximately $0.8 million of expense related to stock options grantedprior to fiscal 2006 and approximately $0.8 million of expense related torestricted stock grants, compared to approximately $0.1 million of expenserelated to restricted stock grants in the first three quarters of fiscal 2005.

The Company’s U.S.Retail other selling, general and administrative expenses increased approximately$1.8 million for the quarter ended September 30, 2006 from the quarter ended October1, 2005.  For the three quarters ended September30, 2006, U.S. Retail other selling, general and administrative expensesincreased $5.2 million from the three quarters ended October 1, 2005.   Additionally, such expenses also increasedas a percentage of net sales to 21.6% and 21.0%, respectively, for the quarterand three quarters ended September 30, 2006, compared to 19.7% and 18.9% for thequarter and three quarters ended October 1, 2005, respectively.  The majority of the increase for U.S. Retailfrom the quarter and three quarters ended October 1, 2005 related to plannedincreases in employee costs.  Theseincreases include restricted stock and stock option expense, as discussedabove, as well as employee costs to support current operations, such as coststo strengthen and build the Company’s information technology organization andcosts to support a retail network, an initiative which is currently focused onexpanding our doctor referral network.  Additionally, a portion of the increase in other selling, general andadministrative expenses related to costs associated with supporting the Company’slegislative efforts.

ClearLab’s otherselling, general and administrative expenses increased by approximately $1.4million for the quarter ended September 30, 2006 from the quarter ended October1, 2005. ClearLab’s other selling, general and administrative expensesincreased by approximately $3.7 million for the three quarters ended September30, 2006 from the three quarters ended October 1, 2005.  A majority of ClearLab’s increase in

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both the quarterand three quarters ended September 30, 2006 related to costs to strengthen itsmanagement team and costs related to the introduction of the AquaSoft Singlesproduct.

***Other income (expense), net.***  Other income (expense) improved toapproximately $(0.1) million and $0.6 million for the quarter and threequarters ended September 30, 2006, respectively, from approximately $(0.8)million and $(2.6) million for the quarter and three quarters ended September30, 2005, respectively.  For the thirdquarter of fiscal 2006, other income consisted of approximately $0.5 million inforeign currency exchange transaction gains offset by approximately $0.6 millionin interest expense and other miscellaneous expenses.  Other expense in the third quarter of fiscal2005 consisted mainly of approximately $0.3 million in foreign currencyexchange transaction losses and approximately $0.3 million in interest expenseand other miscellaneous expenses.  Forthe three quarters ended September 30, 2006, other income consisted mainly ofapproximately $2.0 million of foreign currency exchange transaction gainsoffset by $1.4 million in interest expense. For the three quarters ended October 1, 2005, other expense consistedmainly of interest expense of approximately $1.0 million and foreign currencyexchange transaction losses of approximately $1.4 million.  Interest expense is incurred primarily due tothe use of the Company’s credit facility and other debt.  The exchange gains and losses relateprimarily to intercompany loans to ClearLab.

***Income taxes.*** The Company is taxed in three separate jurisdictions -   the U.S., Singapore and the United Kingdom.  The Company’s effective U.S. income tax ratefor the three quarters ended September 30, 2006 was approximately 43%, ascompared with the U.S. income tax rate for the three quarters ended October 1,2005 of 40%.  The increase in theeffective U.S. income tax rate for the three quarters ended September 30, 2006primarily resulted from the increase in permanent nondeductible expenses,including those relating to the Company’s lobbying efforts.  The Company’s effective U.S. income tax ratefor the quarter ended September 30, 2006 was 38%, as compared with the U.S.income tax rate for the quarter ended October 1, 2005 of 42%.  This decrease in the effective U.S. incometax rate for the third quarter of fiscal 2006 resulted primarily from an incometax benefit recognized by the Company with the reversal of tax accrualsassociated with the resolution of certain tax matters.

Duringthe second quarter of fiscal 2006, the Company elected not to finalize aSingapore pioneer tax certificate in order to renegotiate the potentialbenefits and time period related thereto. Through the first quarter of fiscal 2006, the Company’s Singaporeoperations had met the requirements for the pioneer tax certificate inSingapore. This pioneer tax certificate allowed for a seven-year tax holidaythat reduced the Singapore statutory tax rate to 0% on qualified income for2003 and future periods through the end of the tax holiday. Without the taxholiday, the Singapore statutory tax rate is 20%. During the first threequarters of fiscal 2006, the Company did not record a tax benefit for the lossfrom the operations of ClearLab International due to uncertainty with respectto the realization of a tax benefit in Singapore relating to losses.   In the first quarter of fiscal 2006, theCompany recorded a current tax provision in Singapore due to Japanesewithholding tax on payments received from the Japanese license agreement. Theforeign tax credit for this Japanese withholding tax is not eligible forcarryforward in the Singapore tax jurisdiction.

Forthe first three quarters of fiscal 2006, the Company recorded a valuationallowance for the full amount of deferred income tax assets in excess oftaxable temporary differences in Singapore and the U.K., as it is more likelythan not that these deferred tax assets will not be realized.

TheCompany expects that its fiscal 2006 effective income tax rates willapproximate 43% for the U.S. operations. For the U.K. and Singapore operations,the Company expects that the effective tax rate will be 0%, with the exceptionof the Japanese withholding tax on license payments made to ClearLabInternational. The Company’s effective income tax rates may change as facts andcircumstances change.

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**Liquidity and Capital Resources**

TheCompany’s principal sources of liquidity have been cash provided by operatingactivities and proceeds from debt financings. The Company’s principal uses of cash have been to meet debt servicerequirements, finance acquisitions, finance capital expenditures, fund workingcapital needs and repurchase common stock. The Company anticipates that these uses will continue to be theprincipal demands on its cash in the future. As of September 30, 2006, the Company had net working capital (deficit) ofapproximately $(19.6) million, compared to $7.7 million as of December 31,2005.  This large decrease in net workingcapital in the third quarter of fiscal 2006 relates to the Company’s line ofcredit that is now classified as current on the condensed consolidated balancesheet, as the maturity date is February 27, 2007.  The Company is in the process of extendingthis loan agreement to extend the maturity date and provide for borrowings ofup to $40 million during the term of the extension.  The extension is expected to be completedbefore the end of fiscal 2006.

TheCompany believes that its cash on hand, together with cash generated fromoperating activities and the borrowings available through its credit facility,will be sufficient to support planned operations through the foreseeablefuture.  The Company announced on July26, 2006 that it had engaged an investment bank to assist in performing astrategic review of ClearLab.  In orderto fully commercialize its products, particularly the AquaSoft Singles product,the Company anticipates that ClearLab will require significant additionalfunding over the foreseeable future, which may not be available through theCompany’s cash flows from operations, and will likely require the Company tosecure alternative funding.  The firstround of this strategic review of ClearLab has been completed.  Based on this review, the Company is nowcommitted to a separation of ClearLab from the U.S. Retail business and expectsto announce terms related to this separation by the end of March 2007.  The Company has also undergone an extensivereview of ClearLab’s manufacturing operations. Subject to any consultation that may be necessary under United Kingdomlaw, the Company is evaluating a consolidation of ClearLab’s manufacturing,research and development operations which are currently carried out in the Singaporeand United Kingdom manufacturing facilities.  Should the Company commence with this consolidation of ClearLab’soperations, it may incur significant restructuring charges and its financialcondition and results of operations could be adversely affected.  Shouldthe Company’s plans or expectations change, related to ClearLab or otherwise,the Company may be required to seek additional sources of funds and there canbe no assurance that such funds will be available on satisfactory terms.  Failure to obtain such financing could delayor prevent the Company’s planned growth, and could adversely affect the Company’sbusiness, financial condition, liquidity and results of operations.

As aresult of regulatory requirements, the Company’s liquidity, capital resourcesand results of operations may be negatively impacted in the future if theCompany incurs increased costs (including legal fees) or fines, is prohibitedfrom selling its products or experiences losses of a substantial portion of theCompany’s customers for whom the Company is unable to obtain or verify a prescriptiondue to the requirements of the FCLCA.

TheCompany has a loan agreement with a U.S. bank providing for a revolving creditfacility. On January 13, 2006, the Company entered into a modifiedagreement which modified this loan agreement effective as of December 30,2005. The modified loan agreement provides for borrowings of up to$30 million, $35 million, or $40 million, depending on the Company’sminimum fixed coverage ratio assessed on a quarterly basis, as defined in theagreement.  Accordingly, as of September30, 2006, the Company’s borrowing capacity under the line was $40 million;subsequent to the third quarter of fiscal 2006, the borrowing capacity wasreduced to $35 million.  Additionally,the agreement provides for letters of credit up to a maximum of$15 million outstanding or payable at any time. The amount of any lettersof credit outstanding is deducted from the amount available for borrowing. Thematurity date of the loan agreement is February 27, 2007, as such; theamounts due under the line of credit are reported as current liabilities in thecondensed consolidated balance sheet as of September 30, 2006.

Outstandingborrowings on the revolving credit facility bear interest at a floating rateequal to the lender’s prime interest rate plus a margin or the lender’s LIBORrate plus a margin. The interest rate is adjusted quarterly and ranges betweenprime minus 0.25 percent and prime plus 0.25 percent or between theapplicable LIBOR rate plus 1.75 percent and the applicable LIBOR rate plus2.25 percent, depending on the Company’s maximum leverage ratio, asdefined in the agreement. As of September 30, 2006, the prime rate margin is 0percent and the LIBOR rate

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margin is 2.00 percent. Interest is payablemonthly. As of September 30, 2006, the Company’s outstanding borrowings on thecredit facility, including bank overdrafts, were $27.2 million. Of thisamount, $12.5 million bore interest at the lender’s LIBOR rate plus2.00 percent (7.33% at September 30, 2006) and the remaining $14.7 millionbore interest at the lender’s prime rate plus 0 percent (8.25% atSeptember 30, 2006). The facility requires the quarterly payment of an unusedcredit fee which ranges from 0.25 percent to 0.38 percent, dependingon the Company’s maximum leverage ratio. There were no outstanding letters of credit as of September 30, 2006.

Outstandingbalances on the credit facility are secured by substantially all of the Company’sU.S. assets, subsidiary debt instruments, 100 percent ownership interestsin all domestic subsidiaries and 65 percent ownership interests in foreignsubsidiaries directly owned by the Company. The modified loan agreementincludes various financial covenants including a capital expenditure limit, amaximum leverage ratio and a minimum fixed charge coverage ratio. The modifiedloan agreement does not permit the Company or its subsidiaries to dissolve,sell, dispose or merge all of their assets or acquire all of 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 modified loan agreement also places a limit on the amount theCompany can loan to any entity, outside the normal course of business.Additionally, the modified agreement allows the Company to declare or pay cashdividends, to repurchase its stock or to perform other similar equitytransactions if such transactions would not exceed $15 million in any fiscalyear and subject to other terms. This agreement defines several customaryevents of default including any material adverse change or any event thatoccurs which may cause a material adverse change in the Company’s or itssubsidiaries’ condition.

As of September 30, 2006, the Company had an unsecured, non-interest bearing note to ClearLab International’s chief technology officer with a principal balance of SGD$625,000 (USD$394,000). The note payable is discounted at 7%.  Payments are due in equal monthly installments through July 2007.

As of September 30,2006, the Company had a term loan payable to a Singapore bank with aprincipal balance of SGD$4,110,000 (USD$2,591,000) that bears interest at 6.75%and is secured by substantially all of the assets of ClearLabInternational.  Interest payments are duemonthly.  Principal payments are due inmonthly installments through December 2007. This note also contains various financial covenants including minimumson net worth and shareholders’ funds. 1-800 CONTACTS, INC. has guaranteed this term loan.

As of September 30, 2006, the Company also had a notepayable to the former parent of ClearLab International with a principal balanceof SGD$6,892,000 (USD$4,345,000) that bears interest at 6% and has asubordinated position to the term loan payable to the Singapore bank.  The note payable is discounted at 7%.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed thisnote.

Cross default clauses exist such that if the Companywere in default on its U.S. debt, the Company would also be in default on itsSingapore debt. If the Company were in default on its Singapore bank term loan,the Company would also be in default on its note payable to the former parentof ClearLab International and its restated loan agreement with its U.S. bank.  As of September 30, 2006, the Company was incompliance with all of the restrictive covenants in its loan agreements.

***Cash flows from operating activities.***  For the three quarters ended September 30,2006 and October 1, 2005, net cash provided by operating activities wasapproximately $4.3 million and $5.2 million, respectively.  During the fiscal 2006 period, cash provided byoperating activities was provided primarily by adjustments to net loss fornon-cash items such as depreciation, amortization and stock compensation,increases in accrued liabilities, as well as decreases in other current assets.The increase in cash was partially offset by the adjustments to net loss forforeign currency exchange gains as well as by decreases in accounts payable andunearned revenue.  In the fiscal 2005period, cash was provided primarily by adjustments to net loss for non-cashitems, increases in accounts payable and accrued liabilities as well as a decreasein other receivables partially offset by increases in inventories, accountsreceivable, other current assets as well as from decreases in income taxespayable and unearned revenue.

***Cash flows from investing activities.***  The Company used approximately $6.0 millionand $12.3 million for investing activities in the three quarters ended September30, 2006 and October 1, 2005, respectively. During the

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first threequarters of fiscal 2006, the Company paid approximately $0.5 million towardssoftware licenses.  In the first threequarters of fiscal 2005, the Company paid approximately $2.1 million indeposits on manufacturing equipment at ClearLab.  The Company also purchased approximately $0.6million of intangible assets during the fiscal 2005 period.

Capitalexpenditures for infrastructure improvements for the three quarters ended September30, 2006 and October 1, 2005 were approximately $5.5 million and $9.5 million,respectively.  Of these amounts,approximately $3.8 million and $5.9 million relate to purchases made at ClearLab,during the respective periods.  TheCompany anticipates additional capital expenditures in fiscal 2006 forinfrastructure as it continues to expand and improve operating facilities,telecommunications systems and management information systems in order tohandle future operations of both its U.S. and international operations.

***Cash flows from financing activities.***  During the three quarters ended September 30,2006 and October 1, 2005, net cash provided by financing activities was approximately$2.1million and $4.1 million, respectively. In the first three quarters of 2006, the Company had net borrowings on itscredit facility of approximately $3.5 million and made principal payments ondebt obligations and capital lease obligations of approximately $1.5million.  In the first three fiscalquarters of 2005, the Company had net borrowings on its credit facility of approximately$5.0 million and made principal payments on debt obligations and capital leaseobligations of approximately $1.3 million. In the first three fiscal quarters of both 2006 and 2005, these amountswere partially offset by proceeds from the exercise of common stock options.

ClearLab leases various manufacturing and otherequipment from financing companies under capital lease arrangements, all ofwhich  is maintained at the Company’s Singaporeand United Kingdom facilities.  Themajority of the leases were assumed in connection with the Company’sacquisitions of ClearLab International and ClearLab UK.  As of September 30, 2006, the present valueof future minimum lease payments was approximately $0.1 million with paymentsscheduled through fiscal 2009.

**Contractual Obligations andCommitments**

Subsequentto December 31, 2005, there have been no material changes to the Company’scontractual obligations and commitments, outside the normal course of business.

**NewAccounting Pronouncements**

InJune 2006, the Financial Accounting Standards Board (FASB) issuedInterpretation No. 48, “Accounting for Uncertainty in Income Taxes,” whichdefines the threshold for recognizing the benefits of tax return positions inthe financial statements as “more-likely-than-not” to be sustained by thetaxing authority. A tax position that meets the “more-likely-than-not”criterion shall be measured at the largest amount of benefit that is more than50% likely of being realized upon ultimate settlement. Interpretation No. 48applies to all tax positions accounted for under SFAS No. 109, “Accounting forIncome Taxes.” Interpretation No. 48 is effective for fiscal years beginningafter December 15, 2006. Upon adoption, the Company will adjust its financialstatements to reflect only those tax positions that are more-likely-than-not tobe sustained as of the adoption date. Any adjustment will be recorded directlyto the beginning retained earnings balance in the period of adoption andreported as a change in accounting principle. The Company is currentlyanalyzing the effects of adopting Interpretation No. 48.

InSeptember 2006, the FASB issued Statement of Financial Accounting Standard No.157, “Fair Value Measurements” (“FAS 157”). FAS 157 provides a definition offair value, establishes acceptable methods of measuring fair value and expandsdisclosures for fair value measurements. The principles apply under accountingpronouncements which require measurement of fair value. The Company does notexpect the adoption of FAS 157 to have a material impact on its financialstatements.

InSeptember 2006, the SEC issued Staff Accounting Bulletin No. 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”). SAB 108 provides guidanceon how prior year misstatements should be taken into consideration whenquantifying misstatements in current year financial statements for purposes ofdetermining whether the current year’s financial statements are materiallymisstated. SAB 108 permits registrants to record the cumulative effect ofinitial adoption

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by recording thenecessary “correcting” adjustments to the carrying values of assets andliabilities as of the beginning of that year with the offsetting adjustmentrecorded to the opening balance of retained earnings only if material under thedual method. SAB 108 is effective for fiscal years ending on or afterNovember 15, 2006 The Company is currently analyzing the effects ofadopting SAB 108.

InJune 2006, the Emerging Issues Task Force (“EITF”) reached a consensus on EITFIssue No. 06-03 (“EITF 06-03”), “How Taxes Collected from Customers andRemitted to Governmental Authorities Should Be Presented in the IncomeStatement (That Is, Gross versus Net Presentation).”  EITF 06-03 provides that the presentation oftaxes assessed by a governmental authority that is directly imposed on arevenue-producing transaction between a seller and a customer on either a grossbasis (included in revenues and costs) or on a net basis (excluded fromrevenues) is an accounting policy decision that should be disclosed.  The provisions of EITF 06-03 will become effectiveas of December 31, 2006.  The Companydoes not expect the adoption of EITF 06-03 to have a material impact on itsconsolidated financial statements.

**CriticalAccounting Policies**

Accountingpolices that require significant judgments and estimates include revenuerecognition (including sales returns and allowances and customer rebates);realizability of inventories; realizability of deferred income tax assets;assessment of realizability of long-lived assets; stock-based compensation; andlegal and regulatory contingencies.  Adescription of the Company’s significant accounting policies is included in thenotes to the consolidated financial statements included in the Company’s AnnualReport on Form 10-K for the fiscal year ended December 31, 2005.  Judgments and estimates are based onhistorical experience as well as relevant facts and circumstances known at eachreporting date.  Actual results maydiffer from these estimates.

Salesare generally recognized when products are shipped and the customer takesownership and assumes risk of loss, collection of the related receivable isreasonably assured, persuasive evidence of an arrangement exists and the salesprice is fixed or determinable.  U.S.Retail net sales consist of product sales less a provision for sales returnsand allowances and estimated customer rebates. The Company accrues an estimated amount for unclaimed customer rebatesand sales returns and allowances based on historical information, adjusted foreconomic trends.  To the extent actualrebates, returns and allowances vary from historical experience revisions tothe allowances may be required.  ClearLabnet sales consist of product sales less a provision for sales returns andallowances. The Company provides its customers with standard industry paymentterms and performs ongoing credit evaluations of its customers and provides fordoubtful accounts to the extent determined necessary based on historical dataand current economic trends.  ClearLabnet sales also include license fees from the Company’s Japanese licenseagreement.  Cash payments received fromthis license are recognized systematically over the periods that the fees areearned by the Company.

Inassessing the realizability of inventories, the Company makes judgments as tofuture demand requirements and product expiration dates.  The inventory requirements change based onprojected customer demand, which changes due to fluctuations in marketconditions and product life cycles.

TheCompany has significant long-lived tangible and intangible assets consistingprimarily of property, plant and equipment, goodwill and definite-livedintangibles.  These assets are reviewedfor impairment whenever events or changes in circumstances indicate that thecarrying amounts of such assets may not be recoverable.  In addition, the Company performs animpairment test related to goodwill at least annually.  An impairment analysis related to long-livedtangible and definite-lived intangible assets requires the assessment ofexpected future undiscounted cash flows over the remaining useful life of theasset.  An impairment analysis ofgoodwill requires the use of a fair-value based analysis.  All of the goodwill and a significant portionof the other long-lived assets were generated from the Company’s acquisitionsof ClearLab International, ClearLab UK and Lens1st/Lens Express.  During the third quarter of fiscal 2006, theCompany prepared an impairment analysis and determined there was no impairmenton any of the ClearLab’s long-lived assets, definite-lived intangible assets orgoodwill as of September 30, 2006. If forecasts and assumptions used to supportthe realizability of long-lived assets change in the future, significantimpairment charges could result that would adversely affect the Company’sresults of operations and financial position.

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Deferredincome tax assets are assessed for recoverability and valuation allowances areprovided as necessary to reduce deferred income tax assets to amounts expectedto be realized.  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.

TheCompany records liabilities for legal and regulatory matters when thecontingency is both probable and reasonably estimable.  The Company is involved in several legal andregulatory matters.  The Company, afterconsultation with legal counsel, believes that the ultimate dispositions ofthese matters will not have a material negative 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.

EffectiveJanuary 1, 2006, the Company adopted the fair value recognition provisionsof SFAS No. 123R, using the modified prospective transition method, andtherefore has not restated prior periods’ results. Under this method theCompany recognizes compensation expense for all share-based payments grantedafter January 1, 2006 and prior to, but not yet vested, as of January 1,2006, in accordance with SFAS No. 123R. Under the fair value recognitionprovisions of SFAS No. 123R, the Company recognizes stock-based compensationnet of an estimated forfeiture rate and only recognizes compensation cost forthose shares expected to vest over the requisite service period of the award. Priorto SFAS No. 123R adoption, the Company accounted for share-based payments underAPB No. 25.  Therefore, the Company generallyrecognized compensation expense for restricted stock awards and when it grantedoptions with an exercise price below the market price on the date of grant. TheCompany estimates the value of stock option awards on the date of grant using aBlack-Scholes pricing model. Calculating the fair value of share-based paymentawards requires the input of highly subjective assumptions, including theexpected term of the share-based payment awards and expected stock pricevolatility.  The expected term representsthe average time that options that vest are expected to be outstanding.  The expected volatility rates are estimatedbased on a weighted average of the historical volatilities of the Company’scommon stock.  The assumptions used incalculating the fair value of share-based payment awards represent management’sbest estimates, but these estimates involve inherent uncertainties and theapplication of management judgment. As a result, if factors change and theCompany uses different assumptions, its stock-based compensation expense couldbe materially different in the future. In addition, the Company is required toestimate the expected forfeiture rate and only recognize expense for thoseshares expected to vest. If the Company’s actual forfeiture rate is materiallydifferent from its estimate, the stock-based compensation expense could besignificantly different from what the Company has recorded in the currentperiod.

**Forward-LookingStatements**

Exceptfor purely historical information or statements contained herein, the mattersdiscussed in this Form 10-Q are forward-looking statements within the meaningof the Private Securities Litigation Reform Act of 1995.    Words such as “believes,” “anticipates,” “expects,”“future,” “intends,” “would,” “could,” “might,” “should,” “projects,” “may” andsimilar expressions are intended to identify forward-looking statements,although not all forward-looking statements will contain those words.  The Company undertakes no obligation torevise any of these forward-looking statements to reflect events orcircumstances after the date hereof. These forward-looking statements involverisks and uncertainties and often depend on assumptions, data or methods thatmay be incorrect or imprecise.  TheCompany’s future operating results may differ materially from the resultsdiscussed in, or implied by, forward-looking statements made by theCompany.  Factors that may cause suchdifferences include, but are not limited to, general economic conditions, the health and size of the contactlens industry, consumer acceptance of ClearLab’s products, product healthbenefits,  the outcome of the strategicreview of ClearLab, inventory acquisition and management,  manufacturing operations, legislative effortsand results, governmental regulations and other regulatory considerations,exchange rate fluctuations, advertising spending and effectiveness,unanticipated costs and expected benefits associated with license agreementsand supply agreements, research and development initiatives, and prescriptionrequirements 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 September 30, 2006, theCompany was exposed to changes in interest rates relating to its revolvingcredit facility and other debt obligations. The revolving credit facility bears interest at a variable rate based onthe U.S. prime rate or LIBOR. The Company’s outstanding borrowings on thecredit facility, including bank overdrafts, were approximately $27.2 million asof September 30, 2006. The remainder of the Company’s interest bearing debtobligations, including capital lease obligations, are denominated in Singaporedollars and British pounds and bear interest at a fixed rate.  As of September 30, 2006, the face amounts ofthe outstanding borrowings on these fixed rate debt obligations wereapproximately $7.0 million.  If interest rates were to change by afull percentage point, the net impact on interest expense would beapproximately $0.3 million per year.

***Foreign Currency Risk***TheCompany faces foreign currency risks primarily as a result of its Singapore andUnited Kingdom operations and the intercompany balances, which are denominatedin U.S. dollars, between its U.S. and these international operations.  The functional currency of the Company’sSingapore operations is the Singapore dollar. The Company has debt and other long-term obligations of approximately$7.4 million that are denominated in Singapore dollars and mature over the nextthree years.  If the U.S. dollar weakensrelative to the Singapore dollar, additional funds may be required to meetthese obligations if the debt cannot be adequately serviced from the Singaporeoperations.  Fluctuations in exchangerates between the U.S. dollar and the Singapore dollar could lead to additionalcurrency exchange losses or gains on the intercompany balances and transactionsdenominated in currencies other than the functional currency.  For the third quarter of fiscal 2006, theCompany recorded approximately $0.1 million of foreign currency transactiongains on the intercompany balances between the U.S. and Singapore operations.  From the date of the ClearLab Internationalacquisition, July 24, 2002, through November 2, 2006, the exchange rate hasfluctuated approximately 12.0 percent (weakening of the U.S. dollar).   If the Singapore dollar were to weakenagainst the U.S. dollar by 10 percent, the Company would record a $3.4 milliondollar foreign currency loss on the intercompany balances that exist as ofSeptember 30, 2006.

Thefunctional currency of the Company’s United Kingdom operations is the Britishpound.  Fluctuations in exchange ratesbetween the U.S. dollar and the British pound could lead to additional currencyexchange losses or gains on intercompany balances and transactions denominatedin currencies other than the functional currency.  For the third quarter of fiscal 2006, theCompany recorded foreign currency transaction gains of approximately $0.5million on the intercompany balances between the U.S. and United Kingdomoperations; and recorded approximately $0.1 million in foreign currencytransactions losses on sales with external parties.  From the date of the ClearLab UK acquisition,February 24, 2004, through November 2, 2006, the exchange rate has fluctuatedapproximately 2.2 percent (weakening of the U.S. dollar).  If the British pound were to weaken againstthe U.S. dollar by 10 percent, the Company would record a $1.8 million dollarforeign currency loss on the intercompany balances that exist as of September30, 2006.

The Company has notentered into any foreign currency derivative financial instruments; however, itmay choose to do so in the future in an effort to manage or hedge its foreigncurrency risk.

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

***(a)**Evaluation of disclosure controls and procedures*.**  The Company’s Chief Executive Officer andChief Financial Officer, after evaluating the effectiveness of the Company’sdisclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)and 15d-15(e)) as of the end of the period covered by this report (the “EvaluationDate”), have concluded that, as of the Evaluation Date, the Company’sdisclosure controls and procedures were adequate and effective to ensure thatmaterial information relating to the Company and its consolidated subsidiarieswould be made known to them by others within those entities.

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***(b) Changes in internal controls overfinancial reporting.*** There were no significant changes in the Company’s internal controls overfinancial reporting or in other factors that have materially affected, or arereasonably likely to materially affect, the Company’s internal controls overfinancial reporting subsequent to the Evaluation Date.  As a result, no corrective actions weretaken.

TheCompany’s management, including its Chief Executive Officer and Chief FinancialOfficer, does not expect that the Company’s disclosure controls and proceduresor its internal controls over financial reporting will prevent all error andall fraud.  A control system, no matterhow well conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met.  Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs.  Because of inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, within the Company have beendetected.

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

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

Fromtime to time the Company is involved in legal matters generally incidental toits business. It is the opinion of management, after discussion with legalcounsel, that except for legal and professional fees that the Company incursfrom time to time, the ultimate dispositions of all of these matters will nothave a material impact on the financial position, liquidity or results ofoperations of the Company. However, there can be no assurance that the Companywill be successful in its efforts to satisfactorily resolve these matters, andthe ultimate outcome could result in a material negative impact on the Company’sfinancial position, liquidity or results of operations.

**Item 1A.                 *Risk Factors***

Otherthan the additional risk factors set forth below, there are no material changesfrom the risk factors previously disclosed in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2005.

**The Company has expended significant resources in thedevelopment of its ClearLab operations and may not realize value equal to itsinvestment.**

OnJuly 26, 2006, the Company announced that it had engaged an investment bank toassist in performing a strategic review of its ClearLab operations.  The first round of this strategic review ofClearLab has been completed.  Based onthis review, the Company is now committed to a separation of ClearLab from theU.S. retail business. The Company has invested significant amounts in acquiringand developing ClearLab and its operations and products.  The Company can provide no assurance thatseparation of ClearLab can be accomplished on favorable terms or that such separationwill allow the Company to recover its investment in ClearLab.

**The Company’s strategic review of ClearLab may result in theCompany continuing to incur significant additional expense to support ClearLab.**

Basedon its strategic review of ClearLab, the Company is now committed to aseparation of ClearLab from the U.S. retail business.  However, the Company may be unable to effect aseparation of ClearLab upon favorable terms.  In order to fully commercialize ClearLab’sproducts, particularly the AquaSoft Singles product, the Company anticipatesthat ClearLab will require significant additional funding over the foreseeablefuture. The Company can provide no assurance that separation of ClearLab fromthe U.S. retail business can be accomplished on favorable terms or that theCompany will be able to reduce or eliminate ClearLab cash requirements.

**Item 2.****                   *****Unregistered Sales of EquitySecurities and Use of Proceeds***

None.

**Item 3.****                   *****Defaults Upon Senior Securities***

None.

**Item 4.****                   *****Submission of Matters to a Voteof Security Holders***

None.

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

None.

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

**(A)Exhibits**
| Exhibit No. | ** ** | **Description  of Exhibit**                                                                                         |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------|
| 3.1 (i)     |       | Restated  Certificate of Incorporation of the Company. (1)                                                          |
| 3.1 (ii)    |       | Restated By-Laws  of the Company. (1)                                                                               |
| 4.1         |       | Form of  certificate representing shares of Common Stock, $0.1 par value per share.  (2)                            |
| 10.1        |       | First Amendment  to 1-800 CONTACTS, INC. Amended and Restated 2004 Stock Incentive Plan,  effective October 1, 2006 |
| 31.1        |       | Certification  Required Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                  |
| 31.2        |       | Certification  Required Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                  |
| 32.1        |       | Certification  Required Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                  |
| 32.2        |       | Certification  Required Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                  |

 

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|        |   | (1)   Incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the quarterly  period ended April 4, 1998 (Commission File No. 0-23633). |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                        |
|   |   | (2)   Incorporated  by reference to the same numbered exhibit to the Company’s Registration  Statement on Form S-1 (Registration No. 333-41055).   |

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**SIGNATURES**

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

 
|                               | **1-800 CONTACTS, INC.** |
|-------------------------------|--------------------------|
|                          |                     |
|                          |                     |
|  Dated: November 9, 2006 | By:                      | /s/ Jonathan C. Coon |   |
|                          |                     | Name: |   | Jonathan C. Coon |
|                          |                     | Title: |   | Chief Executive  Officer |
|                          |                     |   |   |   |
|                          | By:                      | /s/ Robert G.  Hunter |   |
|                          |                     | Name: |   | Robert G. Hunter |
|                          |                     | Title: |   | Chief Financial  Officer |
|                               |                          |  |  |  |  |

 

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