** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, DC  20549**

 

----

 

**FORM 10-Q**

 

**(Mark one)**

 

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

 

**For the quarterly period ended April1, 2006**

 

                                  **or**

 

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

 

**For the transition period from                      to                        .**

** **

**Commission file number:   0-23633**

 

**1-800 CONTACTS, INC.**

(Exact name of registrantas specified in its charter)

 

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

 

| **(801)  316-5000**                                        |
|------------------------------------------------------------|
| (Registrant’s 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.

 

ýYes    No o

 

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

 
| Large  accelerated filer o |   | Accelerated filer ý |   | Non-accelerated filer o |
|----------------------------|--------|--------------------------|--------|-------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

 

o Yes    ýNo

 

As of May 4, 2006, the Registrant had 14,009,689 sharesof Common Stock, par value $0.01 per share, outstanding.

 

 

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**1-800 CONTACTS, INC.**

 

**INDEX**

 
| **PART  I.   FINANCIAL INFORMATION** |                                                                                                                |
|------------------------------------------------|---------------------------------------------------------------------------------------------------------------------|
| Item 1.                                        | Financial  Statements (unaudited)                                                                                   |   |
|                                           | Condensed  Consolidated Balance Sheets as of December 31, 2005  and April 1, 2006                              |   |
|                                           | Condensed  Consolidated Statements of Operations for the Quarter Ended  April 2, 2005 and April 1, 2006        |   |
|                                           | Condensed  Consolidated Statements of Cash Flows for the Quarter Ended  April 2, 2005 and April 1, 2006.  |   |
|                                           | Notes  to Condensed Consolidated Financial Statements                                                               |   |
| Item  2.                                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   |
| Item  3.                                       | Quantitative  and Qualitative Disclosures About Market Risk                                                    |   |
| Item  4.                                       | Controls  and Procedures                                                                                            |   |
|                                           |                                                                                                                |   |
| **PART  II. OTHER INFORMATION**                |                                                                                                                |   |
| Item 1.                                        | Legal  Proceedings.                                                                                                 |   |
| Item 1A.                                       | Risk Factors                                                                                                        |   |
| Item  2.                                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                   |   |
| Item  3.                                       | Defaults  Upon Senior Securities                                                                                    |   |
| Item  4.                                       | Submission  of Matters to a Vote of Security Holders                                                                |   |
| Item 5.                                        | Other  Information                                                                                                  |   |
| Item 6.                                        | Exhibits                                                                                                       |   |
|                                                |                                                                                                                     |  |  |

 

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**PART 1. FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(in thousands)**

**(unaudited)**

** **

**ASSETS**

 
| ** **                                                            | ** ** | **December 31,** | ** ** | **April 1,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                            | ** ** | **2005**              | ** ** | **2006**          | ** ** |
| CURRENT ASSETS:                                                       |       |                  |       |              |       |
| Cash                                                                  |       | $                     | 1,481      |              | $          | 407 |   |
| Accounts  receivable, net                                             |       | 3,451                 |       | 3,027             |       |
| Other  receivables                                                    |       | 1,738                 |       | 1,564             |       |
| Inventories, net                                                      |       | 21,458                |       | 21,596            |       |
| Deferred income  taxes                                                |       | 1,624                 |       | 1,872             |       |
| Other current  assets                                                 |       | 3,792                 |       | 2,202             |       |
| Total current  assets                                                 |       | 33,544                |       | 30,668            |       |
| PROPERTY AND EQUIPMENT, net                                           |       | 29,705                |       | 31,389            |       |
| DEFERRED INCOME TAXES                                                 |       | 1,087                 |       | 1,054             |       |
| GOODWILL                                                              |       | 35,405                |       | 35,773            |       |
| DEFINITE-LIVED INTANGIBLES, net                                       |       | 13,847                |       | 13,268            |       |
| OTHER ASSETS                                                          |       | 1,357                 |       | 1,365             |       |
| Total assets                                                          |       | $                     | 114,945    |              | $          | 113,517 |   |
|                                                                  |       |                  |       |              |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                        | ** ** | ** **            | ** ** | ** **        | ** ** |
| ** **                                                            | ** ** | ** **            | ** ** | ** **        | ** ** |
| CURRENT LIABILITIES:                                                  |       |                  |       |              |       |
| Line of credit                                                        |       | $                     | —     |              | $          | 13,061 |   |
| Current portion  of long-term debt                                    |       | 1,633                 |       | 1,686             |       |
| Current portion  of capital lease obligations                         |       | 58                    |       | 28                |       |
| Income taxes  payable                                                 |       | 567                   |       | 4,104             |       |
| Accounts payable                                                      |       | 12,063                |       | 14,533            |       |
| Accrued  liabilities                                                  |       | 8,197                 |       | 9,784             |       |
| Unearned revenue                                                      |       | 3,299                 |       | 4,024             |       |
| Total current  liabilities                                            |       | 25,817                |       | 47,220            |       |
| LONG-TERM LIABILITIES:                                                |       |                  |       |              |       |
| Line of credit                                                        |       | 23,746                |       | —            |       |
| Long-term debt,  net of current portion                               |       | 6,440                 |       | 6,211             |       |
| Capital lease  obligations, net of current portion                    |       | 83                    |       | 70                |       |
| Unearned  revenue, net of current portion                             |       | 973                   |       | 498               |       |
| Other long-term  liabilities                                          |       | 669                   |       | 645               |       |
| Total long-term  liabilities                                          |       | 31,911                |       | 7,424             |       |
| STOCKHOLDERS’ EQUITY:                                            |       |                  |       |              |       |
| Common stock,  13,340 and 13,358 issued and outstanding, respectively |       | 133                   |       | 134               |       |
| Additional  paid-in capital                                           |       | 47,876                |       | 48,351            |       |
| Retained  earnings                                                    |       | 9,613                 |       | 10,794            |       |
| Accumulated  other comprehensive loss                                 |       | (405                  | )          | (406              | )          |
| Total  stockholders’ equity                                      |       | 57,217                |       | 58,873            |       |
| Total  liabilities and stockholders’ equity                      |       | $                     | 114,945    |              | $          | 113,517 |   |

 

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** | ** ** |
|-----------------------------------------------------|------------|-------------------|------------|
| ** **                                          | ** ** | **April 2,**      | ** ** | **April 1,** | ** ** |
| ** **                                          | ** ** | **2005**          | ** ** | **2006** | ** ** |
| NET SALES                                           |       | $                 | 60,283     |   | $ | 63,491 |   |
| COST OF GOODS SOLD                                  |       | 37,775            |       | 39,013 |   |
| Gross profit                                        |       | 22,508            |       | 24,478 |   |
|                                                |       |              |       |   |   |
| SELLING, GENERAL AND ADMINISTRATIVE EXPENSES:       |       |              |       |   |   |
| Advertising                                         |       | 6,538             |       | 3,983 |   |
| Legal and  professional                             |       | 1,284             |       | 1,125 |   |
| Research and  development                           |       | 1,055             |       | 1,328 |   |
| Other selling,  general and administrative          |       | 11,517            |       | 13,679 |   |
| Total selling,  general and administrative expenses |       | 20,394            |       | 20,115 |   |
| INCOME FROM OPERATIONS                              |       | 2,114             |       | 4,363 |   |
| OTHER INCOME (EXPENSE), net                         |       | (641              | )          | 313 |   |
| INCOME BEFORE PROVISION FOR INCOME TAXES            |       | 1,473             |       | 4,676 |   |
| PROVISION FOR INCOME TAXES                          |       | (1,290            | )          | (3,495 | ) |
| NET INCOME                                          |       | $                 | 183        |   | $ | 1,181 |   |
|                                                |       |              |       |   |   |
| PER SHARE INFORMATION:                              |       |              |       |   |   |
| Basic and  diluted net income per common share      |       | $                 | 0.01       |   | $ | 0.09 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                         | ** ** | **Quarter Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                         | ** ** | **April 2,**      | ** ** | **April 1,** | ** ** |
| ** **                                                                         | ** ** | **2005**          | ** ** | **2006** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                              |       |              |       |   |   |
| Net income                                                                         |       | $                 | 183        |   | $ | 1,181 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |              |       |   |   |
| Depreciation and  amortization                                                     |       | 2,126             |       | 2,298 |   |
| Amortization of  debt issuance costs and discounts                                 |       | 48                |       | 56 |   |
| Foreign currency  exchange loss (gain)                                             |       | 312               |       | (732 | ) |
| Stock-based  compensation                                                          |       | 5                 |       | 367 |   |
| Tax benefits  from share-based payment exercises                                   |       | —            |       | (14 | ) |
| Loss on sale of  property and equipment                                            |       | 107               |       | 2 |   |
| Deferred income  taxes                                                             |       | (626              | )          | (216 | ) |
| Changes in  operating assets and liabilities:                                      |       |              |       |   |   |
| Accounts  receivable, net                                                          |       | (321              | )          | 623 |   |
| Inventories, net                                                                   |       | 489               |       | 40 |   |
| Other  receivables                                                                 |       | 447               |       | 174 |   |
| Other current  assets                                                              |       | 72                |       | 1,619 |   |
| Income taxes  payable                                                              |       | 1,190             |       | 3,538 |   |
| Accounts payable                                                                   |       | 1,938             |       | 2,182 |   |
| Accrued  liabilities                                                               |       | 1,276             |       | 1,528 |   |
| Unearned revenue                                                                   |       | (1,070            | )          | 164 |   |
| Net cash  provided by operating activities                                         |       | 6,176             |       | 12,810 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                              |       |              |       |   |   |
| Purchase of  property and equipment                                                |       | (1,282            | )          | (2,658 | ) |
| Proceeds from  sale of property and equipment                                      |       | 27                |       | — |   |
| Deposits and  other                                                                |       | (598              | )          | (106 | ) |
| Net cash used in  investing activities                                             |       | $                 | (1,853     | ) | $ | (2,764 | ) |

 

5

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| ** **                                              | ** ** | **Quarter Ended** | ** ** |
|---------------------------------------------------------|------------|-------------------|------------|
| ** **                                              | ** ** | **April 2,**      | ** ** | **April 1,** | ** ** |
| ** **                                              | ** ** | **2005**          | ** ** | **2006** | ** ** |
| CASH FLOWS FROM FINANCING ACTIVITIES:                   | ** ** | ** **        | ** ** | ** ** | ** ** |
| Proceeds from  exercise of stock options                |       | $                 | 78         |   | $ | 97 |   |
| Excess tax  benefits from share-based payment exercises |       | —            |       | 27 |   |
| Net repayments  on line of credit                       |       | (5,988            | )          | (10,684 | ) |
| Principal  payments on capital lease obligations        |       | (13               | )          | (46 | ) |
| Principal  payments on long-term debt                   |       | (421              | )          | (464 | ) |
| Net cash used in  financing activities                  |       | (6,344            | )          | (11,070 | ) |
| EFFECT OF FOREIGN EXCHANGE RATES ON CASH                |       | 36                |       | (50 | ) |
| NET DECREASE IN CASH                                    |       | (1,985            | )          | (1,074 | ) |
| CASH AT BEGINNING OF PERIOD                             |       | 3,105             |       | 1,481 |   |
| CASH AT END OF PERIOD                                   |       | $                 | 1,120      |   | $ | 407 |   |
|                                                    |       |              |       |   |   |
| SUPPLEMENTAL CASH FLOW INFORMATION:                     |       |              |       |   |   |
| Cash paid for  interest                                 |       | $                 | 262        |   | $ | 430 |   |
| Cash paid for  income taxes                             |       | 725               |       | 150 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

6

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**1-800CONTACTS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

# **NOTE1. PRESENTATION OF CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

# ** **

The accompanying condensed consolidated financialstatements have been prepared by the Company, without audit, pursuant to therules and regulations of the Securities and Exchange Commission. Certaininformation and disclosures normally included in financial statements preparedin accordance with accounting principles generally accepted in the UnitedStates of America have been condensed or omitted pursuant to such rules andregulations. These condensed consolidated financial statements reflect alladjustments (consisting only of normal recurring adjustments), which in theopinion of management, are necessary to present fairly the results ofoperations of the Company for the periods presented. It is suggested that thesecondensed consolidated financial statements be read in conjunction with theaudited financial statements and the notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2005.

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period. Actual results could differfrom these estimates.

 

# **NOTE2. INVENTORIES**

# ** **

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

 

| ** **                               | ** ** | **December 31,** | ** ** | **April 1,** | ** ** |
|------------------------------------------|------------|------------------|------------|--------------|------------|
| ** **                               | ** ** | **2005**         | ** ** | **2006**     | ** ** |
| Purchased contact lenses and accessories |       | $                | 13,554     |         | $          | 11,723 |   |
| Manufactured inventories:                |       |             |       |         |       |
| Raw materials                            |       | 1,322            |       | 1,288        |       |
| Work in process                          |       | 1,894            |       | 1,747        |       |
| Finished goods contact  lenses           |       | 4,688            |       | 6,838        |       |
| Total                                    |       | $                | 21,458     |         | $          | 21,596 |   |

 

Provision is made to reduce excess and obsolete inventoriesto their estimated net realizable values. As of December 31, 2005 and April 1,2006, reserves for excess and obsolete inventories were approximately $2.2million and $2.4 million, respectively.

 

**NOTE 3. NET INCOME PER COMMON SHARE**

 

Basic net income per common share (“Basic EPS”)excludes dilution and is computed by dividing net income by theweighted-average number of common shares outstanding during the period. Dilutednet income per common share (“Diluted EPS”) reflects the potential dilution thatcould occur if stock options or other common stock equivalents were exercisedor converted into common stock using the treasury stock method. The computationof Diluted EPS does not assume exercise or conversion of securities that wouldhave an antidilutive effect on net income per common share. Additionally, theCompany has not reflected performance awards in Diluted EPS since theperformance conditions have not been satisfied as of April 1, 2006. Forthe quarter ended April 2, 2005, options to purchase 830,124 shares of commonstock were not included in the computation of Diluted EPS because the effectwould be antidilutive. For the quarter ended April 1, 2006, options topurchase 690,134 shares of common stock and 32,041 shares of unvested commonstock were not included in the computation of Diluted EPS because the effectwould be antidiultive.

 

7

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The following is a reconciliation of the numerator anddenominator used to calculate Basic and Diluted EPS (in thousands, except pershare amounts): 

 
| ** **                       | ** ** | **Quarter Ended April 2, 2005** | ** ** | **Quarter Ended April 1, 2006** | ** ** |
|----------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **Net  Income**                 | ** ** | **Shares**                      | ** ** | **Per-Share****Amount** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** | **Per-Share****Amount** | ** ** |
|                             |       |                            |       |                            |       |   |   |   |   |   |   |   |   |
| Basic EPS                        |       | $                               | 183        |                            | 13,302     |   | $ | 0.01 |   | $ | 1,181 |   | 13,345 |   | $ | 0.09 |   |
| Effect of stock options          |       |                            |       | 191                             |       |   |   |   |   | 96 |   |   |   |
| Effect of unvested stock  awards |       |                            |       |                            |       |   |   |   |   |   |   |   |   |
| Diluted EPS                      |       | $                               | 183        |                            | 13,493     |   | $ | 0.01 |   | $ | 1,181 |   | 13,441 |   | $ | 0.09 |   |

 

**NOTE 4. COMPREHENSIVE INCOME**

 

Comprehensive income for the quarters ended April 2,2005 and April 1, 2006 consists of the following components (in thousands):

 
| ** **                   | ** ** | **Quarter Ended**  | ** ** |
|------------------------------|------------|--------------------|------------|
| ** **                   | ** ** | **April 2,  2005** | ** ** | **April 1,  2006** | ** ** |
| Net income                   |       | $                  | 183        |   | $ | 1,181 |   |
| Foreign currency translation |       | (117               | )          | (1 | ) |
| Comprehensive income         |       | $                  | 66         |   | $ | 1,180 |   |

 

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**

 

Effective January 1, 2006, the Company adoptedStatement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), “Share-BasedPayment,” (“SFAS No. 123R”), which requires stock-based compensation to bemeasured based on the fair value of the award on the date of grant andrecognized over the period during which service is required in exchange for theaward. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SABNo. 107”) relating to SFAS No. 123R. The Company has applied the provisions ofSAB No. 107 in its adoption of SFAS No. 123R.

 

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

 

SFAS No. 123R applies to all of the Company’s outstandingunvested share-based payment awards as of January 1, 2006 and all prospectiveawards. All of the Company’s stock-based awards, which are stock options andrestricted stock awards, are classified as equity instruments. In accordancewith SFAS No. 123R, the Company elected to use the modified prospectivetransition method and therefore, financial statements prior to adoption remainunchanged. Under this transition method, compensation cost for the quarterended April 1, 2006, includes amounts associated with (i) unvested stockoptions granted prior

 

8

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toJanuary 1, 2006, (ii) restricted stock awards granted prior to January 1, 2006and (iii) restricted stock awards granted during the quarter. Compensation costrecognized in the first quarter of fiscal 2006 for unvested options as ofJanuary 1, 2006 was based on the grant-date fair value estimated inaccordance with the original provisions of SFAS No. 123. The followingdiscusses certain other elections and assumptions the Company made as a resultof adopting SFAS No. 123R:

 

•      *Black-ScholesModel.*Forthe Company’s pro forma disclosures under SFAS No. 123, it used theBlack-Scholes option pricing model. Upon the adoption of SFAS No. 123R,the Company has elected to continue to use the Black-Scholes option pricingmodel to compute the fair value of options granted on or after January 1,2006.

 

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

 

•      *Short-cutMethod.*TheCompany has elected to use the short-cut method in accordance with FSP 123R-3in measuring its APIC pool available to absorb tax deficiencies recognized insubsequent periods from the exercise of unqualified stock options and vestingof restricted stock awards. Under the short-cut method, the Company hasdetermined that it has no APIC pool as of January 1, 2006. Accordingly,realized tax deficiencies in excess of tax benefits related to fully vestedawards as of January 1, 2006, will be recorded as additional income tax expensein the period determined.

 

Prior to the adoption of SFAS No. 123R, theCompany presented tax benefits resulting from share-based compensation asoperating cash flows in the consolidated statements of cash flows. SFAS 123Rrequires that cash flows resulting from tax deductions in excess ofcompensation cost recognized in the financial statements be classified asfinancing cash flows. However, under the short-cut method, for all vestedawards as of January 1, 2006, any realized tax benefits are recorded asfinancing cash flows and an increase to additional paid in capital. For thefirst quarter of fiscal 2006, approximately $27,000 of excess tax benefits weregenerated.

 

Stock-based expense for the first quarter of fiscal2006 includes expense, recognized over the applicable vesting periods, for newrestricted stock share-based awards and for restricted stock and stock optionshare-based awards granted prior to, but not yet vested, as of January 1,2006.  As a result of adopting SFAS No. 123R, the stock-basedcompensation expense for employees and non-employee directors for the firstquarter of fiscal 2006 totaled approximately $0.4 million.  The totalincome tax benefit related to stock-based expense during the first quarter offiscal 2006 was approximately $0.1 million. The impact on basic and dilutedearnings per share for the first quarter of fiscal 2006 was a decrease ofapproximately $0.02 per share. In addition, prior to the adoption of SFASNo. 123R, the Company presented the tax benefit from the exercise ofcommon stock option exercises as, a component of cash flows from operatingactivities.  Upon the adoption of SFAS No. 123R, tax benefitsresulting from tax deductions in excess of the compensation cost recognized forthose options are classified as a component of cash flows from financingactivities.  This resulted in a decrease of $27,000 in cash flows fromoperating activities and an increase of $27,000 in cash flows from financingactivities compared to cash flows from stock-based compensation presented underAPB 25.

 

***Stock –Based Award Plans***

 

***Stock Options.***The Company has established a stockoption plan that provides for the issuance of a maximum 1,940,000 shares ofcommon stock to officers, employees, directors and consultants. The plan allowsfor the issuance of both incentive stock options, nonqualified stock optionsand restricted stock. Incentive and nonqualified stock options are granted atnot less than 100 percent of the fair market value of the underlyingcommon stock on the date of grant. As of April 1, 2006, 17,398 shares areavailable for future granting.

 

Priorto the establishment of the stock option plan, the Company issued nonqualifiedstock options to various key employees, a consultant and a director of theCompany.

 

9

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All options granted through January 1, 2000 vestequally over a three-year period and expire in ten years. The stock optionsissued as a portion of the consideration for the assignment of certaintechnologies and intellectual property in conjunction with the acquisition ofClearLab International and other options issued to the chief technology officerof ClearLab International vest equally at the end of the third, fourth andfifth years and expire in ten years. All other options granted subsequent toJanuary 1, 2000, vest equally over a four-year period and expire in fiveto ten years.

 

Stock options remainoutstanding under these various plans as of January 1, 2006.******There were no optionsgranted from these plans during the first quarter of fiscal 2006, and theCompany does not currently plan to grant any stock options in fiscal 2006. UnderSFAS No. 123, pro-forma expense for stock options was calculated using astraight-line vesting schedule over the vesting period of approximately fouryears.  Had the Company used the fair value based accounting method forstock option expense prescribed by SFAS No. 123, the Company’s net income andearnings per share for the first quarter of fiscal 2005 would have been reducedto the pro-forma amounts illustrated as follows (in thousands, except per shareamounts):

 
| ** **                                                                         | ** ** | **Quarter Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                         | ** ** | **April 2, 2005** | ** ** |
| Net income (loss):                                                                 |       |              |       |
| As reported                                                                        |       | $                 | 183        |   |
| Add: Stock based  compensation expense included in reported net income, net of tax |       | 5                 |       |
| Deduct:  Fair-value based compensation, net of tax                                 |       | (314              | )          |
| Pro forma                                                                          |       | $                 | (126       | ) |
|                                                                               |       |              |       |
| Basic and diluted net income(loss) per common share:                               |       |              |       |
| As reported                                                                        |       | $                 | 0.01       |   |
| Pro forma                                                                          |       | $                 | (0.01      | ) |

 

The Company’sstock option activity during the first quarter of fiscal 2006 is as follows (inthousands, except option prices and years):

 
| ** **                                           | ** ** | ** **    | ** ** | ** **   | ** ** | **Weighted**     | ** ** | ** **    | ** ** |
|------------------------------------------------------|------------|---------------|------------|--------------|------------|------------------|------------|---------------|------------|
| ** **                                           | ** ** | ** **    | ** ** | **Weighted** | ** ** | **Average**      | ** ** | ** **    | ** ** |
| ** **                                           | ** ** | ** **    | ** ** | **Average**  | ** ** | **Remaining**    | ** ** | **Aggregate** | ** ** |
| ** **                                           | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual**  | ** ** | **Intrinsic** | ** ** |
| ** **                                           | ** ** | **Options**   | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Value**     | ** ** |
|                                                 |       |          |       |         |       |             |       |          |       |
| Options outstanding at  December 31, 2005            |       | 1,243         |       | $            | 20.90      |             |       |          |       |   |
| Exercised                                            |       | (14           | )          | 7.14         |       |             |       |          |       |
| Forfeited                                            |       | (14           | )          | 22.19        |       |             |       |          |       |
| Expired                                              |       | (2            | )          | 23.94        |       |             |       |          |       |
| Options outstanding at April  1, 2006                |       | 1,213         |       | $            | 21.03      |             | 4.17       |          | $          | 1,421 |   |
| Options vested and expected to vest at April 1, 2006 |       | 1,152         |       | 20.67        |       | 4.13             |       | 1,420         |       |
|                                                 |       |          |       |         |       |             |       |          |       |
| Options exercisable at April  1, 2006                |       | 808           |       | $            | 17.56      |             | 3.76       |          | $          | 1,416 |   |

 

The total intrinsic value of options exercised duringthe first quarters of fiscal 2006 and 2005 totaled approximately $0.1 millionfor both respective periods.  The weighted average fair value of stockoption grants was $11.30 for the first quarter of fiscal 2005. No stock optionswere granted in the first quarter of fiscal 2006.

 

10

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The fair value of options granted in the first quarterof fiscal 2005 was estimated using the Black-Scholes option valuation modelthat used the assumptions noted in the table below. Expected volatility andexpected dividend yield are based on actual historical experience of theCompany’s stock. The expected life represents the period of time that optionsgranted are expected to be outstanding. The risk-free rate is based on the U.S.Treasury security with terms equal to the expected time of exercise as of thegrant date.

 
| ** **              | ** ** | **Quarter Ended** | ** ** |
|-------------------------|------------|-------------------|------------|
| ** **              | ** ** | **April 2, 2005** | ** ** |
| Risk-free interest rate |       | 3.7               | %          |   |
| Expected dividend yield |       | 0.0               | %          |   |
| Volatility              |       | 66                | %          |   |
| Expected life           |       | 5 years           |       |

 

For the first quarter of fiscal 2006, stock optionexpense is recognized on a straight-line basis over the four year vestingperiod. Approximately $0.3 million was charged to expense in the first quarterof fiscal 2006. The Company has applied a weighted average forfeitureassumption of 15.03% in the calculation of such expense.

 

As of April 1, 2006, there was approximately $1.4million of unrecognized compensation cost related to non-vested stock options,which is expected to be recognized over a weighted-average period ofapproximately one year.

 

Cash received from option exercises during the firstquarter of fiscal 2006 was approximately $0.1 million. The total tax benefitgenerated from options granted prior to December 31, 2005, which were exercisedduring the first quarter of fiscal 2006, was approximately $27,000 which wascredited to additional paid-in capital.

 

***Restricted ShareAwards****.*During thefiscal quarter ended April 1, 2006, the Company’s Board of Directors approved agrant of 599,096 shares of restricted common stock to various employees andexecutives of the Company. The restricted share grants were valued at theclosing stock price on the date of the grant, March 27, 2006, which was $13.14.The restricted share grants include both time-vesting and performance-vestingrestricted shares. The time-vesting shares (273,451 awards) vest 20% per yearbeginning November 30, 2006 and ending November 30, 2010. Theperformance-vesting shares (325,645 awards) vest upon achievement of certainoperational milestones - such as obtaining sources for “doctors only” lenses oncompetitive terms, development of certain contact lens products and theachievement of an eight quarter cumulative financial target of at least $81million consolidated earnings before taxes by or before the end of fiscal2010.   Both the time-vesting andthe performance-vesting shares are subject to various change in controlprovisions involving the Company and its subsidiaries that may result in theaccelerated vesting of unvested shares as well as conversion of unvested sharesinto a cash amount at the time of the change in control.

 

The Company also granted 50,000 shares of restrictedcommon stock to its five non-employee Directors. These grants vest equally overa three-year period ended March 27, 2009, the vesting of these awards will beaccelerated upon a change in control of the Company. The restricted sharegrants were also valued at the closing stock price on the date of the grant,March 27, 2006, which was $13.14. An additional 2,500 shares of restrictedcommon stock were granted to one non-employee Director. This restricted sharegrant was valued at the closing stock price on the date of the grant, March 29,2006, which was $13.28 and vests on July 28, 2006.

 

11

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The Company’s activity relating to restricted shareawards during the first quarter of fiscal 2006 was as follows (in thousands,except fair values):

 
| ** **                    | ** ** | **Number of Restricted** | ** ** | **Weighted Average  Grant Date Fair** | ** ** |
|-------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **Share Awards**         | ** ** | **Value Per Award**                   | ** ** |
| Unvested at December 31, 2005 |       | 36                       |       | $                                     | 17.82      |   |
| Granted                       |       | 652                      |       | 13.14                                 |       |
| Vested                        |       | (4                       | )          | 22.69                                 |       |
| Forfeited and expired         |       | —                   |       | —                                |       |
| Unvested at April 1, 2006     |       | 684                      |       | $                                     | 13.33      |   |

 

For the first quarter of fiscal 2006, approximately$0.1 million was charged to expense relating to the amortization of thetime-vested restricted share awards. At April 1, 2006 unrecognized compensationexpense related to time-vested restricted share awards totaled approximately$4.5 million and will be recognized over a weighted average period of approximatelyfour years. The fair value of restricted share awards that vested during thequarter ended April 2, 2005 and the quarter ended April 1, 2006 totaled $0 andapproximately $0.1 million, respectively.

 

Expense related to performance-vesting shares will berecognized once it is determined “probable” that the operational milestoneswill be met. At the time the achievement of these operational milestones areconsidered “probable”, the Company will record a cumulative catch-up for theamount of expense that should have been recognized from the date of the grantto the date it was determined achievement was probable and recognize theremaining expense on a straight-line basis through the estimated date ofachievement. Total gross compensation expense, excluding any estimate offorfeitures related to the performance-vesting shares, is approximately $4.3million.

 

**NOTE 6. DEBT OBLIGATIONS**

 

TheCompany has a loan agreement with a U.S. bank providing for a revolving creditfacility. On January 13, 2006, the Company entered into a modifiedagreement which modified this loan agreement effective as of December 30,2005. The modified loan agreement provides for borrowings of up to$30 million, $35 million, or $40 million, depending on the Company’sminimum fixed coverage ratio assessed on a quarterly basis, as defined in theagreement. As of April 1, 2006, the Company could borrow up to $30 million. Subsequentto the first quarter of fiscal 2006, the Company could borrow up to$40 million. Additionally, the agreement provides for letters of credit upto a maximum of $15 million outstanding or payable at any time. The amountof any letters of credit outstanding is deducted from the amount available forborrowing. The maturity date of the loan agreement remains February 27,2007, as such, the amounts due under the line of credit are reported as currentliabilities in the condensed consolidated balance sheet as of April 1, 2005.Outstanding borrowings on the revolving credit facility bear interest at afloating rate equal to the lender’s prime interest rate plus a margin or thelender’s LIBOR rate plus a margin. The interest rate is adjusted quarterly andranges between prime minus 0.25 percent and prime plus 0.25 percentor between the applicable LIBOR rate plus 1.75 percent and the applicableLIBOR rate plus 2.25 percent, depending on the Company’s maximum leverageratio, as defined in the agreement. As of April 1, 2006, the prime rate marginis 0.25 percent and the LIBOR rate margin is 2.25 percent. Interest ispayable monthly. As of April 1, 2006, the Company’s outstanding borrowings onthe credit facility, including bank overdrafts, were $13.1 million. Ofthis amount, $9.0 million bore interest at the lender’s LIBOR rate plus 2.25 percent(7.06% at April 1, 2006) and the remaining $4.1 million bore interest at thelender’s prime rate plus 0.25 percent (8.00% at April 1, 2006). Thefacility requires the quarterly payment of an unused credit fee which rangesfrom 0.25 percent to 0.38 percent, depending on the Company’s maximumleverage ratio.

 

Outstandingbalances on the credit facility are secured by substantially all of the Company’sU.S. assets, subsidiary debt instruments, 100 percent ownership interestsin all domestic subsidiaries and 65 percent ownership interests in foreignsubsidiaries directly owned by the Company. The modified loan agreementincludes various financial covenants including a capital expenditure limit, amaximum leverage ratio and a minimum fixed charge coverage ratio. The modifiedloan agreement does not permit the Company or its subsidiaries to dissolve,sell, dispose or merge all of their assets or acquire all of the assets of anyentity without the written consent of the U.S.

 

12

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bank, unless thetransaction meets the definition of a “Permitted Acquisition Basket”, asdefined in the agreement. The modified loan agreement also places a limit onthe amount the Company can loan to any entity, outside the normal course ofbusiness. Additionally, the modified agreement allows the Company to declare orpay cash dividends, to repurchase its stock or to perform other similar equitytransactions if such transactions would not exceed $15 million in any fiscalyear and subject to other terms. This agreement defines several customaryevents of default including any material adverse change or any event thatoccurs which may cause a material adverse change in the Company’s or itssubsidiaries’ condition.

 

TheCompany’s Singapore bank term loan contains various financial covenantsincluding minimums on net worth and shareholders’ funds of the Singaporeoperations. 1-800 CONTACTS, INC. has guaranteed this term loan.

 

Crossdefault clauses exist such that if the Company were in default on its U.S.debt, the Company would also be in default on its Singapore debt. If theCompany were in default on its Singapore bank term loan, the Company would alsobe in default on its note payable to the former parent of ClearLabInternational and its loan agreement with its U.S. bank.

 

**NOTE 7. COMMITMENTS AND CONTINGENCIES**

 

***Legal and Regulatory Matters***

 

Thesale and delivery of contact lenses are governed by both federal and state lawsand regulations, including the federal Fairness to Contact Lens Consumer Act (“FCLCA”).The FCLCA requires that contact lenses only be sold to customers based on theseller obtaining a copy of the prescription itself or verifying theprescription by direct communication with the customer’s prescriber. Consistentwith this requirement, the Company’s current operating practice is to requireall customers to provide either a valid copy of their prescription or thecontact information for their prescriber so that the Company can verify theirprescription by direct communication with their prescriber. If the Company doesnot have a valid copy of the customer’s prescription, the Company directlycommunicates to the customer’s prescriber the precise prescription informationreceived from the customer and, in accordance with the FCLCA, informs theprescriber that it will proceed with the sale based on this prescriptioninformation unless the prescriber advises it within eight business hours thatsuch prescription information is expired or otherwise invalid. If theprescriber properly advises the Company within this time period that thecustomer’s prescription is expired or otherwise invalid, the Company’s practiceis to cancel the customer’s order. On the other hand, if the prescriber eitheradvises the Company that the prescription is valid or fails to respond properlywithin the required time period, the Company’s practice is to complete the salebased on the prescription information communicated to the prescriber, as expresslypermitted by the FCLCA. The Company retains copies of the written prescriptionsthat it receives and maintains records of its communications with the customer’sprescriber. The FCLCA provides for several means of direct communication witheye care practitioners, and the Company may alter its prescription verificationprocedures from time to time in keeping with the FCLCA and FTC guidelines.

 

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

 

***Advertising Commitments***

 

As of April 1, 2006, the Company had entered intocertain noncancelable commitments with various advertising companies that willrequire the Company to pay approximately $5.9 million during the remainder of2006.

 

13

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**NOTE 8. SEGMENT INFORMATION**

 

The Company has two operating segments. Theseoperating segments represent components of the Company for which separatefinancial information is available and are evaluated regularly by management indetermination of resource allocation and performance assessment. The Company’sU.S. Retail segment includes the operations of 1-800 CONTACTS, a directmarketer of replacement contact lenses. The Company’s International segmentincludes the operations of ClearLab International and ClearLab UK, developers,marketers, manufacturers and distributors of contact lenses. The U.S. Retail segment includes revenue from theoptical retail store agreement and the International segment includes revenuefrom the Japanese license and royalty agreement. Operating segment informationfor the first quarter ended April 2, 2005 and April 1, 2006 is as follows (inthousands):

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

 
| **Quarter Ended April 1, 2006** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|-------------------|------------|------------------|------------|-----------|------------|
|                                                |       |                 |       |              |       |             |       |      |       |
| Net sales                                           |       | $                    | 59,173     |              | $          | 4,318            |       | $         | —     |   | $ | 63,491 |   |
| Gross profit                                        |       | 23,624               |       | 638               |       | 216              |       | 24,478    |       |
| Research and development                            |       | 10                   |       | 1,318             |       | —           |       | 1,328     |       |
| Other selling, general and  administrative expense  |       | 11,713               |       | 1,966             |       | —           |       | 13,679    |       |
| Income (loss) from operations                       |       | $                    | 7,006      |              | $          | (2,859           | )          | $         | 216        |   | $ | 4,363 |   |

 

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The following reconciles totalsegment income from operations to income before provision for income taxes forthe quarters ended April 2, 2005 and April 1, 2006 as follows (in thousands):

 
| ** **                                              | ** ** | **Quarter Ended** | ** ** |
|---------------------------------------------------------|------------|-------------------|------------|
| ** **                                              | ** ** | **April 2, 2005** | ** ** | **April 1, 2006** | ** ** |
| Income from operations                                  |       | $                 | 2,114      |   | $ | 4,363 |   |
| Interest expense, net                                   |       | (301              | )          | (412 | ) |
| Foreign currency exchange  transaction gain (loss), net |       | (312              | )          | 732 |   |
| Other, net                                              |       | (28               | )          | (7 | ) |
| Income before provision for  income taxes               |       | $                 | 1,473      |   | $ | 4,676 |   |

 

Identifiable segment assets areas follows (in thousands):

 
| **Fiscal Year Ended December 31,  2005** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|-----------------|------------|-------------------|------------|-----------|------------|
|                                     |       |            |       |              |       |      |       |
| Long-lived assets, net                   |       | $               | 35,130     |              | $          | 43,828    |       | $ | 78,958 |   |
| Total assets                             |       | 54,758          |       | 60,187            |       | 114,945   |       |
|                                          |            |                 |            |                   |            |           |            |  |  |  |

 
| **Quarter Ended April 1, 2006** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|-------------------|------------|-----------|------------|
|                                                |       |                 |       |              |       |      |       |
| Long-lived assets, net                              |       | $                    | 34,627     |              | $          | 45,803    |       | $ | 80,430 |   |
| Total assets                                        |       | 52,947               |       | 60,570            |       | 113,517   |       |
|                                                     |            |                      |            |                   |            |           |            |  |  |  |

 

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

** **

**Overview**

 

The Company is a direct marketer of replacementcontact lenses and is also a manufacturer, developer and distributor of its ownbranded and private label contact lenses through its operations in Singaporeand the United Kingdom. The Company’s U.S. Retail operations sell almost all ofthe popular brands of contacts lenses, including those manufactured by Johnson& Johnson Vision Care, CIBA Vision, Bausch & Lomb and CooperVision. ClearLabis the Company’s international contact lens development, manufacturing anddistribution business.

 

***JapaneseLicense and Royalty Agreement.***In December 2004, theCompany signed an agreement which grants Menicon Co., LTD (Menicon), Japan’slargest independent contact lens manufacturer, exclusive rights to develop,manufacture and market certain disposable contact lenses and relatedintellectual property in Japan. Under the terms of the agreement, Meniconlicenses from the Company different types of intellectual property, includingcontact lens material, manufacturing technology and related knowledge. Duringthe first quarter of fiscal 2006, the Company received a payment of $2 million andhas received a total of $10 million under the agreement to date.

 

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

 

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

 

Thisagreement expired in January 2006; however, both parties continue tooperate their contact lens businesses jointly as they work towards confirmingthe terms of a new arrangement. The Company is deferring any decision to launcha national network with optical retail stores until a resolution can be foundto industry practices relating to “doctors only” lenses and after a review ofthe Company’s progress with the doctor referral network.

 

***DoctorReferral Network.******  ***The Company is currently expanding itsnational doctor referral network with select optical retail chains andindependent practitioners and plans to have 1,000 locations by the end of 2006.Under this referral program, when a current or potential customer needs a newcontact lens prescription, the Company can facilitate the process of obtainingan eye examination through this network of providers. This process minimizesthe interruptions in product consumption for the consumer and improves theCompany’s ability to capture new customers and retain its current customers.

 

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

 

***SupplierAgreements.******  ***The Companyhas agreements with its top two vendors for improved pricing and marketingsupport. This support comes in the form of cooperative marketing and rebateprograms designed to promote the manufacturer’s products and build sales. Aspart of its ongoing relationship with its suppliers, the Company periodicallyreviews its specific marketing plans and negotiates cooperative marketingprograms and product pricing.

 

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# **RegulatoryConsiderations**

# ** **

***Fairnessto Contact Lens Consumer Act.***In November 2003, Congress passed the Fairness to Contact Lens ConsumerAct (“FCLCA”), which establishes a national uniform standard for both eye carepractitioners and direct marketers with regard to releasing and verifyingconsumer contact lens prescriptions as well as other requirements relating tothe sale of contact lenses. The FCLCA became effective February 4, 2004, andnow 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 also directs contact lens sellers to contact eyecare practitioners to request verification of consumer prescriptions beforeshipping all orders (if the prescription is not already on file), and itprovides that failure to respond within eight business hours shall result inthe prescription being presumed valid, thereby eliminating the ability of eyecare practitioners to impede sales by direct marketers simply by ignoring orrefusing to respond to their requests to verify 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). It alsodirected the Federal Trade Commission (“FTC”) 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 completed and published this study on February 15, 2005, with norecommendations for further changes in federal law.

 

Satisfying the prescription verification requirementof the FCLCA obligates a contact lens seller either to obtain a copy of theprescription itself or to verify the prescription by direct communication withthe customer’s prescriber. Consistent with this requirement, the Company’scurrent operating practice is to require all customers to provide either avalid copy of their prescription or the contact information for theirprescriber so that the Company can verify their prescription by directcommunication with their prescriber. If the Company does not have a valid copyof the 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 properly advises the Company within this time periodthat the customer’s prescription is expired or otherwise invalid, the Company’spractice is to cancel the customer’s order. On the other hand, if theprescriber either advises the Company that the prescription is valid or failsto respond properly within the required time period, the Company’s practice isto complete the sale based on the prescription information communicated to theprescriber, as expressly permitted by the FCLCA. The Company retains copies ofthe written prescriptions that it receives and maintains records of itscommunications with the customer’s prescriber. The FCLCA provides for severalmeans of direct communication with eye care practitioners, and the Company mayalter its prescription verification procedures from time to time in keepingwith the FCLCA and FTC guidelines.

 

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**Results of Operations**

 

The Company’s fiscal year consists of a 52/53-weekperiod ending on the Saturday nearest to December 31. Fiscal 2006 is a 52-weekyear and will end on December 30, 2006.

 

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

 

The following table presents the Company’s results ofoperations expressed as a percentage of net sales for the periods indicated:

 
| ** **                                           | ** ** | **Quarter Ended** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|
| ** **                                           | ** ** | **April 2,**      | ** ** | **April 1,** | ** ** |
| ** **                                           | ** ** | **2005**          | ** ** | **2006** | ** ** |
| NET SALES                                            |       | 100.0             | %          | 100.0 | % |
| COST OF GOODS SOLD                                   |       | 62.7              |       | 61.4 |   |
| Gross profit                                         |       | 37.3              |       | 38.6 |   |
|                                                 |       |              |       |   |   |
| SELLING, GENERAL & ADMINISTRATIVE EXPENSES:      |       |              |       |   |   |
| Advertising                                          |       | 10.8              |       | 6.3 |   |
| Legal and  professional                              |       | 2.1               |       | 1.8 |   |
| Research and  development                            |       | 1.8               |       | 2.1 |   |
| Other selling,  general & administrative         |       | 19.1              |       | 21.5 |   |
| Total selling, general & administrative expenses |       | 33.8              |       | 31.7 |   |
| INCOME FROM OPERATIONS                               |       | 3.5               |       | 6.9 |   |
| OTHER INCOME (EXPENSE), net                          |       | (1.1              | )          | 0.5 |   |
| INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES      |       | 2.4               |       | 7.4 |   |
| PROVISION FOR INCOME TAXES                           |       | (2.1              | )          | (5.5 | ) |
| NET INCOME                                           |       | 0.3               | %          | 1.9 | % |

 

***Netsales***. Net sales for the quarter ended April 1, 2006increased 5.3% to $63.5 million from $60.3 million for the quarter ended April2, 2005. Net sales for the Company’s U.S. Retail operations for the firstquarter of fiscal 2006 were $59.2 million compared to $56.4 million for thefirst quarter of fiscal 2005. U.S. Retail net sales increased primarily from anincrease in sales on the internet due mainly to upgrades the Company made to itswebsite during fiscal 2005 and from targeted online marketing programs.

 

During the quarter ended April 1, 2006 the Companyspent approximately $4.0 million on advertising spending compared to $6.5million for the quarter ended April 2, 2005. The Company’s reduction inadvertising spending during the quarter from the first quarter of fiscal 2005is consistent with the Company’s plans to spend less on advertising in fiscal2006 as the Company focuses on addressing the threat of ‘doctors only’ lenses. Althoughthe Company saw an increase in sales during the first quarter of 2006 comparedto the first quarter of 2005, the Company expects that U.S. Retail net saleswill be impacted by the decrease in advertising spending later this year. Additionally,U.S. Retail net sales growth continues to be constrained by lost sales relatedto certain ‘doctors only’ contact lenses that the Company cannot obtain inorder to fill orders for customers who wish to purchase the product.

 

Net sales for ClearLabfor the first quarter of fiscal 2006 were consistent with net sales for thefirst quarter of fiscal 2005 at $4.3 million. ClearLab’s results for the firstquarter of fiscal 2006 include $1.5 million in license fees from the Company’sJapanese license agreement compared to $1.0 million in the first quarter offiscal 2005.

 

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The increase in licensefees was largely offset by a decrease of $0.4 million in intercompany sales tothe Company’s U.S. Retail business, as ClearLab recorded no sales to the U.S.Retail business in the first quarter of fiscal 2006.

 

***Grossprofit.***Consolidated gross profit as a percentage of netsales increased to 38.6% for the quarter ended April 1, 2006 from 37.3% for thequarter ended April 2, 2005. Gross profit as a percentage of net sales for theCompany’s U.S. Retail operations increased to 39.9% in the first quarter offiscal 2006 from 39.4% in the first quarter of fiscal 2005. The Company expectsthe U.S. Retail gross profit margin to remain at approximately 40% throughoutthe remainder of fiscal 2006, although the margin may vary somewhat fromquarter to quarter.

 

Grossprofit as a percentage of net sales for ClearLab was 14.8% for the firstquarter of fiscal 2006, compared to 14.1% for the first quarter of fiscal 2005.The Company expects to see improvement in gross margins from ClearLab in fiscal2006 as production and sales volumes increase.

 

***Advertisingexpense.***Advertising expense for the quarter endedApril 1, 2006 decreased to $4.0 million from $6.5 million for the first quarterended April 2, 2005. As a percentage of net sales, advertising expense for thefirst quarter of fiscal 2006 decreased to 6.3% from 10.8% for the first quarterof fiscal 2005. The Company expects to decrease fiscal 2006 advertisingexpenses by approximately $10 to $12 million from fiscal 2005 as itfocuses its resources towards legislative and public relations initiatives.However, if opportunities present themselves, the Company may increaseadvertising spending above currently planned levels. The Company’s experiencehas been that increases in advertising expenditures have a direct impact on thegrowth of net sales not only in the current period but also in future periods.

 

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

 

***Legaland professional fees.***Legal and professional fees forthe quarter ended April 1, 2006 decreased $0.2 million, or 12%, from thefirst quarter ended April 2, 2005. As a percentage of net sales, legal andprofessional fees decreased to 1.8% for the first quarter of fiscal 2006 from2.1% for the first quarter of fiscal 2005.

 

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

 

***Researchand development expenses.***Research and developmentexpenses for the quarter ended April 1, 2006 increased to $1.3 million, or 2.1%of net sales, from $1.1 million, or 1.8% of net sales, from the quarter ended April2, 2005. During the first quarter of fiscal 2006, the Company continued to fundresearch and development efforts for ClearLab’s operations.

 

Total fiscal 2006 research and development costs willbe dependent on progress with research and development efforts relating toexpanding ClearLab’s product offering and developing its intellectual property.

 

***Otherselling, general and administrative expenses.***Otherselling, general and administrative expenses for the quarter ended April 1,2006 increased approximately $2.2 million, or 18.8%, to $13.7 million from thequarter ended April 2, 2005. As a percentage of net sales other selling,general and administrative expenses for the first quarter of fiscal 2006 alsoincreased to 21.5% from 19.1% for the first quarter of fiscal 2005. The firstquarter of fiscal 2006 results include approximately $0.3 million of expenserelated to stock options granted prior to fiscal 2006 and approximately $0.1million of expense related to restricted stock grants compared to approximately$5,000 of expense related to restricted stock grants in the first quarter offiscal 2005.

 

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The majority of theincrease in the consolidated other selling, general and administrative expensesin the first quarter of 2006 relates to the Company’s U.S. Retail businesswhich had a $1.6 million increase from the same quarter in the prior year. Additionally,such expenses also increased as a percentage of net sales to 19.8% for thefirst quarter of fiscal 2006 from 17.9% for the first quarter of fiscal 2005. Themajority of the increase for U.S. Retail from the first quarter of fiscal 2005relates to planned increases in employee costs to support a retail network, aninitiative which is currently focused on expanding our doctor referral network,and to strengthen and build the Company’s Information Technology organizationand technology infrastructure. The Company also had increases in other selling,general and administrative expenses related to the Company’s legislativeefforts.

 

ClearLab’s otherselling, general and administrative expenses increased by approximately $0.6million for the quarter ended April 1, 2006 from the quarter ended April 2,2005. A majority of ClearLab’s increase related to increases in employee coststo support the enhancement and scale up of its operations.

 

***Otherincome (expense), net.***For the quarter ended April 1,2006, the Company had other income of $0.3 million compared to other expensefor the quarter ended April 2, 2005 of $(0.6) million. For the first quartersof fiscal 2005 and 2006, other income (expense) consisted mainly of interestexpense, resulting from use of the revolving credit facility and foreignexchange transaction gains or losses. Interest expense for the first quarter offiscal 2006 increased $0.1 million to $0.4 million compared to$0.3 million in the first quarter fiscal 2005. The Company recorded a foreignexchange transaction gain of approximately $0.7 million and a loss ofapproximately $(0.3) million during the quarters ended April 1, 2006 and April2, 2005, respectively. These exchange gains and losses relate primarily tointercompany loans to ClearLab.

 

***Incometaxes.***The Company is taxed in three separatejurisdictions-U.S., Singapore and the United Kingdom. The Company’s effectiveU.S. income tax rate for the quarter ended April 1, 2006 is approximately 45%as compared with the 39% reported for the quarter ended April 2, 2005. Theincrease in the effective U.S. income tax rate primarily results from theincrease in permanent nondeductible expenses, including those relating to theCompany’s lobbying efforts.

 

During 2005, the Company’s Singapore operations metthe requirements for the pioneer tax certificate in Singapore. This pioneer taxcertificate allows for a seven-year tax holiday in Singapore beginning withfiscal 2003, with an extension for an additional three years if certainconditions are met. The tax holiday has clawback provisions if the Company doesnot continually meet certain research and development, capital investment andemployment requirements. The tax holiday reduces the Singapore statutory taxrate to 0% on qualified income for 2003 and future periods through the end ofthe tax holiday. The Company expects to continue to meet the requirements forthis pioneer tax certificate. During the first quarter of fiscal 2006, theCompany did not record a tax benefit for the loss from the operations ofClearLab International due to the pioneer tax certificate and the uncertaintywith respect to the realization of a tax benefit in Singapore relating tolosses prior to 2003. However, the Company recorded a current tax provision inSingapore due to Japanese withholding tax on payments received from theJapanese license agreement. The foreign tax credit for this Japanesewithholding tax is not eligible for carryforward in the Singapore taxjurisdiction.

 

In the first quarter of fiscal 2006, the Company recordeda valuation allowance for deferred tax assets in excess of taxable temporarydifferences in the U.K. as it is more likely than not that these deferred taxassets will not be realized.

 

The Company expects that its fiscal 2006 effectiveincome tax rates will approximate 45% for the U.S. operations. For the U.K. andSingapore operations, the Company expects that the effective tax rate will be0% with the exception of the Japanese withholding tax on license payments madeto ClearLab International. The Company’s effective income tax rates may changeas facts and circumstances change.

 

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**Liquidity and Capital Resources**

 

The Company’s principal sources of liquidity have beencash provided by operating activities and 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 Company anticipates that these uses willcontinue to be the principal demands on its cash in the future. As of April 1,2006, the Company had net working capital (deficit) of approximately $(16.6) million,compared to $7.7 million as of December 31, 2005. This large decrease in networking capital during the first quarter of fiscal 2006 relates to the Company’sline of credit that is now classified as current on the Condensed ConsolidatedBalance Sheet as the maturity date is February 27, 2007. The Company intends torenew or refinance this line of credit prior to the maturity date.

 

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. Should the Company’s plans or expectationschange, the Company may be required to seek additional sources of funds andthere can be no assurance that such funds will be available on satisfactoryterms. Failure to obtain such 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 requirements of the FCLCA.

 

TheCompany has a loan agreement with a U.S. bank providing for a revolving creditfacility. On January 13, 2006, the Company entered into a modifiedagreement which modified this loan agreement effective as of December 30,2005. The modified loan agreement provides for borrowings of up to$30 million, $35 million or $40 million, depending on the Company’sminimum fixed coverage ratio assessed on a quarterly basis, as defined in theagreement. As of April 1, 2006, the Company could borrow up to $30 million. Subsequentto the first quarter of fiscal 2006, the Company could borrow up to$40 million. Additionally, the agreement provides for letters of credit upto a maximum of $15 million outstanding or payable at any time. The amountof any letters of credit outstanding is deducted from the amount available forborrowing. The maturity date of the loan agreement remains February 27,2007, as such, the amounts due under the line of credit are reported as currentliabilities in the condensed consolidated balance sheet as of April 1, 2005.Outstanding borrowings on the revolving credit facility bear interest at afloating rate equal to the lender’s prime interest rate plus a margin or thelender’s LIBOR rate plus a margin. The interest rate is adjusted quarterly andranges between prime minus 0.25 percent and prime plus 0.25 percentor between the applicable LIBOR rate plus 1.75 percent and the applicableLIBOR rate plus 2.25 percent, depending on the Company’s maximum leverageratio, as defined in the agreement. As of April 1, 2006, the prime rate marginis 0.25 percent and the LIBOR rate margin is 2.25 percent. Interest ispayable monthly. As of April 1, 2006, the Company’s outstanding borrowings onthe credit facility, including bank overdrafts, were $13.1 million. Ofthis amount, $9.0 million bore interest at the lender’s LIBOR rate plus 2.25 percent(7.06% at April 1, 2006) and the remaining $4.1 million bore interest at thelender’s prime rate plus 0.25 percent (8.00% at April 1, 2006). Thefacility requires the quarterly payment of an unused credit fee which rangesfrom 0.25 percent to 0.38 percent, depending on the Company’s maximumleverage ratio.

 

Outstandingbalances on the credit facility are secured by substantially all of the Company’sU.S. assets, subsidiary debt instruments, 100 percent ownership interestsin all domestic subsidiaries and 65 percent ownership interests in foreignsubsidiaries directly owned by the Company. The modified loan agreementincludes various financial covenants including a capital expenditure limit, amaximum leverage ratio and a minimum fixed charge coverage ratio. The modifiedloan agreement does not permit the Company or its subsidiaries to dissolve,sell, dispose or merge all of their assets or acquire all of the assets of anyentity without the written consent of the U.S. bank, unless the transactionmeets the definition of a “Permitted Acquisition Basket”, as defined in theagreement. The modified loan agreement also places a limit on the amount theCompany can loan to any entity, outside the normal course of business.Additionally, the modified agreement allows the Company to declare or pay cashdividends, to repurchase its stock or to perform other similar equitytransactions if such transactions would not exceed $15 million in any fiscalyear and subject to other terms. This agreement defines several customaryevents of

 

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default including anymaterial adverse change or any event that occurs which may cause a materialadverse change in the Company’s or its subsidiaries’ condition.

 

As of April 1, 2006, the Company had an unsecured, non-interest bearing note to ClearLab International’s chief technology officer with a principal balance of SGD$1,000,000 (USD$617,000). The note payable is discounted at 7%. Payments are due in equal monthly installments through July 2007.

 

As of April 1, 2006, the Company had a term loanpayable to a Singapore bank with a principal balance of SGD$5,110,000(USD$3,155,000) that bears interest at 6.75% and is secured by substantiallyall of the assets of ClearLab International. Interest payments are due monthly.Principal payments are due in monthly installments through December 2007. Thisnote also contains various financial covenants including minimums on net worthand shareholders’ funds. 1-800 CONTACTS, INC. has guaranteed this term loan.

 

As of April 1, 2006, theCompany also had a note payable to the former parent of ClearLab Internationalwith a principal balance of SGD$6,892,000 (USD$4,255,000) that bears interestat 6% and has a subordinated position to the term loan payable to the Singaporebank. The note payable is discounted at 7%. Interest payments are due monthly. Principalpayments are due in monthly installments from January 2008 through December2009. 1-800 CONTACTS, INC. has guaranteed this note.

 

Cross default clausesexist such that if the Company were in default on its U.S. debt, the Companywould also be in default on its Singapore debt. If the Company were in defaulton its Singapore bank term loan, the Company would also be in default on itsnote payable to the former parent of ClearLab International and its restatedloan agreement with its U.S. bank. As of April 1, 2006, the Company was incompliance with all of the restrictive covenants in its loan documents. 

 

***Cashflows from operating activities.***For the quarters ended April1, 2006 and April 2, 2005, net cash provided by operating activities wasapproximately $12.8 million and $6.2 million, respectively. In the firstquarter of fiscal 2006, cash provided by operating activities was primarily fromnet income adjusted for non-cash items such as depreciation, amortization andstock compensation, increases in the income tax payable, accounts payable andaccrued liabilities as well as decreases in other current assets and accountsreceivable. In the first quarter of fiscal 2005, cash provided by operatingactivities was primarily from net income adjusted for non-cash items such asdepreciation and amortization expense, increases in accounts payable, accruedliabilities and income taxes payable and decreases in other current assets andinventories. This increase was partially offset by decreases in unearnedrevenues and increases in net accounts receivable.

 

***Cash flows from investing activities.***TheCompany used approximately $2.8 million and $1.9 million for investingactivities in the quarters ended April 1, 2006 and April 2, 2005, respectively.In the first quarter of fiscal 2006, the Company’s deposits, associated mainlywith the expansion and improvements in the Company’s infrastructure atClearLab, increased by approximately $0.1 million. In the first quarter offiscal 2005, the Company paid approximately $0.6 million in deposits associatedmainly with the expansion of and improvements in the Company’s infrastructureat ClearLab.

 

Capital expenditures for infrastructure improvementsfor the quarters ended April 1, 2006 and April 2, 2005 were approximately $2.7million and $1.3 million, respectively. Of these amounts, approximately $2.0million and $0.7 million relate purchases made at ClearLab, respectively. TheCompany anticipates additional capital expenditures in fiscal 2006 forinfrastructure as it continues to expand and improve operating facilities,telecommunications systems and management information systems in order tohandle future operations of both its U.S. and international operations.

 

***Financing activities.***During thequarters ended April 1, 2006 and April 2, 2005, net cash used in financingactivities was approximately $11.1 million and $6.3 million, respectively. Inthe first quarter of 2006, the Company had net repayments on its creditfacility of approximately $10.7 million and made principal payments on debtobligations and capital lease obligations of approximately $0.5 million. In thefirst quarter of 2005, the Company paid down its credit facility byapproximately $6.0 million and made principal payments on debt obligations and

 

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capital lease obligations of approximately $0.4 million. In both thefirst quarters of fiscal 2006 and 2005, these amounts were partially offset byproceeds from the exercise of common stock options.

 

The Company leasesvarious manufacturing and other equipment from financing companies undercapital lease arrangements. All of the equipment is maintained at the Singaporeand United Kingdom facilities. The majority of the leases were assumed inconnection with the Company’s acquisitions of ClearLab International andClearLab UK. As of April 1, 2006, the present value of future minimum leasepayments was approximately $0.1 million with payments scheduled through fiscal2009.

 

**Contractual Obligations and Commitments**

 

Subsequent to December 31, 2005, there have been nomaterial changes to the Company’s contractual obligations and commitments,outside the normal course of business.

 

**Critical Accounting Policies**

 

Accounting polices that require significant judgmentsand estimates include revenue recognition (including sales returns andallowances and customer rebates); realizability of inventories; realizabilityof deferred income tax assets; assessment of realizability of long-livedassets; stock-based compensation; and legal and regulatory contingencies. Adescription of the Company’s significant accounting policies is included in thenotes to the consolidated financial statements included in the Company’s Form10-K for the fiscal year ended December 31, 2005. Judgments and estimates arebased on historical experience as well as relevant facts and circumstancesknown at each reporting date. Actual results may differ from these estimates.

 

Sales are generally recognized when products areshipped and the customer takes ownership and assumes risk of loss, collectionof the related receivable is reasonably assured, persuasive evidence of anarrangement exists and the sales price is fixed or determinable. U.S. Retailnet sales consist of product sales less a provision for sales returns andallowances and estimated customer rebates. The Company accrues an estimatedamount for unclaimed customer rebates and sales returns and allowances based onhistorical information, adjusted for economic trends. To the extent actualrebates, returns and allowances vary from historical experience revisions tothe allowances may be required. ClearLab net sales consist of product salesless a provision for sales returns and allowances. The Company provides itscustomers with standard industry payment terms and performs ongoing creditevaluations of its customers and provides for doubtful accounts to the extentdetermined necessary based on historical data and current economic trends. ClearLabnet sales also include license fees from the Company’s Japanese licenseagreement. Cash payments received from this license are recognizedsystematically over the periods that the fees are earned by the Company.

 

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

 

The Company has significant long-lived tangible andintangible assets consisting of property, plant and equipment, goodwill anddefinite-lived intangibles. These assets are reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amounts of suchassets may not be recoverable. In addition, the Company performs an impairmenttest related to goodwill at least annually. An impairment analysis related tolong-lived tangible and definite-lived intangible assets requires theassessment of expected future undiscounted cash flows over the remaining usefullife of the asset. An impairment analysis of goodwill requires the use of afair-value based analysis. All of the goodwill and a significant portion of theother long-lived assets were generated from the Company’s acquisitions ofClearLab International, ClearLab UK and Lens1st/Lens Express. 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 income tax assets are assessed forrecoverability and valuation allowances are provided as necessary to reducedeferred income tax assets to amounts expected to be realized. Should expectationsof taxable

 

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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 taxprovision or benefit at a rate that is based on expected results for the fiscalyear. If future changes in market conditions cause actual results to be more orless favorable, adjustments to the effective income tax rate on a quarterlybasis could be required.

 

The Company records liabilities for legal andregulatory matters when the contingency is both probable and reasonablyestimable. The Company is involved in several legal and regulatory matters. TheCompany, after consultation with legal counsel, believes that the ultimatedispositions of these matters will not have a material impact on its financialposition, liquidity or results of operations. 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.

 

Effective January 1, 2006, the Company adoptedthe fair value recognition provisions of SFAS No. 123R, using the modifiedprospective transition method, and therefore has not restated prior periods’results. Under this method the Company recognizes compensation expense for allshare-based payments granted after January 1, 2006 and prior to but notyet vested as of January 1, 2006, in accordance with SFAS No. 123R. Underthe fair value recognition provisions of SFAS No. 123R, the Company recognizesstock-based compensation net of an estimated forfeiture rate and only recognizescompensation cost for those shares expected to vest over the requisite serviceperiod of the award. Prior to SFAS No. 123R adoption, the Company accounted forshare-based payments under APB No. 25. Therefore, the Company generallyrecognized compensation expense for restricted stock awards and, when it grantedoptions with an exercise price below the market price on the date of grant. TheCompany estimates the value of stock option awards on the date of grant using aBlack-Scholes pricing model. Calculating the fair value of share-based paymentawards requires the input of highly subjective assumptions, including theexpected term of the share-based payment awards and expected stock pricevolatility. The expected term represents the average time that options thatvest are expected to be outstanding. The expected volatility rates areestimated based on a weighted average of the historical volatilities of theCompany’s common stock. The assumptions used in calculating the fair value ofshare-based payment awards represent management’s best estimates, but theseestimates involve inherent uncertainties and the application of managementjudgment. As a result, if factors change and the Company uses differentassumptions, its stock-based compensation expense could be materially differentin the future. In addition, the Company is required to estimate the expectedforfeiture rate and only recognize expense for those shares expected to vest.If the Company’s actual forfeiture rate is materially different from itsestimate, the stock-based compensation expense could be significantly differentfrom what the Company has recorded in the current period.

 

**Forward-Looking Statements**

** **

Except for historicalinformation contained herein, the matters discussed in this form 10-Q areforward-looking statements within the meaning of Section 21E of the SecuritiesExchange Act of 1934, as amended, and Section 7A of the Securities Act of 1933,as amended. These forward-looking statements involve risks and uncertaintiesand often depend on assumptions, data or methods that may be incorrect orimprecise. The Company’s future operating results may differ materially fromthe results discussed in, or implied by, forward-looking statements made by theCompany. Factors that may cause such differences include, but are not limitedto, those discussed below and the other risks detailed in the Company’s otherreports filed with the Securities and Exchange Commission. Words such as “believes,”“anticipates,” “expects,” “future,” “intends,” “would,” “may” and similarexpressions are intended to identify forward-looking statements. The Companyundertakes no obligation to revise any of these forward-looking statements toreflect events or circumstances after the date hereof.

 

Factors that may affectfuture results may include, but are not limited to, those factors set forthunder Item 1A. of Part II of this Form 10-Q.

 

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

** **

***Interest Rate Risk.***As of April 1,2006, the Company was exposed to changes in interest rates relating to itsrevolving credit facility and other debt obligations. The revolving creditfacility bears interest at a variable rate based on the U.S. prime rate or LIBOR.The Company’s outstanding borrowings on the credit facility, including bankoverdrafts, were approximately $13.1 million as of April 1, 2006. The remainderof the Company’s interest bearing debt obligations, including capital leaseobligations, is denominated in Singapore dollars and British pounds and bearsinterest at a fixed rate. As of April 1, 2006, the face amounts of theoutstanding borrowings on these fixed rate debt obligations were approximately$7.5 million. If interest rates were to change by a full percentage point, thenet impact on interest expense would be approximately $0.1 million per year.

 

***Foreign CurrencyRisk.***The Company faces foreign currency risks primarilyas a result of its acquired Singapore and United Kingdom operations and theintercompany balances between its U.S. and these international operations whichare denominated in U.S. dollars. The functional currency of the Company’sSingapore operations is the Singapore dollar. The Company has debt and otherlong-term obligations of approximately $8.0 million that are denominated inSingapore dollars and mature over the next four years. If the U.S. dollarweakens relative to the Singapore dollar, additional funds may be required tomeet these obligations if the debt cannot be adequately serviced from theSingapore operations. Fluctuations in exchange rates between the U.S. dollarand the Singapore dollar could lead to additional currency exchange losses orgains on the intercompany balances and transactions denominated in currencies otherthan the functional currency. For the first quarter of fiscal 2006, the Companyrecorded a foreign currency transaction gain of approximately $0.6 million onthe intercompany balances between the U.S. and Singapore operations. From thedate of the ClearLab International acquisition, July 24, 2002, through May 4,2006 the exchange rate has fluctuated approximately 10.9 percent (weakening ofthe U.S. dollar). If the Singapore dollar were to weaken against the U.S.dollar by 10 percent, the Company would record a $2.6 million dollar foreigncurrency loss on the intercompany balances that exist as of April 1, 2006.

 

The functional currency of the Company’s UnitedKingdom operations is the British pound. Fluctuations in exchange rates betweenthe U.S. dollar and the British pound could lead to additional currencyexchange losses or gains on intercompany balances and transactions denominatedin currencies other than the functional currency. For the first quarter offiscal 2006, the Company recorded a foreign currency transaction gain ofapproximately $0.1 million on the intercompany balances between the U.S. andUnited Kingdom operations. From the date of the ClearLab UK acquisition,February 24, 2004, through May 4, 2006 the exchange rate has fluctuated approximately1.4 percent (strengthening of the U.S. dollar). If the British pound were toweaken against the U.S. dollar by 10 percent, the Company would record a $1.4million dollar foreign currency loss on the intercompany balances that exist asof April 1, 2006.

 

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

 

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

 

***(a)**Evaluation of disclosure controls and procedures*.**The Company’s Chief Executive Officer and Chief Financial Officer, afterevaluating the effectiveness of the Company’s disclosure controls andprocedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of theend of the period covered by this report (the “Evaluation Date”), haveconcluded that, as of the Evaluation Date, the Company’s disclosure controlsand procedures were adequate and effective to ensure that material informationrelating to the Company and its consolidated subsidiaries would be made knownto them by others within those entities.

 

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***(b) Changes in internal controls over financial reporting.***Therewere no significant changes in the Company’s internal controls over financialreporting or in other factors that have materially affected, or are reasonablylikely to materially affect, the Company’s disclosure controls and proceduressubsequent to the Evaluation Date. As a result, no corrective actions weretaken.

 

The Company’s management, including its ChiefExecutive Officer and Chief Financial Officer, does not expect that the Company’sdisclosure controls and procedures or its internal controls over financialreporting will prevent all error and all fraud. A control system, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. Further, thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of inherent limitations in all control systems, no evaluation ofcontrols can provide absolute assurance that all control issues and instancesof fraud, if any, within the Company have been detected.

 

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

** **

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

 

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

 

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

 

There are no material changes from the risk factorspreviously disclosed in our Annual Report on Form   10-K for the fiscal year ended December 31,2005.

 

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

 

None.

 

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

 

None.

 

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

 

None.

** **

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

 

None.

 

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

** **

**(A) Exhibits**

** **
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                    |
|----------------------|------------|-----------------------------------------------------------------------------------------|
| 3.1 (i)              |       | Restated Certificate of Incorporation of the  Company. (1)                              |
| 3.1 (ii)             |       | Restated By-Laws of the Company. (1)                                                    |
| 4.1                  |       | Form of certificate representing shares of Common  Stock, $0.1 par value per share. (2) |
| 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.      |

 

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

 

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

 

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** **

**SIGNATURES**

 

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

 
|                |   | **1-800 CONTACTS, INC.** |
|---------------------|--------|--------------------------|
|                |   |                     |
|                |   |                     |
| Dated: May 11, 2006 | By:    | /s/ Jonathan C. Coon     |   |
|                |   | Name:                    | Jonathan C. Coon |
|                |   | Title:                   | Chief Executive Officer |
|                |   |                     |
|                | By:    | /s/ Robert G. Hunter     |   |
|                |   | Name:                    | Robert G. Hunter |
|                |   | Title:                   | Chief Financial Officer |
|                     |        |                          |  |  |  |  |

 

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