**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC  20549**

 

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**FORM10-Q**

 
| **(Mark one)**                                                                                                                                                                                                                                                                  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                                                                                                                                                      | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                            |
| **For  the quarterly period ended July 3, 2004**                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                            |
| **o**                                                                                                                                                                                                                                                                           | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                            |
| **For  the transition period  from                     to                     **. |
|                                                                                                                                                                                                                                                                            |
| **Commission  file number:  0-23633**                                                                                                                                                                                                                                      |

 

**1-800CONTACTS, INC.**(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                     | ** ** | **87-0571643**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **66 E.  Wadsworth Park Drive, 3rd Floor  Draper, UT**           | ** ** | **84020**                             |
| (Address of principal  executive offices)                        |       | (Zip Code)                            |
|                                                             |       |                                  |
| **(801)  924-9800**                                              |
| (Registrant’s telephone  number, including area code)       |

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for the past90 days.

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

 

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

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

 

As of August 6,2004, the Registrant had 13,286,621 shares of Common Stock, par value $0.01 pershare, outstanding.

 

 

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**1-800 CONTACTS, INC.**

 

**INDEX**

 
| **PART I.**  |   | **FINANCIAL INFORMATION**                                                                                               |   |
|--------------|--------|-------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.      |   | Financial Statements                                                                                                    |   |
|         |   | Condensed  Consolidated Balance Sheets as of January 3, 2004 and July 3, 2004                                           |   |
|         |   | Condensed  Consolidated Statements of Operations for the Quarter and Two Quarters Ended  June 28, 2003 and July 3, 2004 |   |
|         |   | Condensed  Consolidated Statements of Cash Flows for the Two Quarters Ended  June 28, 2003 and July 3, 2004             |   |
|         |   | Notes  to Condensed Consolidated Financial Statements                                                                   |   |
| Item  2.     |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                             |   |
| Item  3.     |   | Quantitative  and Qualitative Disclosures About Market Risk                                                             |   |
| Item 4.      |   | Controls and Procedures                                                                                                 |   |
|         |   |                                                                                                                    |   |
| **PART II.** |   | **OTHER INFORMATION**                                                                                                   |   |
| Item 1.      |   | Legal Proceedings                                                                                                       |   |
| Item 2.      |   | Changes in Securities and  Use of Proceeds                                                                         |   |
| Item 3.      |   | Defaults upon Senior Securities                                                                                         |   |
| Item 4.      |   | Submission of Matters to a  Vote of Security Holders                                                                    |   |
| Item 5.      |   | Other Information.                                                                                                      |   |
| Item 6.      |   | Exhibits and Reports on Form 8-K                                                                                        |   |

 

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**PART 1. FINANCIAL INFORMATION**

**       Item1. Financial Statements**

 

**1-800 CONTACTS, INC.CONDENSED CONSOLIDATED BALANCESHEETS (in thousands)(unaudited)**

 
| ** **                                            | ** ** | **January 3,  2004** | ** ** | **July 3,  2004** | ** ** |
|-------------------------------------------------------|------------|----------------------|------------|-------------------|------------|
| **ASSETS**                                            |       |                 |       |              |       |
| CURRENT ASSETS:                                       |       |                 |       |              |       |
| Cash                                                  |       | $                    | 1,075      |              | $          | 330 |   |
| Accounts  receivable, net                             |       | 944                  |       | 1,210             |       |
| Inventories, net                                      |       | 24,127               |       | 25,166            |       |
| Prepaid income  taxes                                 |       | 797                  |       | 193               |       |
| Deferred income  taxes                                |       | 548                  |       | 900               |       |
| Other current  assets                                 |       | 1,752                |       | 3,448             |       |
| Total current  assets                                 |       | 29,243               |       | 31,247            |       |
| PROPERTY, PLANT  AND EQUIPMENT, net                   |       | 13,183               |       | 17,346            |       |
| DEFERRED INCOME  TAXES                                |       | 710                  |       | 922               |       |
| GOODWILL                                              |       | 33,853               |       | 33,768            |       |
| DEFINITE-LIVED  INTANGIBLE ASSETS, net                |       | 9,207                |       | 16,325            |       |
| OTHER ASSETS                                          |       | 735                  |       | 973               |       |
| Total assets                                          |       | $                    | 86,931     |              | $          | 100,581 |   |
|                                                  |       |                 |       |              |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**        |       |                 |       |              |       |
| CURRENT  LIABILITIES:                                 |       |                 |       |              |       |
| Current portion  of long-term debt                    |       | $                    | 3,381      |              | $          | 1,253 |   |
| Current portion  of capital lease obligations         |       | 191                  |       | 158               |       |
| Accounts payable                                      |       | 8,558                |       | 8,549             |       |
| Accrued  liabilities                                  |       | 4,847                |       | 6,922             |       |
| Total current  liabilities                            |       | 16,977               |       | 16,882            |       |
| LONG-TERM  LIABILITIES:                               |       |                 |       |              |       |
| Line of credit                                        |       | —               |       | 17,420            |       |
| Long-term debt,  less current portion                 |       | 14,683               |       | 8,566             |       |
| Capital lease obligations,  less current portion      |       | 64                   |       | 56                |       |
| Deferred income  tax liabilities                      |       | —               |       | 2,545             |       |
| Total long-term  liabilities                          |       | 14,747               |       | 28,587            |       |
| STOCKHOLDERS’  EQUITY                            |       |                 |       |              |       |
| Common stock,  13,113 and 13,287 issued, respectively |       | 131                  |       | 133               |       |
| Additional  paid-in capital                           |       | 42,346               |       | 45,773            |       |
| Retained  earnings                                    |       | 12,834               |       | 9,480             |       |
| Accumulated  other comprehensive loss                 |       | (104                 | )          | (274              | )          |
| Total  stockholders’ equity                      |       | 55,207               |       | 55,112            |       |
| Total  liabilities and stockholders’ equity      |       | $                    | 86,931     |              | $          | 100,581 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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**1-800 CONTACTS, INC.CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS(in thousands, except per share amounts)(unaudited)**

 
| ** **                                                 | ** ** | **Quarter Ended**  | ** ** | **Two Quarters Ended** | ** ** |
|------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **June 28,  2003** | ** ** | **July 3,  2004**      | ** ** | **June 28,  2003** | ** ** | **July 3,  2004** | ** ** |
| NET SALES                                                  |       | $                  | 46,354     |                   | $          | 49,971 |   | $ | 93,016 |   | $ | 100,820 |   |
| COST OF GOODS  SOLD                                        |       | 28,580             |       | 30,698                 |       | 59,140 |   | 62,251 |   |
| Gross profit                                               |       | 17,774             |       | 19,273                 |       | 33,876 |   | 38,569 |   |
|                                                       |       |               |       |                   |       |   |   |   |   |
| OPERATING EXPENSES:                                        |       |               |       |                   |       |   |   |   |   |
| Advertising                                                |       | 3,586              |       | 7,224                  |       | 7,380 |   | 16,039 |   |
| Legal and  professional                                    |       | 1,755              |       | 1,341                  |       | 3,376 |   | 3,181 |   |
| Research and  development                                  |       | 197                |       | 443                    |       | 2,000 |   | 1,335 |   |
| Purchased  in-process research and development             |       | —             |       | —                 |       | — |   | 83 |   |
| Other operating                                            |       | 10,104             |       | 10,766                 |       | 18,753 |   | 20,648 |   |
| Total operating  expenses                                  |       | 15,642             |       | 19,774                 |       | 31,509 |   | 41,286 |   |
|                                                       |       |               |       |                   |       |   |   |   |   |
| INCOME (LOSS)  FROM OPERATIONS                             |       | 2,132              |       | (501                   | )          | 2,367 |   | (2,717 | ) |
|                                                       |       |               |       |                   |       |   |   |   |   |
| OTHER EXPENSE,  net                                        |       | (323               | )          | (699                   | )          | (823 | ) | (1,055 | ) |
|                                                       |       |               |       |                   |       |   |   |   |   |
| INCOME (LOSS)  BEFORE BENEFIT (PROVISION) FOR INCOME TAXES |       | 1,809              |       | (1,200                 | )          | 1,544 |   | (3,772 | ) |
|                                                       |       |               |       |                   |       |   |   |   |   |
| BENEFIT  (PROVISION) FOR INCOME TAXES                      |       | (1,249             | )          | 52                     |       | (1,472 | ) | 418 |   |
|                                                       |       |               |       |                   |       |   |   |   |   |
| NET INCOME  (LOSS)                                         |       | $                  | 560        |                   | $          | (1,148 | ) | $ | 72 |   | $ | (3,354 | ) |
|                                                       |       |               |       |                   |       |   |   |   |   |
| PER SHARE  INFORMATION:                                    |       |               |       |                   |       |   |   |   |   |
| Basic and  diluted net income (loss) per common share      |       | $                  | 0.04       |                   | $          | (0.09 | ) | $ | 0.01 |   | $ | (0.25 | ) |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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**1-800 CONTACTS, INC.CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS(in thousands)(unaudited)**

 
| ** **                                                                                           | ** ** | **Two Quarters Ended** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                           | ** ** | **June 28,  2003**     | ** ** | **July 3,  2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                               |       |                   |       |   |   |
| Net income  (loss)                                                                                   |       | $                      | 72         |   | $ | (3,354 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                   |       |   |   |
| Depreciation and  amortization                                                                       |       | 3,008                  |       | 3,606 |   |
| Amortization of  debt issuance costs and discounts                                                   |       | 96                     |       | 197 |   |
| Purchased  in-process research and development                                                       |       | —                 |       | 83 |   |
| Unrealized  foreign currency exchange loss                                                           |       | 77                     |       | 85 |   |
| Loss on sale of  property and equipment                                                              |       | 6                      |       | 73 |   |
| Stock-based  compensation                                                                            |       | 731                    |       | — |   |
| Deferred income  taxes, net of effects of acquisition                                                |       | (59                    | )          | (1,101 | ) |
| Changes in  operating assets and liabilities, net of effects of acquisitions:                        |       |                   |       |   |   |
| Accounts  receivable                                                                                 |       | (992                   | )          | (275 | ) |
| Inventories                                                                                          |       | 10,510                 |       | (706 | ) |
| Other current  assets                                                                                |       | (356                   | )          | (1,382 | ) |
| Accounts payable                                                                                     |       | (3,115                 | )          | (786 | ) |
| Accrued  liabilities                                                                                 |       | 664                    |       | 1,463 |   |
| Income taxes  payable / prepaid income taxes                                                         |       | 1,180                  |       | 682 |   |
| Unearned revenue                                                                                     |       | 92                     |       | (1 | ) |
| Net cash  provided by (used in) operating activities                                                 |       | 11,914                 |       | (1,416 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                               |       |                   |       |   |   |
| Purchase of  property and equipment                                                                  |       | (1,655                 | )          | (3,406 | ) |
| Proceeds from  sale of property and equipment                                                        |       | 33                     |       | 4 |   |
| Purchase of  intangible assets                                                                       |       | (28                    | )          | (1,011 | ) |
| Cash paid for  acquisitions                                                                          |       | (7,012                 | )          | (3,776 | ) |
| Deposits and  other                                                                                  |       | (55                    | )          | (186 | ) |
| Net cash used in  investing activities                                                               |       | $                      | (8,717     | ) | $ | (8,375 | ) |

 

5

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| ** **                                           | ** ** | **Two Quarters Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **June 28,  2003**     | ** ** | **July 3,  2004** | ** ** |
| CASH FLOWS FROM  FINANCING ACTIVITIES:               |       |                   |       |   |   |
| Proceeds from  exercise of common stock options      |       | $                      | 715        |   | $ | 138 |   |
| Restricted stock  grants                             |       | —                 |       | 6 |   |
| Net (repayments)  borrowings on line of credit       |       | (1,931                 | )          | 17,420 |   |
| Debt issuance  costs                                 |       | —                 |       | (193 | ) |
| Principal  payments on capital lease obligations     |       | (206                   | )          | (165 | ) |
| Principal  payments on long-term debt                |       | (1,311                 | )          | (8,240 | ) |
| Net cash  provided by (used in) financing activities |       | (2,733                 | )          | 8,966 |   |
| EFFECT OF FOREIGN  EXCHANGE RATES ON CASH            |       | (1                     | )          | 80 |   |
|                                                 |       |                   |       |   |   |
| NET (DECREASE)  INCREASE IN CASH                     |       | 463                    |       | (745 | ) |
| CASH AT  BEGINNING OF PERIOD                         |       | 259                    |       | 1,075 |   |
| CASH AT END OF  PERIOD                               |       | $                      | 722        |   | $ | 330 |   |
|                                                 |       |                   |       |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                 |       |                   |       |   |   |
| Cash paid for  interest                              |       | $                      | 560        |   | $ | 641 |   |
| Cash paid for  income taxes                          |       | 350                    |       | — |   |

 

SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:

 

During the first quarter of 2003, the Company purchased certain assetsand assumed certain liabilities of Lens Express and Lens 1st.  The purchase consideration included cash of$7,012, common stock with a fair value of $19,859 and assumed operatingliabilities of $4,099.

 

During the second quarter of 2003, the performance guarantee was metrelating to 700,000 shares of the Company’s restricted common stock held inescrow as partial consideration for the July 2002 acquisition of ClearLab.  The Company recorded additional purchaseconsideration of approximately $16,980 for these shares.  The Company recorded this as goodwill, net ofa contingent consideration liability recorded at the purchase date.  The amount of goodwill as of June 28, 2003was $11,205 (see Note 6).

 

During the first quarter of 2004, the Company purchased the stock ofVisionTec (subsequently renamed ClearLab UK, Ltd.).  The purchase consideration included cash of$3,776 and common stock with a fair value of $3,200 (see Note 6).

 

See accompanying notes tocondensed consolidated financial statements.

 

6

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**1-800 CONTACTS, INC.NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS(Unaudited)**

 

# **NOTE1.  PRESENTATION OF CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

The accompanyingcondensed consolidated financial statements have been prepared by the Company,without audit, pursuant to the rules and regulations of the Securities andExchange Commission.  Certain informationand disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules andregulations.  These condensedconsolidated financial statements reflect all adjustments (consisting only ofnormal recurring adjustments), which in the opinion of management, arenecessary to present fairly the results of operations of the Company for theperiods presented.  It is suggested thatthese condensed consolidated financial statements be read in conjunction withthe audited financial statements and the notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended January 3, 2004.

 

# **NOTE2.  INVENTORIES**

 

Inventories arerecorded at the lower of cost (using the first-in, first-out method) or marketvalue.  Inventories consisted of thefollowing (in thousands):

 
| ** **                     | ** ** | **January 3,  2004** | ** ** | **July 3,  2004** | ** ** |
|--------------------------------|------------|----------------------|------------|-------------------|------------|
| Purchased  contact lenses      |       | $                    | 20,943     |              | $          | 20,438 |   |
| Manufactured  inventories:     |       |                 |       |              |       |
| Raw materials                  |       | 429                  |       | 636               |       |
| Work in process                |       | 2,681                |       | 3,831             |       |
| Finished goods  contact lenses |       | 74                   |       | 261               |       |
| Total                          |       | $                    | 24,127     |              | $          | 25,166 |   |

 

Provision is madeto reduce excess and obsolete inventories to their estimated net realizablevalues.  As of January 3, 2004 and July3, 2004, reserves for excess and obsolete inventories were $623,000 and$1,098,000, respectively.

 

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

 

Basic net income (loss) per common share (“Basic EPS”)excludes dilution and is computed by dividing net income (loss) by theweighted-average number of common shares outstanding during the period.  Diluted net income (loss) per common share (“DilutedEPS”) reflects the potential dilution that could occur if stock options orother common stock equivalents were exercised or converted into commonstock.  The computation of Diluted EPSdoes not assume exercise or conversion of securities that would have anantidilutive effect on net income (loss) per common share. For the quarter andtwo quarters ended July 3, 2004, options to purchase 1,415,875 and 1,408,178shares of common stock, respectively, were not included in the computation ofDiluted EPS because the effect would be antidilutive.  For the quarter and two quarters ended June28, 2003, options to purchase 611,448 and 909,465 shares of common stock,respectively, were not included in the computation of Diluted EPS because theeffect would be antidilutive.

 

7

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

 
| ** **              | ** ** | **Quarter Ended June 28, 2003** | ** ** | **Quarter Ended July 3, 2004** | ** ** |
|-------------------------|------------|---------------------------------|------------|--------------------------------|------------|
| ** **              | ** ** | **Net  Income**                 | ** ** | **Shares**                     | ** ** | **Per-Share****Amount** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per-Share****Amount** | ** ** |
|                    |       |                            |       |                           |       |   |   |   |   |   |   |   |   |
| Basic EPS               |       | $                               | 560        |                           | 12,552     |   | $ | 0.04 |   | $ | (1,148 | ) | 13,286 |   | $ | (0.09 | ) |
| Effect of stock options |       | —                          |       | 210                            |       | — |   | — |   | — |   | — |   |
| Diluted EPS             |       | $                               | 560        |                           | 12,762     |   | $ | 0.04 |   | $ | (1,148 | ) | 13,286 |   | $ | (0.09 | ) |

 
| ** **              | ** ** | **Two Quarters Ended June 28, 2003** | ** ** | **Two Quarters Ended July 3, 2004** | ** ** |
|-------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **              | ** ** | **Net  Income**                      | ** ** | **Shares**                          | ** ** | **Per-Share****Amount** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per-Share****Amount** | ** ** |
|                    |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| Basic EPS               |       | $                                    | 72         |                                | 12,269     |   | $ | 0.01 |   | $ | (3,354 | ) | 13,237 |   | $ | (0.25 | ) |
| Effect of stock options |       | —                               |       | 224                                 |       | — |   | — |   | — |   | — |   |
| Diluted EPS             |       | $                                    | 72         |                                | 12,493     |   | $ | 0.01 |   | $ | (3,354 | ) | 13,237 |   | $ | (0.25 | ) |

 

**NOTE4.  COMPREHENSIVE INCOME (LOSS)**

 

Comprehensive income (loss) for the quarter and twoquarters ended June 28, 2003 and July 3, 2004 consists of the followingcomponents (in thousands): 

 
| ** **                         | ** ** | **Quarter Ended** | ** ** | **Two Quarters Ended** | ** ** |
|------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                         | ** ** | **June 28, 2003** | ** ** | **July 3, 2004**       | ** ** | **June 28, 2003** | ** ** | **July 3, 2004** | ** ** |
| Net income  (loss)                 |       | $                 | 560        |                   | $          | (1,148 | ) | $ | 72 |   | $ | (3,354 | ) |
| Foreign currency  translation loss |       | (442              | )          | (147                   | )          | (302 | ) | (170 | ) |
| Comprehensive  income (loss)       |       | $                 | 118        |                   | $          | (1,295 | ) | $ | (230 | ) | $ | (3,524 | ) |

 

The foreign currency translation loss resultsprimarily from changes in exchange rates relative to the U.S. dollar from thetranslation of the Company’s Singapore and United Kingdom subsidiaries’financial statements.

 

**NOTE 5.  STOCK-BASED COMPENSATION**

 

The Company applies Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations and uses the intrinsic method of accounting for its stockoption grants to employees and directors. No compensation expense has been recognized for stock option awardsgranted at or above fair market value of the stock on the date of grant.

 

Under Statement of Financial Accounting Standards(“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” compensationexpense is recognized for the fair market value of each option as estimated onthe date of grant using the Black-Scholes option-pricing model.  SFAS No. 148, “Accounting for Stock-BasedCompensation – Transition and Disclosure,” amends SFAS No. 123, to providealternative methods of transition for a voluntary change to the fair marketvalue based method of accounting for stock-based employee compensation.  In addition, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 to require new prominent disclosures inboth annual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used on reportedresults. The Company has elected to adopt the “disclosure only” provisions ofSFAS No. 148.

 

8

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If compensation expense for all stock options had beendetermined consistent with SFAS No. 123, the Company’s net income (loss) andbasic and diluted net income (loss) per common share would have been as follows(in thousands, except per share amounts):

 
| ** **                                            | ** ** | **Quarter Ended**  | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|
| ** **                                            | ** ** | **June 28,  2003** | ** ** | **July 3,  2004** | ** ** |
| Net income  (loss):                                   |       |               |       |   |   |
| As reported                                           |       | $                  | 560        |   | $ | (1,148 | ) |
| Fair-value based  compensation, net of tax            |       | (258               | )          | (412 | ) |
| Pro forma                                             |       | $                  | 302        |   | $ | (1,560 | ) |
|                                                  |       |               |       |   |   |
| Basic and  diluted net income(loss) per common share: |       |               |       |   |   |
| As reported                                           |       | $                  | 0.04       |   | $ | (0.09 | ) |
| Pro forma                                             |       | $                  | 0.02       |   | $ | (0.12 | ) |

 
| ** **                                             | ** ** | **Two Quarters Ended** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **June 28,  2003**     | ** ** | **July 3,  2004** | ** ** |
| Net income  (loss):                                    |       |                   |       |   |   |
| As reported                                            |       | $                      | 72         |   | $ | (3,354 | ) |
| Fair-value based  compensation, net of tax             |       | (539                   | )          | (828 | ) |
| Pro forma                                              |       | $                      | (467       | ) | $ | (4,182 | ) |
|                                                   |       |                   |       |   |   |
| Basic and  diluted net income (loss) per common share: |       |                   |       |   |   |
| As reported                                            |       | $                      | 0.01       |   | $ | (0.25 | ) |
| Pro forma                                              |       | $                      | (0.04      | ) | $ | (0.32 | ) |

 

The weightedaverage per share fair value of options granted during the quarters ended June28, 2003 and July 3, 2004 and the two quarters ended June 28, 2003 and July 3,2004 was $14.28 and $9.43, and $13.85 and $12.04, respectively.  The fair value of each option grant has beenestimated on the grant date using the Black-Scholes option-pricing model withthe following weighted average assumptions:

 
| ** **               | ** ** | **Quarter Ended**  | ** ** | **Two Quarters Ended** | ** ** |
|--------------------------|------------|--------------------|------------|------------------------|------------|
| ** **               | ** ** | **June 28,  2003** | ** ** | **July 3,  2004**      | ** ** | **June 28,  2003** | ** ** | **July 3,  2004** | ** ** |
| Risk-free  interest rate |       | 2.2                | %          | 3.6                    | %          | 2.6 | % | 3.1 | % |
| Expected  dividend yield |       | 0.0                | %          | 0.0                    | %          | 0.0 | % | 0.0 | % |
| Volatility               |       | 76.1               | %          | 67.0                   | %          | 77.0 | % | 67.8 | % |
| Expected life            |       | 5 years            |       | 5 years                |       | 5 years |   | 5 years |   |

 

**NOTE 6.  RECENT ACQUISITIONS**

 

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

 

On March 13, 2003, the Company signed a letter ofintent with VisionTec, a developer and manufacturer of contact lenses based inthe United Kingdom, and certain of its shareholders.  The Company agreed to pay VisionTec anon-refundable sum equal to $1.5 million to be used by the entity for researchand development activities relating to contact lenses.  Of the total, $0.7 million was paid on March14, 2003, and the remaining $0.8 million was paid on June 13, 2003.  In addition, the Company was granted asix-month option to either: (1) acquire all of the shares of common stock ofthe entity; or (2) acquire from the entity a worldwide license to manufacture,market, sell or otherwise use or exploit specific technology developed by theentity.  As consideration for thisoption, the Company

 

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paid $0.1 million to VisionTec on March 14, 2003.  In the event that the Company did notexercise the option to purchase the shares of VisionTec, the Company agreed topay the entity an additional $0.8 million. The Company also reimbursed VisionTec and its shareholders approximately$0.2 million for legal and financial expenses incurred by the entity inconnection with the agreement.

 

On September 12, 2003, the Company exercised theoption to acquire all of the shares of common stock of VisionTec.  During the period between September 12, 2003and the closing of the acquisition on February 24, 2004, the Company continuedto pay certain fees and expenses of the entity related to the entity’s researchand development activities.  The Companypaid approximately $2.1 million to VisionTec from September 12, 2003 throughJanuary 3, 2004 and $0.5 million from January 3, 2004 through February 24,2004, for such research and development activities.

 

In connection withthe agreement, and the transactions discussed above, the Company expensed atotal of approximately $3.9 million from March 13, 2003 through January 3, 2004(inclusive of the $0.2 million in costs) related to these research anddevelopment initiatives and $0.5 million in the first quarter of fiscal 2004 endedApril 3, 2004.

 

On February 24,2004, the Company completed the acquisition of all of the outstanding stock ofVisionTec (subsequently renamed ClearLab UK). The consideration paid included approximately $3.8 million in cash(including $0.6 million in transaction costs) and 155,084 shares of theCompany’s common stock with a fair value of approximately $3.2 million.  In addition, the Company has agreed to pay aper unit royalty on the sale of contact lenses to the former shareholders ofVisionTec for a period of ten years.

 

The Company filed a registration statement with the Securitiesand Exchange Commission (“SEC”) covering the resale of the 155,084 shares bythe former stockholders of VisionTec.

 

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

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

 

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

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

 

Core technologiesand patents are definite-lived intangible assets that are being amortized overtwelve years.

 

**NOTE 7.  COMMON STOCK TRANSACTIONS**

 

During the twoquarters ended July 3, 2004, employees exercised stock options to purchase18,892 shares of common stock for a total of approximately $138,000.  The Company recorded an increase inadditional paid-in capital of approximately $85,000 as a result of the incometax benefit related to these stock option exercises.

 

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During the twoquarters ended July 3, 2004, the Company granted nonqualified stock options topurchase 128,478 shares of common stock to employees and directors of theCompany.  The exercise price of theoptions was $22.00 per share, which was not less than the quoted fair marketvalue at the grant date. The options vest equally over a four-year period andexpire in five years.

 

On February 24,2004, the Company completed the acquisition of ClearLab UK and issued 155,084shares of the Company’s common stock with a fair value of approximately $3.2million (see Note 6).  The restrictedstock was registered with the Securities and Exchange Commission (“SEC”) onForm S-3 effective June 18, 2004.

 

**NOTE 8.  DEBT OBLIGATIONS**

 

Effective February27, 2004, the Company executed a restated loan agreement with its existing U.S.bank, providing for a revolving credit facility for borrowings of up to $28million through June 1, 2004, and reducing thereafter on the first day of eachSeptember, December, March and June by $0.4 million until the maturity date ofFebruary 27, 2007.  Additionally, the agreement provides for letters ofcredit up to a maximum of $15 million outstanding or payable at any time. The executed restated loan agreement specifies that if the maximumleverage ratio, as defined in the restated loan agreement, is greater than 2.5,then the amounts outstanding on the revolving credit facility together with theamount of all outstanding letters of credit can at no time exceed the Company’sbook value of inventory.  As of July 3, 2004, the Company was subject tothis restriction and could only borrow up to the $25.2 million book value ofits inventory.  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 restated loan agreementoriginally specified that interest based on the lender’s prime rate is theprime rate plus 0.75 percent until July 31, 2004, and thereafter is adjustedquarterly, ranging between prime plus 0.0 percent and prime plus 1.25 percent,depending on the Company’s maximum leverage ratio.  The restated loan agreement also originallyspecified that interest based on the lender’s LIBOR rate is the LIBOR rate forthe applicable period plus 2.75 percent until July 31, 2004, and thereafter isadjusted quarterly, ranging between LIBOR plus 2.0 percent and LIBOR plus 3.25percent, depending on the Company’s maximum leverage ratio.  On June 25, 2004, the restated loan agreementwas modified to stipulate that until the maximum leverage ratio, as defined inthe restated loan agreement, is less than or equal to 3.0, the LIBOR rateapplicable margin will be 3.25 percent and the prime rate applicable marginwill be 1.25 percent.  As of July 3,2004, the Company was subject to these specifications.  Interest is payable monthly.  As of July 3, 2004, the Company’s outstandingborrowings on the credit facility, including bank overdrafts, were $17.4million.  Of this amount, $12.0 millionbore interest at the lender’s LIBOR rate plus 3.25 percent (4.54% at July 3,2004) and the remaining $5.4 million bore interest at the lender’s prime rateplus 1.25 percent (5.50% at July 3, 2004).  The facility requires thepayment of an unused credit fee, which is also determined by the Company’smaximum leverage ratio.  The unusedcredit fee is payable quarterly at 0.5 percent until July 31, 2004.  Thereafter, the unused credit fee is adjustedquarterly, ranging from 0.38 percent to 0.5 percent, depending on the Company’smaximum leverage ratio.

 

All outstandingbalances on this credit facility are secured by substantially all of theCompany’s U.S. assets, subsidiary debt instruments, 100 percent ownershipinterests in all domestic subsidiaries and 65 percent ownership interests inforeign subsidiaries directly owned by the Company.  The new loanagreement includes various financial covenants including a capital expenditurelimit, a maximum leverage ratio, a minimum working capital requirement, aminimum fixed charge coverage ratio and a minimum net worth requirement. The new loan agreement does not permit the Company or its subsidiaries todissolve, sell, dispose or merge all of their assets or acquire all of theassets of any entity without the written consent of the U.S. bank, unless thetransaction meets the definition of a “Permitted Acquisition Basket”, asdefined in the agreement.  The new loan agreement also places a limit onthe amount the Company can loan to any entity, outside the normal course ofbusiness.  Additionally, the agreement does not permit the Company todeclare or pay any cash dividends, to repurchase its stock or to perform othersimilar equity transactions prior to December 31, 2005; thereafter, suchtransactions are subject to other terms.  This agreement defines severalcustomary events of default including any material adverse change or any eventthat occurs which may cause a material adverse change in the Company’s or itssubsidiaries’ condition.

 

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The June 25, 2004 modification to the restated loanagreement also modified the maximum leverage ratio financial covenant.  As of July 3, 2004, the Company was incompliance with all applicable covenants, as modified and clarified by the U.S.bank.

 

The Company’s Singapore bank term loan containsvarious financial covenants including minimums on net worth and shareholders’funds of the Singapore operations.  As ofJuly 3, 2004, the Company was in compliance with all applicable covenants.  1-800 CONTACTS, INC. has guaranteed this termloan.

 

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 indefault on its Singapore bank term loan, the Company would also be in defaulton its note payable to the parent of IGEL and its restated loan agreement withits U.S. bank.

 

**NOTE 9.  COMMITMENTS AND CONTINGENCIES**

 

*Legal Matters*

 

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

 

On April 7, 1999, the Kansas Board of Examiners inOptometry (“KBEO”) commenced a civil action against the Company in the DistrictCourt of Shawnee County, Kansas. The complaint was amended on May 28, 1999, andalleges that “on one or more occasions” the Company sold contact lenses in thestate of Kansas without receipt of a prescription. The amended complaint seeksan order enjoining the Company from further engaging in the alleged activity,and does not seek monetary damages. The Company filed an answer to the amendedcomplaint denying all material allegations, and setting forth severalaffirmative defenses.  The Company has vigorouslydefended this lawsuit, which has now been pending for over five (5) years.  In June, 2002, the court granted a summaryjudgment motion in favor of the KBEO. However, the court made no findings ofany violations of Kansas law, and based its decision on a Kansas optometry lawthat has been repealed and amended by the Kansas legislature. The Companyappealed this decision, and on November 7, 2003, the Kansas Court ofAppeals reversed the trial court’s order, and remanded the case back to thetrial court for further proceedings. Thus, as a result of the Appellate court’sorder, there was no injunction against the Company as of November 7, 2003.Following receipt of the Appellate Court’s order, the parties each submittedproposed orders to the trial court. The KBEO asked the court to re-enter summaryjudgment in its favor, and to reinstate the injunction, and the Company askedthe court to dismiss the case, based either on the lack of any basis forinjunctive relief, or because the case is now moot based on changes to Kansaslaw which took effect while the case was pending on appeal, or based on therecent passage of the FCLCA which took effect on February 4, 2004. By order dated April 30, 2004, the trial court reinstated the injunctionprohibiting the Company from selling contact lenses without a validprescription under K.S.A. 65-1504b unless and until a determination is madethat the Fairness to Contact Lens Consumers Act (“FCLCA”) preempts itsenforcement.  The Company has filed a motion asking the Court to clarifyits injunction, to provide that Defendant

 

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is required to comply with the prescription verification requirementsset forth in the new federal law in order to obtain a valid prescription asrequired by K.S.A. 65-1504b or, alternatively, to amend or alter its Order denyplaintiff’s motion for summary judgment, granting summary judgment to defendantand entering an order denying the requested injunctive relief, based in part onthe preemptive effect of the FCLCA.  Thismotion remains pending.

 

Since the FCLCAwas enacted last year, the Company has continued to adhere to the prescriptionverification procedures set forth in this new federal law.  To the extentK.S.A. 65-1504 continues to have any application at all, the Company believesthat by complying with the FCLCA it does not run afoul of K.S.A. 65-1504and therefore intends to continue adhering to the prescription verificationprocedures set forth in the FCLCA.  On June 29, 2004, the FTC issueda rule confirming that the FCLCA preempts state laws that purport to requirestricter prescription verification procedures or that are otherwiseinconsistent with the FCLCA. Accordingly, the Company does not believe that K.S.A. 65-1504 does orcan require it to change its existing business practices in any way.  However, should any claim or interpretationregarding K.S.A. 65-1504 be advanced to the contrary, the Company isprepared to vigorously contest any such claim or interpretation.

 

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

 

***Advertising Commitments***

 

As of July 3,2004, the Company had entered into certain noncancelable commitments withvarious advertising companies that will require the Company to payapproximately $7.5 million for advertising during the remainder of 2004.

 

***Purchase Commitments***

 

As of July 3,2004, the Company had entered into certain noncancelable commitments with acertain supplier that will require the Company to purchase approximately $8.5million of inventory during the third quarter of fiscal 2004.

 

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**NOTE 10.  SEGMENT INFORMATION**

 

Asa result of the acquisition of IGEL (ClearLab International) in the thirdquarter of fiscal 2002 and the recently acquired VisionTec (ClearLab UK), theCompany has two operating segments. These operating segments represent components of the Company for whichseparate financial information is available and evaluated regularly bymanagement in determining resource allocation and performance assessment.  The Company’s U.S. Retail segment includesthe operations of 1-800 CONTACTS and the operations from the Lens Express andLens 1st acquisitions.  TheCompany’s International segment includes the operations of ClearLabInternational and ClearLab UK, both of which are developers and manufacturersof contact lenses.  Operating segmentinformation for the quarter and two quarters ended June 28, 2003 and July 3,2004 are as follows (in thousands):

 
| ** **                     | ** ** | **Quarter Ended** | ** ** |
|--------------------------------|------------|-------------------|------------|
| ** **                     | ** ** | **June 28, 2003** | ** ** | **July 3, 2004** | ** ** |
| ** **                     | ** ** | **U.S.  Retail**  | ** ** | **International** | ** ** | **Total** | ** ** | **U.S.  Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
| Net sales                      |       | $                 | 44,701     |   | $ | 1,653 |   | $ | 46,354 |   | $ | 48,742 |   | $ | 1,229 |   | $ | 49,971 |   |
| Gross profit  (loss)           |       | 17,045            |       | 729 |   | 17,774 |   | 19,825 |   | (552 | ) | 19,273 |   |
| Research and  development      |       | 147               |       | 50 |   | 197 |   | — |   | 443 |   | 443 |   |
| Other operating  expense       |       | 8,592             |       | 1,512 |   | 10,104 |   | 9,606 |   | 1,160 |   | 10,766 |   |
| Income (loss)  from operations |       | 3,055             |       | (923 | ) | 2,132 |   | 1,835 |   | (2,336 | ) | (501 | ) |
|                                |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                     | ** ** | **Two Quarters Ended** | ** ** |
|------------------------------------------------|------------|------------------------|------------|
| ** **                                     | ** ** | **June 28, 2003**      | ** ** | **July 3, 2004** | ** ** |
| ** **                                     | ** ** | **U.S.  Retail**       | ** ** | **International** | ** ** | **Total** | ** ** | **U.S.  Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
| Net sales                                      |       | $                      | 89,832     |   | $ | 3,184 |   | $ | 93,016 |   | $ | 98,193 |   | $ | 2,627 |   | $ | 100,820 |   |
| Gross profit  (loss)                           |       | 32,793                 |       | 1,083 |   | 33,876 |   | 38,755 |   | (186 | ) | 38,569 |   |
| Research and  development                      |       | 1,909                  |       | 91 |   | 2,000 |   | 536 |   | 799 |   | 1,335 |   |
| Purchased  in-process research and development |       | —                 |       | — |   | — |   | — |   | 83 |   | 83 |   |
| Other operating  expense                       |       | 16,617                 |       | 2,136 |   | 18,753 |   | 18,575 |   | 2,073 |   | 20,648 |   |
| Income (loss)  from operations                 |       | 3,666                  |       | (1,299 | ) | 2,367 |   | 686 |   | (3,403 | ) | (2,717 | ) |
|                                                |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Identifiable segment assets are as follows (inthousands):

 
| ** **             | ** ** | **January 3, 2004** | ** ** | **July 3, 2004**  | ** ** |
|------------------------|------------|---------------------|------------|-------------------|------------|
| ** **             | ** ** | **U.S. Retail**     | ** ** | **International** | ** ** | **Total** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
| Long-lived assets, net |       | $                   | 30,615     |              | $          | 25,628 |   | $ | 56,243 |   | $ | 30,728 |   | $ | 36,711 |   | $ | 67,439 |   |
| Total assets           |       | 56,274              |       | 30,657            |       | 86,931 |   | 57,173 |   | 43,408 |   | 100,581 |   |
|                        |            |                     |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 11.  VENDOR REBATE AND INCENTIVE ARRANGEMENTS**

 

The Company enters into arrangements to receivecash consideration from certain of its vendors. The arrangements include manufacturer rebates and cooperative marketingprogram reimbursements.  Cashconsideration from some vendor agreements are dependent upon reaching minimumpurchase thresholds. The Company evaluates the likelihood of reaching purchasethresholds using past experience and current year forecasts. When rebates canbe reasonably estimated, the Company records a portion of the rebate as it makesprogress towards the purchase threshold. In accordance with EITF 02-16, it is generally presumed that amountsreceived from vendors are a reduction of the prices paid for theirproducts.  Therefore, that cashconsideration is reflected as a reduction of cost of goods sold if theinventory has been sold by the Company or a reduction of inventory if theproduct inventory is still on hand at the reporting date. When the Companyreceives reimbursements for specific, incremental, identifiable advertisingcosts incurred for advertising the vendors’ products, the cash considerationreceived is recorded as a reduction to advertising expense in the Company’sconsolidated statements of operations.

 

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**Item 2.    Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

**Overview**

 

The Company is aleading direct marketer of replacement contact lenses and also conducts contactlens manufacturing, development, and distribution operations in Singapore andthe United Kingdom.  The Company sellsall of the popular brands of contact lenses, including those manufactured byJohnson & Johnson Vision Care, CIBA Vision, Bausch & Lomb, OcularSciences and CooperVision.

 

***InternationalOperations (ClearLab)*.** On July 24, 2002, the Company completed the acquisition of certain netassets and the majority of the business operations of IGEL (subsequentlyrenamed ClearLab International), a developer and manufacturer of contact lensesbased in Singapore.  ClearLab International is the principal marketingorganization for the Company’s international wholesale manufacturing anddistribution business, focusing on the marketing of contact lens products tomajor retailers and distributors, as well as providing contract manufacturingcapacity for other contact lens manufacturers.  ClearLab Internationalmanufactures a wide range of frequent replacement spherical and toric lensesand is focused on developing new lens materials.

 

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

 

ClearLabInternational’s and ClearLab UK’s development and manufacturing capabilitiesalso provide the Company with greater access to future contact lens productsfor the U.S. retail market.  This iscritical to the Company’s strategy should the Company’s access to contactlenses from the major contact lens manufacturers be disrupted, curtailed orotherwise negatively impacted, or if the manufacturers do not provide theCompany with contact lenses at competitive pricing and with competitivemarketing support.

 

***Johnson & Johnson Vision Care Agreement.***  In December 2002, the Company announced thatit had reached an agreement with Johnson & Johnson Vision Care to become anauthorized retailer of Johnson & Johnson Vision Care contact lenses.  The Company modified its operating systems inconnection with this agreement. The Company implemented new prescriptionverification procedures for Johnson & Johnson Vision Care by geographicregion based on time zone.  The Companybegan this implementation in February 2003 and completed it in April 2003. TheCompany began buying direct from Johnson & Johnson Vision Care during March2003.

 

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

 

***Cole National Marketing Agreement.*** On June 30, 2003, the Company and ColeNational Corporation (“Cole”) announced that they had signed an agreement underwhich the Company’s customers can receive discounted eye exams and valuepricing on eyeglasses, sunglasses and other vision products that the Companydoes not sell from a network of doctors contracted with Cole Managed Vision andassociated with more than 1,500 Pearle Vision, Pearle VisionCare, Sears Opticaland Target Optical stores in the U.S. During the second quarter of fiscal 2004, the Company and Cole extendedthis agreement through March 31, 2005. Under this agreement, Cole is offering its network of doctors to theCompany to be used for contacts lens exam referrals and the Company retains thecontact lens business of customers referred to Cole stores.

 

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As part of the agreement, the Company and Cole havealso worked together on a variety of cross-marketing programs and promotions oftheir respective products in select test markets.  The goal of these cross-marketing programs isto find other ways that the Company and Cole can help create value together.

 

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

 

During the first quarter of fiscal 2004, the Companycompleted the consolidation of a majority of the operating facilities acquiredfrom Lens 1st into its principal operating facilities in Utah.

 

***SupplierAgreements.*** During the latter part of 2003, the Companyreached agreements with its top three vendors for improved pricing andmarketing support.  This support willcome in the form of cooperative marketing and rebate programs designed topromote the manufacturer’s products and build sales.  As part of its ongoing relationship with itssuppliers, the Company periodically reviews its specific marketing plans andnegotiates cooperative marketing programs with these vendors.

 

# **RegulatoryConsiderations**

 

***Fairness to Contact Lens Consumer Act*.**  In November 2003, Congress passed theFairness to Contact Lens Consumer Act (“FCLCA”), which establishes a nationaluniform standard for both eye care practitioners and direct marketers withregard to releasing and verifying consumer contact lens prescriptions as wellas other requirements relating to the sale of contact lenses.  The FCLCA became effective February 4, 2004,and now requires all eye care practitioners to give patients a copy of theirprescription as soon as they have been fitted for contact lenses, whether thepatients ask for it or not.  It alsorequires all eye care practitioners to respond to direct marketers’ requests toverify consumer prescriptions and provides that their failure to respond withineight business hours shall result in the prescription being presumed valid,thereby eliminating the ability of eye care practitioners to impede sales bydirect marketers simply by ignoring or refusing to respond to their requests toverify prescriptions.  The FCLCA alsoprovides that prescriptions will be valid for a minimum of at least one year(absent some special medical reason justifying a shorter period) and that thetime for expiration shall not begin to run until the eye care practitioner hasgiven the patient a copy of his or her prescription.  It also directs the Federal TradeCommission (“FTC”) to promulgate implementing rules and to conduct a studyexamining the strength of competition in the market for contact lenses and tosubmit a report to Congress within twelve months of the FCLCA effective date.This FTC study will specifically address, among other things, the use of doctorexclusive brands (i.e., contact lenses available only for sale from an eye carepractitioner) and other practices that impede competition.

 

The FCLCA also requires that contact lenses only besold to consumers based on a valid prescription.  Satisfying this prescription requirementobligates the seller either to obtain a copy of the prescription itself or toverify the prescription by direct communication with the customer’sprescriber.  Consistent with this requirement,the Company’s current operating practice is to require all customers to provideeither a valid copy of their prescription or the contact information for theirprescriber so that the Company can verify their prescription by directcommunication with their prescriber.  Ifthe Company does not have a valid copy of the customer’s prescription, theCompany directly communicates to the customer’s prescriber the preciseprescription information received from the customer and informs the prescriberthat it will proceed with the sale based on this prescription informationunless the prescriber advises it within eight business hours that suchprescription 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

 

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the prescriber, as expressly permitted by the FCLCA.  The Company retains copies of the writtenprescriptions that it receives and maintains records of its communications withthe customer’s prescriber.

 

Net sales for fiscal 2003 and the first two quartersof fiscal 2004 were negatively impacted by canceled orders due to the Company’simplementation of its prescription verification procedures, including, mostsignificantly, those implemented as part of the Johnson & Johnson VisionCare agreement in 2003, and the revisions to the Company’s prescriptionverification procedures instituted on February 4, 2004 in response to theFCLCA. The Company is taking steps to recover these canceled orders principallyby offering to its customers who do not hold a valid prescription for contactlenses referrals for contact lens exams to a Cole doctor under the Cole agreement.  The Company is uncertain as to the ultimateimpact its revised prescription verification procedures will have on future netsales, and the Company is uncertain as to the number of canceled orders thatcan subsequently be recovered through its doctor network referral program withCole.

 

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**Results of Operations**

 

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

 

The followingtable presents the Company’s results of operations expressed as a percentage ofnet sales for the periods indicated:
| ** **                                                 | ** ** | **Quarter Ended**  | ** ** | **Two Quarters Ended** | ** ** |
|------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **June 28,  2003** | ** ** | **July 3,  2004**      | ** ** | **June 28,  2003** | ** ** | **July 3,  2004** | ** ** |
| NET SALES                                                  |       | 100.0              | %          | 100.0                  | %          | 100.0 | % | 100.0 | % |
| COST OF GOODS  SOLD                                        |       | 61.7               |       | 61.4                   |       | 63.6 |   | 61.7 |   |
| Gross profit                                               |       | 38.3               |       | 38.6                   |       | 36.4 |   | 38.3 |   |
|                                                       |       |               |       |                   |       |   |   |   |   |
| OPERATING  EXPENSES:                                       |       |               |       |                   |       |   |   |   |   |
| Advertising                                                |       | 7.7                |       | 14.5                   |       | 7.9 |   | 15.9 |   |
| Legal and  professional                                    |       | 3.8                |       | 2.7                    |       | 3.6 |   | 3.2 |   |
| Research and  development                                  |       | 0.4                |       | 0.9                    |       | 2.2 |   | 1.3 |   |
| Purchased  in-process research and development             |       | —             |       | —                 |       | — |   | 0.1 |   |
| Other operating                                            |       | 21.8               |       | 21.5                   |       | 20.2 |   | 20.5 |   |
| Total operating  expenses                                  |       | 33.7               |       | 39.6                   |       | 33.9 |   | 41.0 |   |
| INCOME (LOSS)  FROM OPERATIONS                             |       | 4.6                |       | (1.0                   | )          | 2.5 |   | (2.7 | ) |
| OTHER EXPENSE,  net                                        |       | (0.7               | )          | (1.4                   | )          | (0.9 | ) | (1.0 | ) |
| INCOME (LOSS)  BEFORE BENEFIT (PROVISION) FOR INCOME TAXES |       | 3.9                |       | (2.4                   | )          | 1.6 |   | (3.7 | ) |
| BENEFIT  (PROVISION) FOR INCOME TAXES                      |       | (2.7               | )          | 0.1                    |       | (1.5 | ) | 0.4 |   |
| NET INCOME  (LOSS)                                         |       | 1.2                | %          | (2.3                   | )%         | 0.1 | % | (3.3 | )% |

 

***Netsales***.  Net salesfor the quarter ended July 3, 2004 increased 7.8% to $50.0 million from $46.4million for the quarter ended June 28, 2003. For the two quarters ended July 3, 2004, net sales increased 8.4% to$100.8 million from $93.0 million for the two quarters ended June 28,2003.  Net sales for the Company’s U.S.Retail operations, for the second quarter of fiscal 2004 and the first twoquarters of fiscal 2004 were $48.8 million and $98.2 million,respectively.  The increase in net salesis mainly due to increased advertising and manufacturer rebate programsinstituted during the prior quarter for select products, as well as a currentquarter retail price increase principally on phone orders.  Net sales were negatively impacted by morethan $10 million due to a substantial increase in the number and percentage oforders the Company canceled as a result of the prescription verificationprocedures implemented as part of the Johnson & Johnson Vision Careagreement during the period February through April 2003 and the revisions tothe Company’s prescription verification procedures instituted on February 4,2004 in compliance with the FCLCA (see “Federal Regulation”).  The Company’s cancellation rate for the firsttwo quarters of fiscal 2004 was approximately 20%, which is approximately 70%greater than the Company’s cancellation rate for the first two quarters offiscal 2003.

 

The Company hastaken steps to minimize these canceled orders, including continued developmentof a doctor network through the Cole agreement and the establishment of adoctor network department to help obtain the necessary prescription informationthat is required to complete an order. The Company is uncertain of the ultimate long-term impact that theseprescription verification procedures required by the FCLCA and the Company’sefforts to recover the canceled sales will have on future net sales, however,it does believe that the cancellation percentage has peaked and will decline inthe third fiscal quarter of 2004.

 

 

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Net sales for theCompany’s international operations (ClearLab), for the second quarter of fiscal2004 and the first two quarters of fiscal 2004 were $1.2 million and $2.6million, respectively.  Net sales forClearLab for the second quarter and first two quarters of fiscal 2003 were $1.7million and $3.1 million, respectively. The Company expects ClearLab sales toincrease internationally during the second half of fiscal 2004. 

 

***Gross profit.*** Gross profit as a percentage of net sales increased to 38.6% for thequarter ended July 3, 2004 from 38.3% for the quarter ended June 28, 2003.  For the first two quarters ended July 3,2004, gross profit as a percentage of net sales increased to 38.3% from 36.4%for the two quarters ended June 28, 2003. During the first two quarters of fiscal 2004, the majority of the grossprofit improvement was due to the Company’s U.S. Retail operations continuingto realize the expected benefits of a decrease in wholesale prices paid forJohnson & Johnson Vision Care products as well as a current quarter retailprice increase principally on phone orders. During March 2003, the Company began buying directly from Johnson &Johnson Vision Care.  The Company did notrealize the full benefits of purchasing from Johnson & Johnson Vision Careduring the first quarter of fiscal 2003 due to significant amounts of Johnson& Johnson Vision Care inventory held by the Company prior to making directpurchases from them.  During the latterpart of 2003, the Company reached agreement with Johnson & Johnson VisionCare for additional pricing improvements. The Company expects gross profit as a percentage of net sales for itsU.S. Retail operations to remain relatively constant during the remainder offiscal 2004.  During the second quarterof fiscal 2004, the Company recognized a negative gross margin at ClearLab dueto the start-up nature of its U.K. operations which were acquired during thelatter part of the first quarter of fiscal 2004.  The Company expects this trend to reverse andexpects to record a positive gross margin during the second half of fiscal 2004as ClearLab sales increase internationally.

 

***Advertisingexpense. ***Advertisingexpense for the quarter ended July 3, 2004 was $7.2 million, an increase of$3.6 million from the quarter ended June 28, 2003.  As a percentage of net sales, advertisingexpense increased to 14.5% for the second quarter of fiscal 2004 from 7.7% forthe second quarter of fiscal 2003.  Forthe two quarters ended July 3, 2004, advertising expense was $16.0 million, anincrease of $8.7 million from the two quarters ended June 28, 2003.  A majority of the increase was for theCompany’s television advertising campaign. The Company expects total advertising expense incurred will beapproximately $26 million for all of fiscal 2004.  However, if opportunities present themselves,the Company may increase advertising spending above currently planned levels.  The Company’s experience has been that increasesin advertising expenditures have a direct impact on the growth of net sales notonly in the current period but also in future periods.

 

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

 

***Legaland professional fees.*** Legal and professional fees for the quarter ended July 3, 2004 decreased$0.4 million to $1.3 million, or 23.6%, from the quarter ended June 28,2003.  As a percentage of net sales,legal and professional fees decreased to 2.7% for the second quarter of fiscal2004 from 3.8% for the second quarter of fiscal 2003.  For the two quarters ended July 3, 2004,legal and professional fees decreased $0.2 million to $3.2 million, or 5.8%,from the two quarters ended June 28, 2003. As a percentage of net sales, legal and professional fees decreased to3.2% for the first two quarters of fiscal 2004 from 3.6% for the first twoquarters of fiscal 2003.

 

During the quarter, the Company invested in legal and professional feesfor support of its doctor network, an international tax structuring project,Sarbanes-Oxley compliance efforts and other initiatives.  Although the Fairness to Contact Lens Consumer Act (“FCLCA”) became effectiveFebruary 4, 2004, the Company invested considerable effort during the firstfiscal quarter of 2004 preparing comments for the Federal Trade Commission(“FTC”) relating to final rules associated with the FCLCA.  The Company submitted its comments to theproposed

 

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rules during thefirst fiscal quarter of 2004.  TheCompany expects to reduce expenditures on legal and professional fees byapproximately $2.0 million in fiscal 2004 versus expenditures in fiscal2003.  The Company will continue to focusits efforts on compliance with federal rules and regulations.  However, legal and professional fees aresubject to change as circumstances warrant.

 

***Researchand development expenses.*** Research and development expenses for the quarter ended July 3, 2004increased to $0.4 million, or 0.9% of net sales, from $0.2 million, or 0.4% ofnet sales, from the quarter ended June 28, 2003.  For the two quarters ended July 3, 2004,research and development expenses were $1.3 million, or 1.3% of net sales.  The Company’s U.S. Retail operations funded$0.5 million during the first fiscal quarter of 2004 for research anddevelopment activities performed by VisionTec prior to the Company’s acquisitionof the entity on February 24, 2004. During the first two quarters of fiscal 2003, the Company’s U.S. Retailoperations expensed approximately $2.0 million for research and developmentactivities performed by VisionTec.  TheCompany expects to incur total consolidated research and development expensesof approximately $2 million in fiscal 2004, the majority of which is related toClearLab’s operations.

 

***Other operating expenses.***  Other operating expenses for the quarterended July 3, 2004 increased $0.7 million, or 6.6%, from the quarter ended June28, 2003.  As a percentage of net sales,other operating expenses decreased to 21.5% for the second quarter of fiscal2004 from 21.8% for the second quarter of fiscal 2003.  The Company’s U.S. Retail other operatingexpenses increased by approximately $1.0 million for the quarter ended July 3,2004 from the quarter ended June 28, 2003 as the Company added to itsmanagement team and created new functions within the organization including thedoctor referral network department.  Theincrease includes just over $0.1 million for recruiting costs relating to keyinformation technology and marketing positions. The increase also includes an additional $0.3 million for severance andother employee costs related to the elimination of one senior operatingposition. The increase for the quarter in U.S. Retail other operating expenseswas offset by a decrease of $0.3 million in other operating expenses fromClearLab.

 

For the two quarters ended July 3, 2004, other operating expensesincreased $1.9 million to $20.6 million. Other operating expenses for theCompany's U.S. Retail operations increased by $2.0 million.  A majority of this increase related to thecontinued enhancement of its operating infrastructure and management team tomeet the demands of the business and the requirements of the FCLCA.  The Company also incurred approximately $0.2million in costs related to the consolidation of the operations of Lens 1stfrom Michigan to Utah.  The increase inU.S. Retail was offset by a decrease of $0.1 million in other operatingexpenses from ClearLab.

 

The Company expects other operating expenses to fluctuate as apercentage of net sales as the Company continues to grow and expand its U.S.and international operations. 

 

***Otherexpense, net.*** Other expense increased to approximately $0.7 million and $1.1 millionfor the quarter and two quarters ended July 3, 2004, respectively, fromapproximately $0.3 million and $0.8 million for the quarter and two quartersended June 28, 2003, respectively.  Forthe first quarter of fiscal 2004, other expense consisted mainly of interestexpense, offset slightly by an unrealized foreign exchange transaction gain of$0.1 million.  For the two quarters endedJuly 3, 2004, other expense consisted mainly of interest expense and anunrealized foreign exchange transaction loss. The interest expense resulted from the use of the revolving creditfacility and debt related to the acquisition of VisionTec (ClearLab UK, Ltd.)and ClearLab International. The unrealized foreign exchange transaction loss ofapproximately $0.1 million for the two quarters ended July 3, 2004, relatedprimarily to intercompany loans to ClearLab. For the first two quarters offiscal 2003, other expense consisted mainly of interest expense and unrealizedforeign exchange transaction losses incurred by the Company.  The unrealized foreign exchange transaction lossesrelated primarily to the intercompany loan to ClearLab International.

 

***Incometaxes. ***The Companyis taxed in three jurisdictions — U.S., Singapore and the United Kingdom.  The Company’s effective U.S. income tax ratefor the first two quarters ended July 3, 2004 was 39% compared to 42% for thetwo quarters ended June 28, 2003.  TheCompany records quarterly

 

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income taxes at theeffective tax rate expected for the year. The decrease in the effective income tax rate primarily results from theestimated annual decrease in permanent nondeductible expenses; including thoserelating to the Company’s lobbying efforts. During the first two quarters of fiscal 2004, the Company did not recorda tax benefit for the loss from the operations of ClearLab International due tothe uncertainty with respect to the realization of a tax benefit inSingapore.  As of the second quarter offiscal 2004, the Company provided a valuation allowance for the full amount ofthe deferred income tax assets in Singapore. For the first two quarters of fiscal 2004, the Company recorded a taxbenefit for the loss from operations of ClearLab UK using an effective tax rateof 27%.  The Company did not provide avaluation allowance for the deferred income tax assets in the United Kingdombecause the deferred tax liabilities recorded as of the date of acquisition ofClearLab UK were in excess of the deferred tax assets generated by the lossfrom operations during the first half of 2004, which operating loss can becarried forward indefinitely.  TheCompany’s estimated effective U.S. and United Kingdom income tax rates maychange as facts and circumstances change.

 

**Liquidity and Capital Resources**

 

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

 

The Company believes that its cash on hand, togetherwith cash generated from operating activities and the borrowings availablethrough the credit facility, will be sufficient to support planned operationsthrough the foreseeable future.  Shouldthe Company’s plans or expectations change, the Company may be required to seekadditional sources of funds and there can be no assurance that such funds willbe available on satisfactory terms. Failure to obtain such financing could delay or prevent the Company’splanned growth, which could adversely affect the Company’s business, financialcondition, liquidity and results of operations.

 

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

 

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

 

The Company willcontinue to pursue research and development activities at ClearLab UK.  ClearLab UK began to manufacture products ina test environment in late 2003, and the Company will continue to expand itsmanufacturing capabilities during the remainder of fiscal 2004 to market theClearLab UK products internationally.

 

**RenewedLoan Agreement** - Effective February 27, 2004, the Companyexecuted a restated loan agreement with its existing U.S. bank, providing for arevolving credit facility for borrowings of up to $28 million through June 1,2004, and reducing thereafter on the first day of each September, December, Marchand June by $0.4 million until the maturity date of February 27, 2007. Additionally, the agreement provides for letters of credit up to a maximum of$15 million outstanding or payable at any time.  The executed restatedloan agreement specifies that if the maximum leverage ratio, as defined in therestated loan agreement, is greater than 2.5, then the amounts

 

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outstanding on therevolving credit facility together with the amount of all outstanding lettersof credit can at no time exceed the Company’s book value of inventory.  Asof July 3, 2004, the Company was subject to this restriction and could onlyborrow up to the $25.2 million book value of its inventory.  Outstanding borrowings on the revolving creditfacility bear interest at a floating rate equal to the lender’s prime interestrate plus a margin or the lender’s LIBOR rate plus a margin.  The restated loan agreement originallyspecified that interest based on the lender’s prime rate is the prime rate plus0.75 percent until July 31, 2004, and thereafter is adjusted quarterly, rangingbetween prime plus 0.0 percent and prime plus 1.25 percent, depending on theCompany’s maximum leverage ratio.  Therestated loan agreement also originally specified that interest based on thelender’s LIBOR rate is the LIBOR rate for the applicable period plus 2.75percent until July 31, 2004, and thereafter is adjusted quarterly, rangingbetween LIBOR plus 2.0 percent and LIBOR plus 3.25 percent, depending on the Company’smaximum leverage ratio.  On June 25,2004, the restated loan agreement was modified to stipulate that until themaximum leverage ratio, as defined in the restated loan agreement, is less thanor equal to 3.0, the LIBOR rate applicable margin will be 3.25 percent and theprime rate applicable margin will be 1.25 percent.  As of July 3, 2004, the Company was subjectto these specifications.  Interest ispayable monthly.  As of July 3, 2004, theCompany’s outstanding borrowings on the credit facility, including bankoverdrafts, were $17.4 million.  Of thisamount, $12.0 million bore interest at the lender’s LIBOR rate plus 3.25percent (4.54% at July 3, 2004) and the remaining $5.4 million bore interest atthe lender’s prime rate plus 1.25 percent (5.50% at July 3, 2004).  Thefacility requires the payment of an unused credit fee, which is also determinedby the Company’s maximum leverage ratio. The unused credit fee is payable quarterly at 0.5 percent until July 31,2004.  Thereafter, the unused credit feeis adjusted quarterly, ranging from 0.38 percent to 0.5 percent, depending onthe Company’s maximum leverage ratio.

 

All outstandingbalances on this credit facility are secured by substantially all of theCompany’s U.S. assets, subsidiary debt instruments, 100 percent ownershipinterests in all domestic subsidiaries and 65 percent ownership interests inforeign subsidiaries directly owned by the Company.  The new loanagreement includes various financial covenants including a capital expenditurelimit, a maximum leverage ratio, a minimum working capital requirement, aminimum fixed charge coverage ratio and a minimum net worth requirement. The new loan agreement does not permit the Company or its subsidiaries todissolve, sell, dispose or merge all of their assets or acquire all of theassets of any entity without the written consent of the U.S. bank, unless thetransaction meets the definition of a “Permitted Acquisition Basket”, asdefined in the agreement.  The new loan agreement also places a limit onthe amount the Company can loan to any entity, outside the normal course ofbusiness.  Additionally, the agreement does not permit the Company todeclare or pay any cash dividends, to repurchase its stock or to perform othersimilar equity transactions prior to December 31, 2005; thereafter, suchtransactions are subject to other terms.  This agreement defines severalcustomary events of default including any material adverse change or any eventthat occurs which may cause a material adverse change in the Company’s or itssubsidiaries’ condition.

 

The June 25, 2004modification to the restated loan agreement also modified the maximum leverageratio financial covenant.  As of July 3,2004, the Company was in compliance with all applicable covenants as modifiedand clarified by the U.S. bank.

 

***Cash flows from operating activities.***  For the two quarters ended July 3, 2004 andJune 28, 2003, net cash (used in) provided by operating activities wasapproximately ($1.4 million) and $11.9 million, respectively.  In the fiscal 2004 period, cash was usedprimarily for increases in inventories, other current assets, accountsreceivable and to fund the net loss, partially offset by an increase in accruedliabilities and accounts payable.  In thefiscal 2003 period, cash was provided primarily by net income and a decrease ininventories partially offset by a decrease in accounts payable.

 

***Cash flows from investing activities.***  The Company used approximately $8.4 millionand $8.7 million for investing activities in the two quarters ended July 3,2004 and June 28, 2003, respectively.  Inthe fiscal 2004 period, the Company paid approximately $3.8 million in cash(including $0.6 million in transaction costs) in connection with the acquisitionof VisionTec.  The Company also purchasedapproximately $1.0 million of intangible assets during the fiscal 2004period.  In the fiscal 2003 period, theCompany paid approximately $7.0 million in cash (including $0.4 million intransaction costs) in connection with the acquisition of Lens Express and Lens1st.

 

Capital expenditures for infrastructure improvementsfor the first two quarters ended July 3, 2004 and June 28, 2003 wereapproximately $3.4 million and $1.7 million, respectively.  Of those amounts, approximately $2.2

 

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million and $0.6 million related to the ClearLab operations,respectively.  The Company anticipatesfunding approximately $1.5 million for each remaining quarter in fiscal 2004for property and equipment at its ClearLab operations.  These funds will primarily by used for theexpansion of its daily lens capacity in response to demand.  The Company also anticipates additionalcapital expenditures throughout the remainder of fiscal 2004 for infrastructureas it continues to expand and improve operating facilities, telecommunicationssystems and management information systems in order to handle future U.Soperations.

 

***Financing activities.***  During the two quarters ended July 3, 2004and June 28, 2003, net cash provided by (used in) financing activities wasapproximately $9.0 million and ($2.7 million), respectively.  In the fiscal 2004 period, the Company hadnet borrowings on its credit facility of approximately $17.4 million and madeprincipal payments on debt obligations and capital lease obligations ofapproximately $8.4 million.  In thefiscal 2003 period, the Company had net repayments on its credit facility ofapproximately $1.9 million and made principal payments on debt obligations andcapital lease obligations of approximately $1.5 million.  In both fiscal periods, these amounts wereoffset by proceeds from the exercise of common stock options.

 

The Company’s Board of Directors authorized the repurchase of up to3,000,000 shares of the Company’s Common Stock. A purchase of the full 3,000,000 shares would equal approximately 23percent of the total shares issued as of July 3, 2004.  The repurchase of common stock is subject tomarket conditions and is accomplished through periodic purchases at prevailingprices on the open market, by block purchases or in privately negotiatedtransactions.  From inception of itsauthorized repurchase programs through July 3, 2004, the Company hadrepurchased 1,706,500 shares for a total cost of approximately $22.1million.  No shares were repurchased bythe Company during fiscal 2003 or the first two quarters of fiscal 2004 and theCompany is currently prohibited by its restated loan agreement from purchasingany additional shares until January 1, 2006. A majority of the repurchased shares were used to acquire ClearLabInternational and Lens 1st/Lens Express.

 

At July 3, 2004, the Company had an unsecured, non-interest bearing noteto ClearLab International’s chief technology officer with a principal balanceof SGD$2,313,000 (USD$1,348,000). The note payable is discounted at 7%.  Payments are due in equal monthlyinstallments through July 2007.

 

At July 3, 2004,the Company had a term loan payable to a Singapore bank with a principalbalance of SGD$8,110,000 (USD$4,727,000) that bears interest at 6.75% and issecured by substantially all of the assets of ClearLab International.  Interest payments are due monthly.  Principal payments are due in monthly installmentsfrom January 2003 through December 2007. This note also contains various financial covenants including minimumson net worth and shareholders’ funds.  Asof July 3, 2004, the Company was in compliance these covenants.  1-800 CONTACTS, INC. has guaranteed this termloan.

 

At July 3, 2004,the Company also had a note payable to the former parent of ClearLabInternational with a principal balance of SGD$6,892,000 (USD$4,017,000) thatbears interest at 6% and has a subordinated position to the term loan payableto the Singapore bank.  The note payableis discounted at 7%.  Interest paymentsare due monthly.  Principal payments aredue in monthly installments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed thisnote.

 

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

 

The Company leasesvarious manufacturing and other equipment from financing companies undercapital lease arrangements.  All of theequipment is maintained at the Singapore and United Kingdom facilities.  The majority of the leases were assumed inconnection with the Company’s acquisition of ClearLab International andVisionTec (ClearLab UK, Ltd.).  As ofJuly 3, 2004, the present value of future minimum lease payments wasapproximately USD$0.2 million with a majority of payments scheduled throughfiscal 2004.

 

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**Contractual Obligations andCommitments**

 

Subsequent to January 3, 2004, there have been no material changes tothe Company’s contractual obligations and commitments, outside the normalcourse of business, other than the renewed loan agreement with the Company’sexisting U.S. bank.

 

**Critical Accounting Policies**

 

Accounting policesthat require significant judgments and estimates include revenue recognition(including sales returns and allowances); realizability of inventories;realizability of deferred income tax assets; accounting for businesscombinations including assessment of realizability of long-lived assets;stock-based compensation; and legal and regulatory contingencies.  A description of the Company’s significantaccounting policies is included in the notes to the consolidated financialstatements included in the Company’s Form 10-K for the fiscal year endedJanuary 3, 2004.  Judgments and estimatesare based on historical experience as well as relevant facts and circumstancesknown at each reporting date.  Actualresults may differ from these estimates.

 

Sales aregenerally recognized when products are shipped and the customer takes ownershipand assumes risk of loss, collection of the related receivable is probable,persuasive evidence of an arrangement exists and the sales price is fixed ordeterminable.  Net sales consist ofproduct sales less provisions for sales returns and allowances and estimatedcustomer rebates.  The Company accrues anestimated amount for unclaimed customer rebates and sales returns andallowances based on historical information, adjusted for current economictrends.  To the extent actual returns andallowances vary from historical experience; revisions to the allowances may berequired.

 

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

 

The Company hassignificant long-lived tangible and intangible assets consisting of property,plant and equipment, goodwill and definite-lived intangibles.  These assets are reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amounts of suchassets may not be recoverable.  Inaddition, the Company performs an impairment test related to goodwill at leastannually.  An impairment analysis relatedto long-lived tangible and definite-lived intangible assets requires theassessment of expected future undiscounted cash flows over the remaining usefullife of the asset.  An impairmentanalysis of goodwill requires the use of a fair-value based analysis.  As of July 3, 2004, the Company determinedthat no impairment existed.  All of thegoodwill and a significant portion of the other long-lived assets weregenerated from the Company’s recent acquisitions of ClearLab International,ClearLab UK, Ltd., Lens Express and Lens 1st. If forecasts andassumptions used to support the realizability of long-lived assets change inthe future, significant impairment charges could result that would adverselyaffect the Company’s results of operations and financial position.

 

Deferred incometax 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.

 

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

 

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**Forward-Looking Statements**

 

Except for thehistorical information contained herein, the matters discussed in this Form 10-Qare forward-looking statements within the meaning of Section 21E of theSecurities Exchange Act of 1934, as amended, and Section 27A of the SecuritiesAct of 1933, as amended.  Theseforward-looking statements involve risks and uncertainties and often depend onassumptions, data or methods that may be incorrect or imprecise.  The Company’s future operating results maydiffer materially from the results discussed in, or implied by, forward-lookingstatements made by the Company.  Factorsthat may cause such differences include, but are not limited to, thosediscussed below and the other risks detailed in the Company’s other reportsfiled with the Securities and Exchange Commission.  Words such as “believes,” “anticipates,”“expects,” “future,” “intends,” “would,” “may,” and similar expressions areintended to identify forward-looking statements.  The Company undertakes no obligation torevise any of these forward-looking statements to reflect events orcircumstances after the date hereof.

 

Factors that mayaffect future results include, but are not limited to the following:

 

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

 

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

 

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

 

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

 

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

 

•                                          TheCompany obtains a large percentage of its inventory from a limited number ofsuppliers, with a single manufacturer accounting for 46 percent, 35 percent and23 percent of the Company’s inventory purchases in fiscal 2001, 2002 and 2003,respectively.  In addition, the Company’stop three suppliers accounted for 70 percent, 63 percent and 59 percent of theCompany’s inventory purchased in fiscal 2001, 2002 and 2003, respectively;

 

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

 

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

 

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

 

•                                          Theretail sale of contact lenses is highly competitive and certain of theCompany’s competitors are large, national optical chains that have greaterresources than the Company;

 

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

 

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

 

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

 

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

 

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

 

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

 

•              The Company’s success is dependent, inpart, on continued use of the Internet;

 

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

 

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

 

•                                          TheCompany may not be able to develop and manufacture a viable, high qualitycontact lens for sale to consumers that meets all federal regulatoryrequirements;

 

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

 

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

 

•                                          TheCompany’s intellectual property rights may be challenged;

 

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

 

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

 

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

 

•                                          TheCompany may incur unforeseen costs or not realize all of the anticipatedbenefits from its relationships with Johnson & Johnson Vision Care, CIBAVision and Cole.

 

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

 

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

 

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**Item3.****    Quantitative and QualitativeDisclosures About Market Risk**

 

***Interest Rate Risk.***** **As of July 3, 2004,the Company was exposed to changes in interest rates relating to its renewedcredit facility and other debt obligations. The renewed 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 $17.4 million asof July 3, 2004. The remainder of the Company’s interest bearing debtobligations, including capital lease obligations, is denominated in Singaporedollars and British Pounds and bear interest at a fixed rate.  As of July 3, 2004, the face amounts of theoutstanding borrowings on these fixed rate debt obligations were approximately$9.0 million.

 

***Foreign CurrencyRisk.***  The Companyfaces foreign currency risks primarily as a result of its acquired Singaporeoperations, its recently acquired United Kingdom operations and theintercompany balances between its U.S. and these international operations.  The functional currency of the Company’sSingapore operations is the Singapore dollar, however, most of the sales of theSingapore operations and some of the expenses are denominated in U.S.dollars.  The Company has debt and otherlong-term obligations of approximately $10.3 million that are denominated inSingapore dollars and mature over the next six years.  Fluctuations in exchange rates between theU.S. dollar and the Singapore dollar could lead to additional currency exchangelosses or gains on the intercompany balances and transactions denominated incurrencies other than the functional currency. If the U.S. dollar weakens relative to the Singapore dollar, additionalfunds may be required to meet these obligations if the debt cannot beadequately serviced from the Singapore operations.  From the date of the ClearLab Internationalacquisition, July 24, 2002, through August 6, 2004 the exchange rate hasfluctuated approximately 1.3 percent (weakening of the U.S. dollar).

 

The functional currency of the Company’s UnitedKingdom operations is the British pound. Fluctuations in exchange rates between the U.S. dollar and the Britishpound could lead to currency exchange losses or gains on any intercompanybalances and transactions denominated in currencies other than the functionalcurrency.  From the date of the ClearLabUK acquisition, February 24, 2004, through August 6, 2004, the exchange ratehas fluctuated approximately 2.3 percent (strengthening of the U.S. dollar).

 

 The Company hasnot entered into any foreign currency derivative financial instruments;however, it may choose to do so in the future in an effort to manage or hedgeits foreign currency risk.

 

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

 

***(a)**Evaluation of disclosure controls andprocedures*.**  The Company’sChief Executive Officer and Chief Financial Officer, after evaluating theeffectiveness of the Company’s disclosure controls and procedures (as definedin Exchange Act Rules 13a-14 and 15d-14) as of the end of the period covered bythis report (the “Evaluation Date”), have concluded that, as of the EvaluationDate, the Company’s disclosure controls and procedures were adequate andeffective to ensure that material information relating to the Company and itsconsolidated subsidiaries would be made known to them by others within thoseentities.

 

***(b) Changes in internal controls.***  There were no significant changes in theCompany’s internal controls or in other factors that could significantly affectthe Company’s disclosure controls and procedures subsequent to the EvaluationDate, nor were there any significant deficiencies or material weaknesses insuch disclosure controls and procedures requiring corrective actions.  As a result, no corrective actions weretaken.

 

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**PART II.                OTHER INFORMATION**

 

**Item1.****                                                           *Legal Proceedings***

 

See notes to condensed consolidated financialstatements.

 

**Item2.                    *Changes in Securitiesand Use of Proceeds***

 

None.

 

**Item3.****                                                           *Defaults upon Senior Securities***

 

None.

 

**Item4.****                                                           *Submission of Matters to a Vote of Security Holders***

 

The annual meeting of stockholders of the Company washeld on May 21, 2004.  The stockholdersapproved the following matters:

 

•                  The election asdirectors of Jonathan C. Coon, Bradley T. Knight and Jason S. Subotky to serveuntil the annual meeting of stockholders in 2007 and until their respectivesuccessors are elected and qualified.

 

| ** **         | ** ** | **Votes Cast** | ** ** |
|--------------------|------------|----------------|------------|
| ** **         | ** ** | **For**        | ** ** | **Against** | ** ** |
| Jonathan C. Coon   |       | 10,400,856     |       | 3,835 |   |
| Bradley T.  Knight |       | 10,306,056     |       | 98,635 |   |
| Jason S. Subotky   |       | 10,400,856     |       | 3,835 |   |

 

The other directors of the Company include thefollowing persons:  (i) Thomas H. Boggs,Jr., John F. Nichols and Garth T. Vincent, who are serving until the annualmeeting of stockholders in 2005; and (ii) E. Dean Butler and Stephen A.Yacktman who are serving until the annual meeting of stockholders in 2006.

 

•                  Approval ofamendment and restatement of the Company’s Amended and Restated 1998 IncentiveStock Option Plan to increase the amount of shares that may be issued under theplan and to allow for the use of restricted stock grants.

 

| **Votes Cast:** | ** ** |
|-----------------|------------|
| For             |       | 5,452,359 |   |
| Against         |       | 1,547,529 |   |
| Abstained       |       | 769,950 |   |
| Unvoted         |       | 3,195,450 |   |
|                 |            |  |  |  |

 

•                  Ratification ofappointment of KPMG LLP as independent auditors to audit the Company’s booksand accounts for the fiscal year ending January 1, 2005.

 

| **Votes Cast:** | ** ** |
|-----------------|------------|
| For             |       | 10,618,019 |   |
| Against         |       | 9,726 |   |
| Abstained       |       | 183 |   |
| Unvoted         |       | — |   |

 

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

 

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

 

**Item 6.****                                                           *Exhibits and Reports on Form8-K***

 

**(A)Exhibits**

** **
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                         |
|-----------------|------------|------------------------------------------------------------------------------------|
|            |       |                                                                               |
| 31.1            |       | Certification Required Pursuant to Section 302 of  the Sarbanes-Oxley Act of2002.  |
| 31.2            |       | Certification Required Pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
| 32.1            |       | Certification Required Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |
| 32.2            |       | Certification Required Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |

 

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

 

•                  Current Reporton Form 8-K filed May 4, 2004, filing of Press Release Announcing Operating andFinancial Results for the first quarter ended April 3, 2004.

 

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**SIGNATURES**

 

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

 
|                          | **1-800 CONTACTS, INC.** |
|-------------------------------|--------------------------|
|                          |                     |   |
|                          |                     |   |
| Dated:  August  12, 2004 | By:                      | /s/ Jonathan C. Coon |   |
|                          | Name:                    | Jonathan C. Coon |
|                          | Title:                   | Chief Executive Officer |
|                          |                     |   |
|                          | By:                      | /s/ Brian W. Bethers |   |
|                          | Name:                    | Brian W. Bethers |
|                          | Title:                   | President and Chief Financial Officer |

 

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