**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC  20549**

 

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**FORM 10-Q**

 

| **(Mark one)**                                                                                                                                                                                                                   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                                                                                                       | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                             |
| **For  the quarterly period ended June 28, 2003**                                                                                                                                                                                |
|                                                                                                                                                                                                                             |
| **o**                                                                                                                                                                                                                            | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                             |
|                                                                                                                                                                                                                             |
| **For  the transition period from                   to                 .** |
|                                                                                                                                                                                                                             |
| **Commission  file number:   0-23633**                                                                                                                                                                                 |
|                                                                                                                                                                                                                                  |  |  |

 

**1-800 CONTACTS, INC.**

(Exact name of registrantas specified in its charter)

 

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

 

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

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

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange act).

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

 

As of August 4, 2003, the Registrant had 13,102,965shares of Common Stock, par value $0.01 per share, outstanding.

 

 

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**1-800 CONTACTS, INC.**

 

**INDEX**

 
| **PART I.  FINANCIAL INFORMATION** |
|-----------------------------------------|
| Item 1.                                 | Financial Statements |
|                                    | Condensed  Consolidated Balance Sheets as of December 28, 2002 and June 28, 2003 |
|                                    | Condensed  Consolidated Statements of Income for the Quarters and Two Quarters Ended  June 29, 2002 and June 28, 2003 |
|                                    | Condensed  Consolidated Statements of Cash Flows for the Two Quarters Ended June 29,  2002 and June 28, 2003 |
|                                    | Notes  to Condensed Consolidated Financial Statements |
| Item  2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| Item  3.                                | Quantitative  and Qualitative Disclosures About Market Risk |
| Item 4.                                 | Controls  and Procedures |
|                                    |   |
| **PART II.  OTHER  INFORMATION**   |
| Item 1.                                 | Legal Proceedings |
| Item  2.                                | Changes  in Securities and Use of Proceeds |
| Item  3.                                | Defaults  upon Senior Securities |
| Item  4.                                | Submission  of Matters to a Vote of Security Holders |
| Item  5.                                | Other  Information |
| Item  6.                                | Exhibits  and Reports on Form 8-K |

 

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**PART I.****    FINANCIAL INFORMATION**

 

**Item 1.****           *Financial Statements***

* *

**1-800CONTACTS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(inthousands)**

**(unaudited)**

 

 
|                                                      |   | **December  28,  2002** |       | **June 28,  2003** |       |
|-----------------------------------------------------------|--------|-------------------------|------------|--------------------|------------|
| **ASSETS**                                                |   |                    |       |               |       |
| CURRENT ASSETS:                                           |   |                    |       |               |       |
| Cash                                                      |   | $                       | 259        |               | $          | 722 |   |
| Accounts  receivable                                      |   | 655                     |       | 974                |       |
| Inventories, net                                          |   | 37,785                  |       | 30,000             |       |
| Prepaid income  taxes                                     |   | 769                     |       | 121                |       |
| Deferred income  taxes                                    |   | 756                     |       | 669                |       |
| Other current  assets                                     |   | 1,095                   |       | 1,296              |       |
| Total current  assets                                     |   | 41,319                  |       | 33,782             |       |
| PROPERTY, PLANT  AND EQUIPMENT, net                       |   | 12,862                  |       | 13,426             |       |
| DEFERRED INCOME  TAXES                                    |   | 365                     |       | 511                |       |
| GOODWILL                                                  |   | —                  |       | 33,508             |       |
| DEFINITE-LIVED  INTANGIBLE ASSETS, net                    |   | 7,089                   |       | 10,664             |       |
| OTHER ASSETS                                              |   | 369                     |       | 628                |       |
| Total assets                                              |   | $                       | 62,004     |               | $          | 92,519 |   |
|                                                      |   |                    |       |               |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**            |   |                    | ** ** |               | ** ** |
| CURRENT  LIABILITIES:                                     |   |                    |       |               |       |
| Line of credit                                            |   | $                       | 5,770      |               | $          | 3,839 |   |
| Current portion  of long-term debt                        |   | 2,349                   |       | 2,666              |       |
| Current portion  of note payable to a related party       |   | 504                     |       | 332                |       |
| Current portion  of capital lease obligations             |   | 372                     |       | 305                |       |
| Accounts payable                                          |   | 8,597                   |       | 8,213              |       |
| Accrued  liabilities                                      |   | 3,327                   |       | 4,509              |       |
| Unearned revenue                                          |   | 403                     |       | 495                |       |
| Total current  liabilities                                |   | 21,322                  |       | 20,359             |       |
| LONG-TERM  LIABILITIES:                                   |   |                    |       |               |       |
| Long-term debt,  less current portion                     |   | 15,988                  |       | 14,677             |       |
| Note payable to  a related party                          |   | 1,377                   |       | 1,182              |       |
| Capital lease  obligations, less current portion          |   | 250                     |       | 103                |       |
| Liability  related to contingent consideration            |   | 5,470                   |       | —             |       |
| Total long-term  liabilities                              |   | 23,085                  |       | 15,962             |       |
| STOCKHOLDERS’  EQUITY:                               |   |                    |       |               |       |
| Common stock,  12,861 and 13,093 issued, respectively     |   | 129                     |       | 131                |       |
| Additional  paid-in capital                               |   | 24,013                  |       | 42,103             |       |
| Retained  earnings                                        |   | 14,272                  |       | 14,344             |       |
| Treasury stock  at cost, 1,473 and 0 shares, respectively |   | (20,739                 | )          | —             |       |
| Accumulated  other comprehensive loss                     |   | (78                     | )          | (380               | )          |
| Total  stockholders’ equity                          |   | 17,597                  |       | 56,198             |       |
| Total  liabilities and stockholders’ equity          |   | $                       | 62,004     |               | $          | 92,519 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

3

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**1-800CONTACTS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**

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

**(unaudited)**

 
|                                                |   | **Quarter Ended**  |   | **Two Quarters Ended** |   |
|-----------------------------------------------------|--------|--------------------|--------|------------------------|--------|
|                                                |   | **June 29,  2002** |   | **June 28,  2003**     |   | **June 29,  2002** |   | **June 28,  2003** |   |
| NET SALES                                           |   | $                  | 42,233 |                   | $      | 46,354 |   | $ | 83,814 |   | $ | 93,016 |   |
| COST OF GOODS  SOLD                                 |   | 29,803             |   | 28,580                 |   | 58,697 |   | 59,140 |   |
| Gross profit                                        |   | 12,430             |   | 17,774                 |   | 25,117 |   | 33,876 |   |
| SELLING, GENERAL  AND ADMINISTRATIVE EXPENSES:      |   |               |   |                   |   |   |   |   |   |
| Advertising  expense                                |   | 3,890              |   | 3,586                  |   | 6,609 |   | 7,380 |   |
| Legal and  professional fees                        |   | 1,140              |   | 1,755                  |   | 2,400 |   | 3,376 |   |
| Research and  development expenses                  |   | —             |   | 197                    |   | — |   | 2,000 |   |
| Other selling,  general and administrative expenses |   | 5,523              |   | 10,104                 |   | 10,914 |   | 18,753 |   |
| Total selling,  general and administrative expenses |   | 10,553             |   | 15,642                 |   | 19,923 |   | 31,509 |   |
| INCOME FROM  OPERATIONS                             |   | 1,877              |   | 2,132                  |   | 5,194 |   | 2,367 |   |
| OTHER EXPENSE,  net                                 |   | (193               | )      | (323                   | )      | (323 | ) | (823 | ) |
| INCOME BEFORE  PROVISION FOR INCOME TAXES           |   | 1,684              |   | 1,809                  |   | 4,871 |   | 1,544 |   |
| PROVISION FOR  INCOME TAXES                         |   | (681               | )      | (1,249                 | )      | (1,928 | ) | (1,472 | ) |
| NET INCOME                                          |   | $                  | 1,003  |                   | $      | 560 |   | $ | 2,943 |   | $ | 72 |   |
|                                                |   |               |   |                   |   |   |   |   |   |
| PER SHARE  INFORMATION:                             |   |               |   |                   |   |   |   |   |   |
| Basic net income  per common share                  |   | $                  | 0.09   |                   | $      | 0.04 |   | $ | 0.26 |   | $ | 0.01 |   |
| Diluted net  income per common share                |   | $                  | 0.09   |                   | $      | 0.04 |   | $ | 0.25 |   | $ | 0.01 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

4

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**1-800CONTACTS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**

** **
|                                                                                         |   | **Two Quarters Ended** |   |
|----------------------------------------------------------------------------------------------|--------|------------------------|--------|
|                                                                                         |   | **June 29,   2002**    |   | **June 28,   2003** |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                       |   |                   |   |   |   |
| Net income                                                                                   |   | $                      | 2,943  |   | $ | 72 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |   |                   |   |   |   |
| Depreciation and  amortization                                                               |   | 848                    |   | 3,008 |   |
| Amortization of  debt issuance costs and discounts                                           |   | —                 |   | 96 |   |
| Unrealized  foreign currency exchange loss                                                   |   | —                 |   | 77 |   |
| (Gain) loss on  sale of property and equipment                                               |   | (2                     | )      | 6 |   |
| Stock-based  compensation                                                                    |   | 3                      |   | 731 |   |
| Deferred income  taxes                                                                       |   | (173                   | )      | (59 | ) |
| Changes in  operating assets and liabilities, net of effects of acquisition:                 |   |                   |   |   |   |
| Accounts  receivable                                                                         |   | —                 |   | (992 | ) |
| Inventories, net                                                                             |   | (6,450                 | )      | 10,510 |   |
| Other current  assets                                                                        |   | (19                    | )      | (356 | ) |
| Accounts payable                                                                             |   | 1,212                  |   | (3,115 | ) |
| Accrued  liabilities                                                                         |   | 178                    |   | 664 |   |
| Income taxes  payable / prepaid income taxes                                                 |   | (829                   | )      | 1,180 |   |
| Unearned revenue                                                                             |   | (86                    | )      | 92 |   |
| Net cash (used  in) provided by operating activities                                         |   | (2,375                 | )      | 11,914 |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                       |   |                   |   |   |   |
| Purchase of  property and equipment                                                          |   | (910                   | )      | (1,655 | ) |
| Proceeds from  sale of property and equipment                                                |   | 15                     |   | 33 |   |
| Purchase of  intangible assets                                                               |   | (13                    | )      | (28 | ) |
| Cash paid for  acquisition                                                                   |   | —                 |   | (7,012 | ) |
| Capitalized  acquisition costs                                                               |   | (520                   | )      | — |   |
| Note receivable  related to acquisition                                                      |   | (550                   | )      | — |   |
| Deposits and  other                                                                          |   | (21                    | )      | (55 | ) |
| Net cash used in  investing activities                                                       |   | (1,999                 | )      | (8,717 | ) |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                       |   |                   |   |   |   |
| Common stock  repurchases                                                                    |   | (2,213                 | )      | — |   |
| Proceeds from  exercise of common stock options                                              |   | 38                     |   | 715 |   |
| Net borrowings  (repayments) on line of credit                                               |   | 6,541                  |   | (1,931 | ) |
| Principal  payments on capital lease obligations                                             |   | —                 |   | (206 | ) |
| Principal  payments on long-term debt                                                        |   | —                 |   | (1,311 | ) |
| Net cash  provided by (used in) financing activities                                         |   | 4,366                  |   | (2,733 | ) |
| EFFECT OF  FOREIGN EXCHANGE RATES ON CASH                                                    |   | (2                     | )      | (1 | ) |
|                                                                                         |   |                   |   |   |   |
| NET (DECREASE)  INCREASE IN CASH                                                             |   | (10                    | )      | 463 |   |
| CASH AT  BEGINNING OF PERIOD                                                                 |   | 36                     |   | 259 |   |
| CASH AT END OF  PERIOD                                                                       |   | $                      | 26     |   | $ | 722 |   |
|                                                                                         |   |                   |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                         |   |                   |   |   |   |
| Cash paid for  interest                                                                      |   | $                      | 286    |   | $ | 560 |   |
| Cash paid for  income taxes                                                                  |   | 2,930                  |   | 350 |   |

 

SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:

 

During the first quarterof 2003, the Company purchased certain assets and assumed certain liabilitiesof Lens Express and

Lens 1st.  The purchase consideration included cash of$7,012, common stock with a fair value of $19,859 and assumed

operating liabilities of$4,099 (see Note 6).

 

During the second quarterof 2003, the performance guarantee was met relating to 700,000 shares of theCompany’s

restricted common stockheld in escrow as partial consideration for the July 2002 acquisition ofClearLab.  The Company

recorded additionalpurchase consideration of approximately $16,980 for these shares.  The Company recorded this as

goodwill, net of acontingent consideration liability recorded at the purchase date.  The amount of goodwill as of

June 28, 2003 was $11,205(see Note 6).

 

See accompanying notes tocondensed consolidated financial statements.

 

5

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**1-800 CONTACTS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

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

 

The accompanyingcondensed consolidated financial statements have been prepared by the Company,without audit, pursuant to the rules and regulations of the Securities andExchange Commission.  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 consolidatedfinancial statements reflect all adjustments (consisting only of normalrecurring adjustments), which in the opinion of management, are necessary topresent fairly the financial position as of June 28, 2003 and the results ofoperations and cash flows of the Company for the periods presented.  These condensed consolidated financialstatements should be read in conjunction with the audited financial statementsand the notes thereto included in the Company’s Annual Report on Form 10-K forthe year ended December 28, 2002.  

 

The results of operationsfor the fiscal 2003 interim periods are not necessarily indicative of theresults that may be expected for the fiscal year ending January 3, 2004.

 

**NOTE 2.  INVENTORIES **

 

Inventories are recordedat the lower of cost (using the first-in, first-out method) or market.  Inventories as of December 28, 2002 and June28, 2003 consisted of the following (in thousands): 

 

|                           |   | **December 28,  2002** |   | **June 28,  2003** |   |
|--------------------------------|--------|------------------------|--------|--------------------|--------|
| Purchased contact  lenses      |   | $                      | 36,571 |               | $      | 28,583 |   |
| Manufactured  inventories:     |   |                   |   |               |   |
| Raw materials                  |   | 109                    |   | 159                |   |
| Work in process                |   | 210                    |   | 538                |   |
| Finished goods contact  lenses |   | 895                    |   | 720                |   |
| Total                          |   | $                      | 37,785 |               | $      | 30,000 |   |

 

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

 

Basic net incomeper common share (“Basic EPS”) excludes dilution and is computed by dividingnet income by the weighted-average number of common shares outstanding duringthe period.  Diluted net income percommon share (“Diluted EPS”) reflects the potential dilution that could occurif stock options or other common stock equivalents were exercised or convertedinto common stock.  The computation ofDiluted EPS does not assume exercise or conversion of securities that wouldhave an antidilutive effect on net income per common share. As of June 29, 2002and June 28, 2003, options to purchase 339,191 and 611,448 shares of commonstock, respectively, were not included in the computation of Diluted EPSbecause the exercise prices of the options were greater than the average marketprice of the common shares.  For the quarterand two quarters ended June 28, 2003, Basic and Diluted EPS includes theweighted-average impact of 700,000 shares of restricted common stock held inescrow because the necessary performance conditions were satisfied in June 2003(see Note 6).  

 

6

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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 June 29, 2002** |   | **Quarter  Ended June 28, 2003** |   |
|-------------------------|--------|----------------------------------|--------|----------------------------------|--------|
|                    |   | **Net Income**                   |   | **Shares**                       |   | **Per-Share  Amount** |   | **Net Income** |   | **Shares** |   | **Per-Share  Amount** |   |
|                    |   |                             |   |                             |   |   |   |   |   |   |   |   |   |
| Basic EPS               |   | $                                | 1,003  |                             | 11,382 |   | $ | 0.09 |   | $ | 560 |   | 12,552 |   | $ | 0.04 |   |
| Effect of stock options |   |                             |   | 124                              |   |   |   |   |   | 210 |   |   |   |
| Diluted EPS             |   | $                                | 1,003  |                             | 11,506 |   | $ | 0.09 |   | $ | 560 |   | 12,762 |   | $ | 0.04 |   |

 
|                    |   | **Two Quarters  Ended June 29, 2002** |   | **Two  Quarters Ended June 28, 2003** |   |
|-------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|
|                    |   | **Net Income**                        |   | **Shares**                            |   | **Per-Share  Amount** |   | **Net Income** |   | **Shares** |   | **Per-Share  Amount** |   |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| Basic EPS               |   | $                                     | 2,943  |                                  | 11,451 |   | $ | 0.26 |   | $ | 72 |   | 12,269 |   | $ | 0.01 |   |
| Effect of stock options |   |                                  |   | 113                                   |   |   |   |   |   | 224 |   |   |   |
| Diluted EPS             |   | $                                     | 2,943  |                                  | 11,564 |   | $ | 0.25 |   | $ | 72 |   | 12,493 |   | $ | 0.01 |   |

 

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

 

Comprehensive income (loss) for the quarters and twoquarters ended June 29, 2002 and June 28, 2003 consists of the following components(in thousands): 

 
|                               |   | **Quarter  Ended** |   | **Two  Quarters Ended** |   |
|------------------------------------|--------|--------------------|--------|-------------------------|--------|
|                               |   | **June 29,  2002** |   | **June 28,  2003**      |   | **June 29,  2002** |   | **June 28,  2003** |   |
| Net income                         |   | $                  | 1,003  |                    | $      | 560 |   | $ | 2,943 |   | $ | 72 |   |
| Foreign currency  translation loss |   | (2                 | )      | (442                    | )      | (2 | ) | (302 | ) |
| Comprehensive  income (loss)       |   | $                  | 1,001  |                    | $      | 118 |   | $ | 2,941 |   | $ | (230 | ) |

 

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

 

**NOTE 5.  STOCK-BASED COMPENSATION**

 

The Company applies Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations and uses the intrinsic method of accounting for its stockoption grants to employees and directors. Accordingly, no compensation expense has been recognized for these stockoption grants.  

 

Under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” compensation cost is recognized for thefair market value of each option as estimated on the date of grant using theBlack-Scholes option-pricing model.  SFASNo. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,”amends SFAS No. 123, to provide alternative methods of transition for avoluntary change to the fair market value based method of accounting forstock-based employee compensation.  Inaddition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 torequire new prominent disclosures in both annual and interim financialstatements about the method of accounting for stock-based employee compensationand the effect of the method used on reported results. The Company has electedto adopt the “disclosure only” provisions of SFAS No. 148.

 

7

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

 
|                                       |   | **Quarter  Ended** |   |
|--------------------------------------------|--------|--------------------|--------|
|                                       |   | **June 29,  2002** |   | **June 28,  2003** |   |
| Net income:                                |   |               |   |   |   |
| As reported                                |   | $                  | 1,003  |   | $ | 560 |   |
| Fair-value based  compensation, net of tax |   | (203               | )      | (258 | ) |
| Pro forma                                  |   | $                  | 800    |   | $ | 302 |   |
|                                       |   |               |   |   |   |
| Basic net income  per common share:        |   |               |   |   |   |
| As reported                                |   | $                  | 0.09   |   | $ | 0.04 |   |
| Pro forma                                  |   | $                  | 0.07   |   | $ | 0.02 |   |
|                                       |   |               |   |   |   |
| Diluted net  income per common share:      |   |               |   |   |   |
| As reported                                |   | $                  | 0.09   |   | $ | 0.04 |   |
| Pro forma                                  |   | $                  | 0.07   |   | $ | 0.02 |   |

 
|                                         |   | **Two  Quarters Ended** |   |
|----------------------------------------------|--------|-------------------------|--------|
|                                         |   | **June 29,  2002**      |   | **June 28,  2003** |   |
| Net income (loss):                           |   |                    |   |   |   |
| As reported                                  |   | $                       | 2,943  |   | $ | 72 |   |
| Fair-value based  compensation, net of tax   |   | (401                    | )      | (539 | ) |
| Pro forma                                    |   | $                       | 2,542  |   | $ | (467 | ) |
|                                         |   |                    |   |   |   |
| Basic net income  (loss) per common share:   |   |                    |   |   |   |
| As reported                                  |   | $                       | 0.26   |   | $ | 0.01 |   |
| Pro forma                                    |   | $                       | 0.22   |   | $ | (0.04 | ) |
|                                         |   |                    |   |   |   |
| Diluted net  income (loss) per common share: |   |                    |   |   |   |
| As reported                                  |   | $                       | 0.25   |   | $ | 0.01 |   |
| Pro forma                                    |   | $                       | 0.22   |   | $ | (0.04 | ) |

 

The weightedaverage per share fair value of options granted during the quarters ended June29, 2002 and June 28, 2003 was $7.22 and $14.28, respectively.  For the two quarters ended June 29, 2002 andJune 28, 2003, the weighted average per share fair value of options granted was$7.47 and $13.85, respectively.  Thefair value of each option grant has been estimated on the grant date using theBlack-Scholes option-pricing model with the following weighted averageassumptions: 

 
|                     |   | **Quarter  Ended** |   | **Two  Quarters Ended** |   |
|--------------------------|--------|--------------------|--------|-------------------------|--------|
|                     |   | **June 29,  2002** |   | **June 28,  2003**      |   | **June 29,  2002** |   | **June 28,  2003** |   |
| Risk-free interest rate  |   | 4.0                | %      | 2.2                     | %      | 4.0 | % | 2.6 | % |
| Expected  dividend yield |   | 0.0                | %      | 0.0                     | %      | 0.0 | % | 0.0 | % |
| Volatility               |   | 74.1               | %      | 76.1                    | %      | 75.6 | % | 77.0 | % |
| Expected life            |   | 5 years            |   | 5 years                 |   | 5 years |   | 5 years |   |

 

8

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**NOTE6.  RECENT ACQUISITIONS**

 

***IGEL (ClearLab)***

* *

On July 24, 2002,the Company completed the acquisition of certain net assets and the majority ofthe business operations of IGEL, a developer and contract manufacturer ofcontact lenses based in Singapore.  Theacquisition was effected through a wholly owned subsidiary of the Company, IGELAcquisition Co. Pte Ltd (subsequently renamed ClearLab Pte Ltd), and includedthe purchase of assets of Igel C.M.Laboratory Pte Ltd and International Vision Laboratories Pte Ltd, bothsubsidiaries of Igel VisioncarePte Ltd, as well as certain other assets from Sinduchajana Sulistyo and StephenD. Newman. The assets acquired included principally the long-term leasehold interests in the land andbuilding where the manufacturing facility is located, as well as equipment,inventories, and certain intellectual property rights, including patents key tothe operation of the acquired business. ClearLab is in the process of final testing for a new brand of contactlens that is expected to provide the Company increased control of production capacityand inventory and the flexibility to make a variety of offers to its customersto enhance its capability to provide high quality, cost-effectiveproducts.  The Company accounted forthis transaction under the purchase method in accordance with SFAS No.141.  The results of operations ofClearLab are included in the consolidated results of the Company from the dateof the acquisition. 

 

The considerationpaid by the Company consisted of approximately $6.6 million in cash (whichincludes $1.2 million in transaction costs), $8.9 million in assumed buildingand business loans to be paid over 7 years, $0.7 million in assumed capitallease obligations, a non-interest bearing note payable of  $2.1 million to be paid over 5 years,700,000 shares of restricted common stock of the Company, and 270,000 commonstock options of the Company in three tranches of 90,000 each with exerciseprices of $15, $25 and $35 per share, respectively. The Company obtained a $10million, five-year term loan from a U.S. bank to provide partial financing forthis asset purchase. 1-800 CONTACTS, INC. also executed guarantees for thebuilding and business loans assumed in the transaction. 

 

The 700,000 sharesof restricted common stock are held in escrow, subject to a performance guarantee,and vest over a two-year schedule with no shares released from escrow for aminimum of one year from the acquisition date. On June 6, 2003, the performance guaranteewas met relating to these shares and 175,000 shares were released on July 24, 2003, in accordance with the vesting provisions.  The remainder of the shares held in escrowwill be released as follows:  350,000 onJanuary 24, 2004 and 175,000 on July 24, 2004. For financial reporting purposes, all shares held in escrow are treatedas outstanding as of June 6, 2003, the date the performance guarantee was met,and the Company reflected additional purchase consideration for the estimatedfair value of these shares of approximately $17.0 million.  The fair value was based upon the closingmarket price of the Company’s common stock on the date the performanceguarantee was met, reduced by an approximate 9% discount due to therestrictions associated with the vesting period of the common stock held inescrow. This discount was determined by an independent third partyappraisal.  

 

The $17.0 millionof additional purchase consideration, net of the contingent considerationliability recorded at the purchase date in accordance with SFAS No. 141, wasrecorded as goodwill.  At June 28, 2003,goodwill related to this transaction amounted to $11.2 million.

 

The value of theoptions to purchase 270,000 shares of common stock will be determined andrecorded as additional purchase consideration at the applicable vestingdates.  These options vest equally atthe end of the third, fourth and fifth years from the acquisition date. 

 

The Company alsorecorded compensation expense and additional paid-in capital of approximately$0.7 million due to the transfer of 28,000 common shares owned by ClearLab’schief technology officer to key employees of ClearLab.  The shares transferred represented a portionof the 700,000 shares held in escrow and are subject to the same performanceguarantee and vesting provisions. Because the performance conditions were met,and there are no additional contingencies, the fair value of the shares wasrecorded as compensation expense during the second quarter of fiscal 2003.  

 

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

 

OnJanuary 30, 2003, the Company completed the acquisition of certain assetsand the assumption of certain liabilities of Lens Express LLC and CamelotVentures/CJ, L.L.C. d/b/a Lens 1st (collectively, the “Seller”), twoleading U.S. mail order contact lens retailers. The assets acquired includeddatabases, customer information, web sites and Internet addresses or domainnames, telephone numbers, certain specified contracts and intellectual propertyrights. In addition, acquired assets included certain property, equipment,inventories, receivables and prepaid expenses. With the exception ofspecifically identified liabilities, the Company did not assume the liabilitiesof the Seller. The liabilities assumed by the Company included certain of theSeller’s identified contracts, accounts payable, accrued liabilities, certaincustomer program obligations and severance obligations as of January 30,2003. 

 

The considerationpaid by the Company consisted of approximately $7.0 million in cash(including $0.5 million in transaction costs), 900,000 shares of restrictedcommon stock of the Company with a fair value of $19.9 million and theassumption of approximately $4.1 million of the aforementioned liabilities. The900,000 shares of restricted common stock are subject to a lock-up period of 12 monthsafter the acquisition date of January 30, 2003, established under theterms of a lock-up agreement.  Inconnection with the acquisition, the Company entered into a registration rightsagreement pursuant to which the Company granted the Seller certain piggybackregistration rights with respect to the 900,000 shares of restricted commonstock.  The following sets forth theconsideration paid by the Company (in thousands, except per share amounts): 

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

 

For purposes ofcomputing the purchase price, the value of the restricted common stock wasdetermined by taking the average closing price of the Company’s common stock asquoted on NASDAQ for the two days before, the day of and the two days followingthe announcement of the signing of a letter of intent to acquire Lens Expressand Lens 1st.  This averageprice was then reduced by a 15 percent discount (as determined by a third partyappraisal) due to the restriction provisions associated with the common sharesissued.  

 

The followingtable sets forth the allocation of the purchase price to the tangible andintangible assets acquired (in thousands): 

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

 

The unaudited proforma information below sets forth summary results of operations as if theacquisitions of ClearLab and Lens 1st and Lens Express had takenplace at the beginning of 2002, after giving effect to certain adjustments,including amortization of intangibles, depreciation, interest expense and otheradjustments directly attributable to the transaction.  The following pro forma information has been prepared forcomparative purposes only and does not purport to be indicative of what wouldhave occurred had the acquisitions occurred at the beginning of fiscal 2002 orof results which may occur in the future (in thousands, except per shareamounts):  

 

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|                                                  |   | **Quarter  Ended** |   | **Two  Quarters Ended** |   |
|-------------------------------------------------------|--------|--------------------|--------|-------------------------|--------|
|                                                  |   | **June 29,  2002** |   | **June 29,  2002**      |   | **June 28,  2003** |   |
|                                                  |   |               |   |                    |   |   |   |
| Net sales                                             |   | $                  | 54,966 |                    | $      | 109,281 |   | $ | 96,425 |   |
| Net income  (loss)                                    |   | (1,258             | )      | (1,579                  | )      | 186 |   |
| Basic and  Diluted Net income (loss) per common share |   | $                  | (0.10  | )                       | $      | (0.13 | ) | $ | 0.01 |   |

 

**NOTE 7.  COMMON STOCK TRANSACTIONS**

 

During the twoquarters ended June 28, 2003, employees exercised stock options to purchase104,574 shares of common stock for a total of approximately $715,000.  The Company recorded an increase inadditional paid-in capital of approximately $533,000 for the income tax benefitrelated to these stock option exercises.

 

During the twoquarters ended June 28, 2003, the Company granted nonqualified stock options topurchase 191,803 shares of common stock to employees and directors of theCompany.  The exercise prices of theoptions range from $18.30 to $27.50 per share, which prices were not less thanthe quoted fair market values at the grant dates. The options vest equally overa four-year period and expire in five to seven years. 

 

The Company’sBoard of Directors has authorized the repurchase of up to 3,000,000 shares ofthe Company’s Common Stock.  A purchaseof the full 3,000,000 shares would equal approximately 23 percent of the totalshares issued as of June 28, 2003.  Therepurchase of common stock is subject to market conditions and is accomplishedthrough periodic purchases at prevailing prices on the open market, by blockpurchases or in privately negotiated transactions.  The repurchased shares were retained as treasury stock to be usedfor corporate purposes.  As of June 28,2003, no shares remain in treasury given the use of such shares in connectionwith the ClearLab and Lens 1st/Lens Express acquisitions.  From inception of its authorized repurchaseprograms through June 28, 2003, the Company had repurchased 1,706,500 sharesfor a total cost of approximately $22.1 million.  No shares were repurchased by the Company during the two quartersended June 28, 2003.

 

During the twoquarters ended June 28, 2003, the Company issued 900,000 shares of restrictedcommon stock as a portion of the consideration for the acquisition of LensExpress and Lens 1st (see Note 6).  Ofthe 900,000 shares, 772,655 were issued from treasury stock. The 900,000 sharesof restricted common stock are subject to a lock-up period of 12 months afterthe acquisition date of January 30, 2003. In connection with the acquisition, the Company entered into aregistration rights agreement pursuant to which the Company granted the Sellercertain piggyback registration rights with respect to the 900,000 shares ofrestricted common stock.  

 

During the quarterended June 28, 2003, the performance conditions were met on the 700,000 sharesof restricted common stock held in escrow as part of the purchase considerationfor the ClearLab acquisition.  Additionally,the Company recorded compensation expense and additional paid-in capital of$0.7 million due to the transfer of shares owned by ClearLab’s chief technologyofficer to key employees of ClearLab (see Note 6).

 

On June 11, 2003,the Company’s Board of Directors approved and adopted, subject to stockholderapproval, certain amendments to the Company’s stock option plan to provide foran increase in the number of shares of common stock reserved for issuance underthe plan from 1,240,000 to 1,590,000.  

 

**NOTE 8.  DEBT OBLIGATIONS**

 

Effective July 22,2002, the Company entered into a  loanagreement, providing for both a $10 million term loan and a revolving creditfacility for borrowings of up to $20 million. The amounts outstanding on both the term loan and the revolving creditfacility are limited to a percentage of eligible inventory.  As of the effective date, the percentage was75% and is reduced by 1.25% each calendar quarter beginning September 30, 2002until the 

 

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percentage is 50%.  The percentage as of June 28, 2003 was71.25%.  The outstanding borrowings aresecured by substantially all of the Company’s U.S. assets including a portionof the Company’s common stock ownership in ClearLab.  The agreement contains various financial covenants including acapital expenditure limit, a minimum working capital requirement, a leverageratio and a minimum net income requirement. Also, if the Company were unable tocure a default on its Singapore debt within 30 days of occurrence, the Companywould be in default on this debt.  As ofDecember 28, 2002, the Company was not in compliance with the minimum netincome covenant or the leverage ratio covenant.  However, the Company obtained waivers through July 30, 2004.  These waivers also established certain newfinancial covenants.  The Company was incompliance with these modified covenants and all other applicable covenants asof June 28, 2003.  

 

Outstandingborrowings on the revolving credit facility bear interest at a floating rateequal to the lender’s prime interest rate plus 0.25 percent (4.25 percent atJune 28, 2003) or 2.75 percent above the lender’s LIBOR for the applicableperiod.  As of June 28, 2003, theinterest rate on the outstanding borrowings was based on the lender’s prime interestrate plus 0.25 percent.  Interest ispayable monthly. The credit facility also includes an unused credit fee equalto one-eighth of one percent, payable quarterly.  As of June 28, 2003, the remaining availability on the creditfacility was $7.8 million. The credit facility was scheduled to expire on April30, 2003, however, the Company obtained an extension of the maturity date toNovember 1, 2003.  The Company is in theprocess of renewing the credit facility. The Company expects that the credit facility will be renewed prior tothe expiration of the extension; however, there can be no assurance that thefacility will be renewed with similar terms. 

 

As of June 28,2003, the U.S. bank term loan interest rate was fixed at the 180-day LIBOR rateplus 3% (4.14% at June 28, 2003) until December 3, 2003.

 

The Company’sSingapore bank term loan contains various financial covenants includingminimums on net worth and shareholders’ funds. As of December 28, 2002, the Company was not in compliance with the networth and shareholders’ funds covenants. However, the Company obtained waivers on noncompliance with thesecovenants through July 31, 2004.

 

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

 

**NOTE 9.  LEGAL MATTERS**

 

On April 7, 1999,the Kansas Board of Examiners in Optometry (“KBEO”) commenced a civil actionagainst the Company.  The action wasfiled in the District Court of Shawnee County, Kansas, Division 6.  The complaint was amended on May 28,1999.  The amended complaint allegesthat “on one or more occasions” the Company sold contact lenses in the state ofKansas without receipt of a prescription. The amended complaint seeks an order enjoining the Company from furtherengaging in the alleged activity.  Theamended complaint does not seek monetary damages.  The Company filed an answer to the amended complaint and, at therequest of the Court, filed a motion for summary judgment.  In November 2000, the Court issued an orderdenying the summary judgment motion, finding that there were factual issuesregarding whether the KBEO can meet the requirements necessary to obtaininjunctive relief, and whether the Kansas law violates the Commerce Clause ofthe United States Constitution. On June 18, 2002, the court granted a summaryjudgment motion in favor of the KBEO. However, the court made no findings of any violations of Kansaslaw.  Further, the court based itsdecision on a Kansas optometry law that has been repealed and amended by theKansas legislature.  To preserve theissues for appeal, on July 2, 2002, the Company filed a motion to alter oramend judgment, asking the court to reverse its decision, and to enter summaryjudgment in favor of the Company, or to dismiss the KBEO’s lawsuit as mootbased on the new law. The court denied the motion on September 12, 2002, findingthat no new evidence had been presented to persuade the court to change itsprior ruling.  The court made no newfindings of fact and did not change its conclusions of law.  On October 11, 2002, the Company filed itsNotice of Appeal with the Kansas Court of Appeals; the Docketing Statement wasfiled on October 30, 2002.  Allpleadings in this appeal have been filed and the case is ready for oralargument on August 27, 2003.

 

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

 

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

 

**NOTE 10.  RECENTLY ISSUED ACCOUNTING STANDARD**

 

In May 2003, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 150, “Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity.”  The new statement establishes standards forhow an issuer classifies and measures certain financial instruments withcharacteristics of both debt and equity. The provisions of SFAS No. 150 apply to the classification anddisclosure requirements for the following three types of financialinstruments:  Mandatorily RedeemableInstruments, Instruments with Repurchase Obligations and Instruments withObligations to Issue a Variable Number of Securities.  The new reporting and disclosure requirements for SFAS No. 150become effective for the first interim period beginning after June 15, 2003 orfor any covered instruments entered into or modified subsequent to May 31,2003.  Management does not expect theadoption of SFAS No. 150 to have a material impact on the Company’s financialposition, results of operations or liquidity.

 

**NOTE 11.  COMMITMENTS AND CONTINGENCIES**

 

***Letter of Intent****.* On March 13, 2003, the Company signed a letter of intent with adeveloper and manufacturer of contact lenses, and certain of itsshareholders.  The Company agreed to paythe developer and manufacturer of contact lenses a non-refundable sum equal to$1.5 million to be used by the entity for research and development activitiesrelating to contact lenses.  Of thetotal, $700,000 was paid on March 14, 2003, and the remaining $800,000 was paidon June 13, 2003.  Because the Companywas contractually committed to the payments, the monies were designated forresearch and development activities and the contact lens developer had nosubstantive operations, the entire amount of these payments was expensed as researchand development in March 2003.  In theevent that the contact lens technologies are successfully commercialized, theCompany will have the right to acquire contact lens products based on thedeveloped technologies on terms no less favorable than those granted oravailable to any other customer, licensee or other third party.  In addition, the Company was granted asix-month option to either: (1) acquire all of the shares of common stock ofthe entity; or, (2) acquire from the entity a worldwide license to manufacture,market, sell or otherwise use or exploit specific technology developed by theentity.  As consideration for thisoption, the Company paid $100,000 to the entity on March 14, 2003, which wasalso expensed as research and development. In the event that the Company does not exercise the option to purchasethe shares of the entity, the Company agreed to pay the entity an additional$800,000 at the end of the option period. The Company also reimbursed theentity and its shareholders $161,000 for legal and financial expenses incurredby the entity in connection with the agreement.  

 

In connection withthe agreement, and the transactions discussed above, the Company expensed atotal of approximately $1.8 million in March 2003 (inclusive of the $161,000 incosts) related to these research and development initiatives.  The Company funded these payments from itsrevolving credit facility.  

 

***Advertising Commitments***

 

As of June 28,2003, the Company had entered into certain noncancelable commitments withvarious advertising companies that will require the Company to payapproximately $8.3 million for advertising during the remainder of 2003.

 

**NOTE 12.  SEGMENT INFORMATION**

 

As a result of the acquisition of IGEL (ClearLab), beginning in the thirdquarter of fiscal 2002, the Company has two operating segments.  These operating segments representcomponents of the Company for which separate 

 

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financial information is available and evaluatedregularly by management in determining resource allocation and performanceassessment.  The Company’s U.S. segmentincludes the operations of 1-800 CONTACTS and the operations from the LensExpress and Lens 1st acquisitions. The Company’s Singapore segment includes the operations of ClearLab, adeveloper and contract manufacturer of contact lenses.  Operating segment information for thequarter and two quarters ended June 28, 2003 is as follows (in thousands):

 
|                          |   | **Quarter Ended June 28, 2003** |   |
|-------------------------------|--------|---------------------------------|--------|
|                          |   | **U.S.**                        |   | **Singapore** |   | **Total** |   |
| Net sales                     |   | $                               | 44,701 |   | $ | 1,653 |   | $ | 46,354 |   |
| Gross profit                  |   | 17,045                          |   | 729 |   | 17,774 |   |
| Income (loss) from operations |   | 3,055                           |   | (923 | ) | 2,132 |   |
|                               |        |                                 |        |  |  |  |  |  |  |  |

 
|                          |   | **Two Quarters Ended June 28,  2003** |   |
|-------------------------------|--------|---------------------------------------|--------|
|                          |   | **U.S.**                              |   | **Singapore** |   | **Total** |   |
| Net sales                     |   | $                                     | 89,832 |   | $ | 3,184 |   | $ | 93,016 |   |
| Gross profit                  |   | 32,793                                |   | 1,083 |   | 33,876 |   |
| Income (loss) from operations |   | 3,666                                 |   | (1,299 | ) | 2,367 |   |
|                               |        |                                       |        |  |  |  |  |  |  |  |

 

Identifiable segment assets asof June 28, 2003 are as follows (in thousands):

 
|                    |   | **U.S.** |   | **Singapore** |   | **Total** |   |
|-------------------------|--------|----------|--------|---------------|--------|-----------|--------|
| Long-lived  assets, net |   | $        | 32,394 |          | $      | 25,204    |   | $ | 57,598 |   |
| Total assets            |   | 63,484   |   | 29,035        |   | 92,519    |   |
|                         |        |          |        |               |        |           |        |  |  |  |

 

**NOTE13.  RELATED PARTY TRANSACTIONS**

 

During the quarter ended June 28, 2003, the Companyincurred legal expenses of approximately $53,000 to a legal firm in which amember of the Company’s Board of Directors is a partner.  These fees represent the total amountincurred subsequent to this individual joining the Company’s Board of Directorsin June 2003.

 

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**Item 2.****           *Management’s Discussion and Analysis of FinancialCondition and Results of Operations***

 

**Overview**

 

The Company is a leading direct marketer ofreplacement contact lenses and also conducts contact lens manufacturingoperations in Singapore.  The Companysells all of the popular brands of contacts lenses, including thosemanufactured by Johnson & Johnson, CIBA Vision, Bausch & Lomb, OcularSciences and CooperVision. The Company was formed in February 1995 and is thesuccessor to the mail order business founded by the Company’s Vice President ofTrade Relations in March 1991.  TheCompany’s net sales grew rapidly from $3.6 million in fiscal 1996 to $169.0million in fiscal 2001.  During fiscal2002, net sales declined slightly to $168.6 million.  During the first two quarters of fiscal 2003, net sales increasedto $93.0 million from $83.8 million in the first two quarters of fiscal2002.  Net sales for the first twoquarters of fiscal 2003 were negatively impacted by canceled orders due to theprescription verification procedures including most significantly thoseimplemented as part of the Vistakon agreement. The Company is taking steps to recover these canceled orders in thefuture, including creating a doctor network through the Cole agreement(discussed below) and establishing a doctor network department to helpcustomers schedule eye exams in order to obtain prescriptions.  The Company is uncertain of the ultimateimpact these prescription verification procedures will have on future netsales.

 

***IGEL (ClearLab).***** **On July 24, 2002, the Company completedthe acquisition of certain net assets and the majority of the businessoperations of IGEL, a developer and contract manufacturer of contact lensesbased in Singapore.  The acquisition waseffected through a wholly owned subsidiary of the Company, IGEL Acquisition Co.Pte Ltd (subsequently renamed ClearLab Pte Ltd).  The results of operations of ClearLab are included in theconsolidated results of the Company from the date of the acquisition. 

 

ClearLab currently manufactures injection cast moldedsoft contacts lenses on a contract basis for various contact lensmanufacturers.  ClearLab alsomanufactures and distributes branded and private label contact lenses viadistributors and other sales channels. ClearLab currently has the capacity to produce in excess of 40 millionlenses annually, which is enough to service approximately one million two-weekdisposable contact lens wearers. ClearLab is in the process of final testing for a new brand of contactlens that is expected to provide the Company increased control of productioncapacity and inventory and the flexibility to make a variety of offers to itscustomers to enhance its capability to provide high quality, cost-effectiveproducts. 

 

The Company expects to begin marketing lenses made byClearLab to its customers in select test markets during the third quarter offiscal 2003 and expects to market these lenses nationally to its customersduring the fourth quarter of fiscal 2003. Based on previous conducted test marketing, the Company believes thatits customers are receptive to an offer from the Company to try both a newproduct and a new eye care practitioner.  The Company believesthat a more active role in theproduct/provider decision may help it address the policies of certainmanufacturers that continue to refuse to sell their brands to the Company andseek to sell their brands exclusively to eyecare practitioners.  TheCompany’s first preference is to sell the customer the lens she is alreadywearing.  In cases where manufacturersor eye care practitioners stand in the way of the customer’s choice to purchasefrom the Company, the Company will be able to offer the customer theopportunity to try an alternative eye care provider and an alternativeproduct.  

 

***Vistakon Agreement.***  In December 2002, the Company announced thatit had reached an agreement with Johnson & Johnson’s eye care division,Vistakon, to become an authorized retailer of Vistakon contact lenses.  The Company has modified its operatingsystems in connection with this agreement. The Company implemented newprocedures for Vistakon by geographic region based on time zone.  The Company began this implementation inFebruary 2003 and completed it in April 2003. The Company began buying directfrom Vistakon during March 2003.  

 

This direct relationship with Vistakon has lowered theCompany’s product acquisition costs and allowed it to offer rebates and otherincentives not previously available to its customers who wear Vistakon lenses.The 

 

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Company has also been able to reduce its inventory investment bypurchasing a more balanced mix of products at lower prices than it hashistorically been able to obtain through indirect sources. This agreement alsoresolves long-standing disputes.  

 

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

 

The consideration paid by the Company consisted ofapproximately $7.0 million in cash (including $0.5 million in transactioncosts), 900,000 shares of restricted Common Stock of the Company with a fairvalue of $19.9 million and the assumption of approximately $4.1 million of theaforementioned liabilities. The 900,000 shares of restricted Common Stock aresubject to a lock-up period of 12 months after the acquisition date ofJanuary 30, 2003. In connection with the acquisition, the Company enteredinto a registration rights agreement granting the Seller certain piggybackregistration rights with respect to the 900,000 shares of restricted CommonStock.  The Company funded the cashconsideration portion of the asset purchase from its revolving credit facility.

 

***Letter of Intent****.* On March 13, 2003, the Company signed a letter of intent with a developerand manufacturer of contact lenses, and certain of its shareholders.  The Company agreed to pay the developer andmanufacturer of contact lenses a non-refundable sum equal to $1.5 million to beused by the entity for research and development activities relating to contactlenses.  Of the total, $700,000 was paidon March 14, 2003, and the remaining $800,000 was paid on June 13, 2003.  Because the Company was contractuallycommitted to the payments, the monies were designated for research and developmentactivities and the contact lens developer had no substantive operations, theentire amount of these payments was expensed as research and development inMarch 2003.  In the event that thecontact lens technologies are successfully commercialized, the Company willhave the right to acquire contact lens products based on the developedtechnologies on terms no less favorable than those granted or available to anyother customer, licensee or other third party. In addition, the Company was granted a six-month option to either: (1)acquire all of the shares of common stock of the entity; or, (2) acquire fromthe entity a worldwide license to manufacture, market, sell or otherwise use orexploit specific technology developed by the entity.  As consideration for this option, the Company paid $100,000 tothe entity on March 14, 2003, which was also expensed as research anddevelopment.  In the event that theCompany does not exercise the option to purchase the shares of the entity, theCompany agreed to pay the entity an additional $800,000 at the end of theoption period. The Company also reimbursed the entity and its shareholders$161,000 for legal and financial expenses incurred by the entity in connectionwith the agreement.  

 

In connection with the agreement, and the transactionsdiscussed above, the Company expensed a total of approximately $1.8 millionduring the first quarter of fiscal 2003 (inclusive of the $161,000 in costs)related to these research and development initiatives.  The Company funded these payments from itsrevolving credit facility.  

 

***Cole National Marketing Agreement.*** OnJune 30, 2003, the Company and Cole National Corporation (“Cole”) announcedthat they had signed an agreement under which the Company’s customers canreceive discounted eye exams and value pricing on eyeglasses, sunglasses andother vision products that the Company does not sell from a network of doctorscontracted with Cole Managed Vision and associated with more than 1,500 PearleVision, Pearle VisionCare, Sears Optical and Target Optical stores in theU.S.  Cole will offer its network ofdoctors for at least one year.  TheCompany will retain the contact lens business of customers referred to Colestores.  

 

As part of the agreement, the Company and Cole willalso work together on a variety of cross-marketing programs and promotions oftheir respective products in select test markets over the coming months.  The goal of these cross-marketing programsis to find other ways that the Company and Cole can help create value together.

 

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**Regulatory Considerations**

 

The sale and delivery of contact lenses are governedby both federal and state laws and regulations.  The Company sells to customers in all 50 states, and each sale islikely to be subject to the laws of the state where the customer islocated.  In some states, the Companyoperates according to agreements it has entered into with local regulatoryauthorities or medical boards or agencies. The Company’s current generaloperating practice is to obtain a copy of the customer’s prescription or topassively verify each customer’s prescription with his/her eye carepractitioner.  If the customer does nothave a copy of his/her prescription, the Company asks the customer for his/herexact prescription specifications and then directly contacts the customer’s eyecare practitioner to passively verify the customer’s prescription.  The Company directly communicates to the eyecare practitioner the prescription specifications received from the customerand informs the eye care practitioner that it will proceed to complete the salebased on such information unless the eye care practitioner advises it that suchinformation is expired or incorrect.  Ifthe eye care practitioner does not advise the Company that such information isexpired or incorrect within a minimum period, the Company’s general practice isto complete the sale and ship the lenses based on the information communicatedto the eye care practitioner.  If theCompany is unable to obtain a copy of the customer’s prescription or passivelyverify the prescription with the customer’s eye care practitioner, theCompany’s policy is not to proceed with the sale.  The Company retains copies of the written prescriptions that itreceives and maintains records of its communications with the customer’sprescriber.

 

The Company has modified its operating systems to giveeye care practitioners a minimum of eight business hours to respond to itsprescription verification requests for Vistakon products.  Eye care practitioners have the option ofreceiving these requests by fax. If the eye care practitioner notifies theCompany within this time period that the customer’s prescription is expired orotherwise invalid, the Company will not ship the order. Absent suchnotification from the eye care practitioner, the Company will proceed with thesale based on the prescription that was communicated to the eye carepractitioner. This system applies to Vistakon orders nationwide with theexception of a few states where the Company has pre-existing agreements toemploy more stringent procedures. 

 

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**Resultsof Operations**

 

The Company’sfiscal year consists of a 52/53-week period ending on the Saturday nearest toDecember 31. Fiscal 2003 is a 53-week year and will end on January 3,2004.  The fourth quarter of fiscal 2003will consist of 14 weeks.  

 

The following table presents the Company’s results ofoperations expressed as a percentage of net sales for the periods indicated:
|                                                |   | **Quarter Ended**  |   | **Two Quarters Ended** |   |
|-----------------------------------------------------|--------|--------------------|--------|------------------------|--------|
|                                                |   | **June 29,  2002** |   | **June 28,  2003**     |   | **June 29,  2002** |   | **June 28,  2003** |   |
| NET SALES                                           |   | 100.0              | %      | 100.0                  | %      | 100.0 | % | 100.0 | % |
| COST OF GOODS  SOLD                                 |   | 70.6               |   | 61.7                   |   | 70.0 |   | 63.6 |   |
| Gross profit                                        |   | 29.4               |   | 38.3                   |   | 30.0 |   | 36.4 |   |
| SELLING, GENERAL  AND ADMINISTRATIVE EXPENSES:      |   |               |   |                   |   |   |   |   |   |
| Advertising  expense                                |   | 9.2                |   | 7.7                    |   | 7.9 |   | 7.9 |   |
| Legal and  professional fees                        |   | 2.7                |   | 3.8                    |   | 2.9 |   | 3.6 |   |
| Research and  development expenses                  |   | —             |   | 0.4                    |   | — |   | 2.2 |   |
| Other selling,  general and administrative expenses |   | 13.1               |   | 21.8                   |   | 13.0 |   | 20.2 |   |
| Total selling,  general and administrative expenses |   | 25.0               |   | 33.7                   |   | 23.8 |   | 33.9 |   |
| INCOME FROM  OPERATIONS                             |   | 4.4                |   | 4.6                    |   | 6.2 |   | 2.5 |   |
| OTHER EXPENSE,  net                                 |   | (0.4               | )      | (0.7                   | )      | (0.4 | ) | (0.9 | ) |
| INCOME BEFORE  PROVISION FOR INCOME TAXES           |   | 4.0                |   | 3.9                    |   | 5.8 |   | 1.6 |   |
| PROVISION FOR  INCOME TAXES                         |   | (1.6               | )      | (2.7                   | )      | (2.3 | ) | (1.5 | ) |
| NET INCOME                                          |   | 2.4                | %      | 1.2                    | %      | 3.5 | % | 0.1 | % |

* *

***Net sales***.  Net sales for the quarter ended June 28, 2003 increased 10% to$46.4 million from $42.2 million for the quarter ended June 29, 2002.  For the two quarters ended June 28, 2003,net sales increased 11% to $93.0 million from $83.8 million for the twoquarters ended June 29, 2002.  Net sales(excluding ClearLab) for the second quarter of fiscal 2003 and the first twoquarters of fiscal 2003 were $44.7 million and $89.8 million,respectively.  The increase in net salesis mainly due to the acquisition of Lens Express and Lens 1st onJanuary 30, 2003, although the Company has realized fewer incremental salesfrom customers of these operations than it had originally expected.

 

Net sales for thefirst two quarters of fiscal 2003 were negatively impacted by canceled ordersdue to the prescription verification procedures including most significantlythose implemented as part of the Vistakon agreement.  The Company is taking steps to recover these canceled orders inthe future, including creating a doctor network through the Cole agreement andestablishing a doctor network department to help customers schedule eye examsin order to obtain prescriptions.  TheCompany is uncertain of the ultimate impact these prescription verificationprocedures will have on future net sales.

 

The Company plansto increase advertising spending during the remainder of fiscal 2003.  The Company also plans to pursue a varietyof cross-marketing programs and promotions with Cole in select test markets.

 

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On August 1, 2003,the Company lowered its retail prices to its customers on Vistakonproducts.  The Company had increased itsretail prices on Vistakon products during December 2001 and has now lowered theprices to levels similar to those prior to the December 2001 increase.  During the second quarter of fiscal 2003,Vistakon products accounted for about 40% of the Company’s net sales.  

 

***Gross profit.***  Gross profit as a percentage of net salesincreased to 38.3% for the quarter ended June 28, 2003 from 29.4% for thequarter ended June 29, 2002.  For thetwo quarters ended June 28, 2003, gross profit as a percentage of net salesincreased to 36.4% from 30.0% for the two quarters ended June 29, 2002.  During the first two quarters of fiscal2003, the Company realized a portion of the expected benefits of a decrease inwholesale prices paid for Vistakon products. During March 2003, the Company began buying directly from Vistakon.  The Company did not realize the fullbenefits expected from purchasing directly from Vistakon during the first twoquarters of fiscal 2003 due to the amount of Vistakon inventory on hand at thetime the Company began purchasing directly from Vistakon.  

 

The Companyexpects gross profit as a percentage of net sales to remain at about the samelevel or improve slightly during the remainder of fiscal 2003.  The Company expects to see the continuedbenefits from purchasing directly from Vistakon, however, these benefits areexpected to be offset primarily by the lowering of the retail price to itscustomers on Vistakon products as mentioned above.  

 

***Advertising expense.***  Advertising expense for the quarter endedJune 28, 2003 decreased $0.3 million, or 8%, from the quarter ended June 29,2002.  As a percentage of net sales,advertising expense decreased to 7.7% for the second quarter of fiscal 2003from 9.2% for the second quarter of fiscal 2002.  For the two quarters ended June 28, 2003, advertising expenseincreased $0.8 million, or 12%, from the two quarters ended June 29, 2002.  As a percentage of net sales, advertisingexpense was constant at 7.9% for the first two quarters of fiscal 2003 and2002.  Currently, the Company plans onspending about $20 million on advertising during fiscal 2003.  Advertising spending for the third andfourth quarters of fiscal 2003 is expected to be about $7 million and $5million, respectively.  However, ifopportunities present themselves, the Company may increase advertising spendingabove currently planned levels.  TheCompany’s experience has been that increases in advertising expenditures have adirect impact on the growth of net sales.

 

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

 

***Legal and professional fees.***  Legal and professional fees for the quarterended June 28, 2003 increased $0.6 million, or 54%, from the quarter ended June29, 2002.  As a percentage of net sales,legal and professional fees increased to 3.8% for the second quarter of fiscal2003 from 2.7% for the second quarter of fiscal 2002.  For the two quarters ended June 28, 2003, legal and professionalfees increased $1.0 million, or 41%, from the two quarters ended June 29,2002.  As a percentage of net sales,legal and professional fees increased to 3.6% for the first two quarters offiscal 2003 from 2.9% for the first two quarters of fiscal 2002.  During the first two quarters of fiscal2003, the Company incurred significant legal and professional fees related toits legal matters and its increased efforts, including significant lobbyingactivities, to overcome the anticompetitive barriers in the industry on behalfof itself and consumers to improve consumers’ choice and access toprescriptions.  The Company expects tocontinue to incur significant legal and professional fees as it continues thisproactive approach.

 

***Research and development expenses.***  Research and development expenses for thequarter ended June 28, 2003 were $0.2 million, or 0.4% of net sales.  For the two quarters ended June 28, 2003,research and development expenses were $2.0 million, or 2.2% of net sales.  The Company did not have any research anddevelopment expenses in the first two quarters of fiscal 2002.  The majority of this amount relates tooutsourced research and development activities with a developer andmanufacturer of contact lenses.  TheCompany will record an additional $800,000 in research and development expensesin the third quarter of fiscal 2003 if the Company does not exercise its optionto purchase shares of this developer and manufacturer of contact lenses.  The Company will also continue to incurresearch and development costs relating to the future development of contactlenses. 

 

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***Other selling, general and administrative expenses.***  Other selling, general and administrativeexpenses for the quarter ended June 28, 2003 increased $4.6 million, or 83%,from the quarter ended June 29, 2002. As a percentage of net sales, other selling, general and administrativeexpenses increased to 21.8% for the second quarter of fiscal 2003 from 13.1%for the second quarter of fiscal 2002. ClearLab accounted for about $1.5 million of the increase for the secondquarter of fiscal 2003.  ClearLab’sresults include non-cash compensation expense of approximately $0.7 millionrelating to the grant of shares of 1-800 CONTACTS’ common stock owned byClearLab’s chief technology officer to key employees of ClearLab.  The Company also incurred approximately $0.5million in incremental amortization related to the acquired Lens Express andLens 1st customer database definite-lived intangible assets and $0.5million relating to ongoing operations of facilities acquired from Lens 1st.  The Company’s employee costs for its mainU.S. operations increased by approximately $0.9 million due to increasing salesand the enhancement of its management and administrative team to meet thecurrent and future demands of the business. The Company also incurred approximately $0.2 million in recruitingexpenses due to executive management searches. The Company’s other operating expenses increased due to the increasedlevel of business activity.  

 

For the twoquarters ended June 28, 2003, other selling, general and administrativeexpenses increased $7.8 million, or 72%, from the two quarters ended June 29,2002.  As a percentage of net sales,other selling, general and administrative expenses increased to 20.2% for thefirst two quarters of fiscal 2003 from 13.0% for the first two quarters offiscal 2002.  ClearLab accounted forabout $2.1 million of the increase for the first two quarters of fiscal2003.  The Company also incurredapproximately $0.3 million in integration costs related to the acquisition ofLens Express and Lens 1st, $0.8 million in incremental amortizationrelated to the acquired Lens Express and Lens 1st customer databasedefinite-lived intangible assets and $0.9 million relating to operations offacilities acquired from Lens 1st. The Company incurredapproximately $0.2 million related to a former executive officer’s severanceagreement and approximately $0.3 in recruiting expenses due to executivemanagement searches.  The Company’semployee costs for its main U.S. operations increased by approximately $1.8million due to increasing sales and the enhancement of its management andadministrative team to meet the current and future demands of the business. TheCompany’s other operating expenses increased due to the increased level ofbusiness activity. 

 

***Other expense, net.***  Other expense increased to approximately$0.3 million and $0.8 million for the quarter and two quarters ended June 28,2003, respectively, from approximately $0.2 million and $0.3 million for thequarter and two quarters ended June 29, 2002, respectively.  For the first two quarters of fiscal 2003,other expense consisted mainly of interest expense, resulting from use of therevolving credit facility and debt related to the acquisition of IGEL.  In addition, during the first two quartersof fiscal 2003, the Company recorded an unrealized foreign exchange loss,relating primarily to an intercompany loan to ClearLab, of approximately $0.1million.  During the second quarter offiscal 2003, the Company recorded an unrealized foreign exchange gain that partiallyoffset the unrealized foreign exchange loss recorded in the first quarter offiscal 2003.  For the first two quartersof fiscal 2002, other expense consisted mainly of interest expense. 

 

***Income taxes. ***TheCompany recorded an effective income tax rate (excluding ClearLab) for thequarter ended June 28, 2003 of 42.0% compared to 40.4% for the quarter endedJune 29, 2002.  For the two quartersended June 28, 2003, the Company recorded an effective income tax rate(excluding ClearLab) of 42.0% compared to 39.6% for the two quarters ended June29, 2002.  The Company records quarterlyincome taxes at the effective tax rate expected for the year.  The increase in the effective income taxrate results from the estimated annual increase in nondeductible expenses,including those relating to the Company’s lobbying efforts.  ClearLab is taxed separately in its taxjurisdiction of Singapore.  During thefirst two quarters of fiscal 2003, the Company did not record a tax benefit forthe loss from ClearLab’s operations due to the uncertainty with respect to therealization of a tax benefit in Singapore. As of June 28, 2003, the Company provided a valuation allowance for thefull amount of the deferred income tax assets in Singapore.  The Company anticipates that its fiscal 2003effective income tax rate will be approximately 42.0% for its U.S. operationsand that no tax benefit will be recorded for ClearLab’s operations.  If future changes cause actual results forthe year to be more or less favorable than those expected, adjustments to theeffective income tax rate could be required. 

 

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**Liquidity and Capital Resources**

* *

***Operating activities.***  For the two quarters ended June 28, 2003 andJune 29, 2002, net cash provided by (used in) operating activities wasapproximately $11.9 million and ($2.4 million), respectively.  In the fiscal 2003 period, cash was providedprimarily by net income and a decrease in inventories partially offset by andecrease in accounts payable.  In thefiscal 2002 period, cash was used primarily to fund a significant increase ininventories partially offset by net income and an increase in accountspayable.  In order to ensure sufficientsupply of inventory, the Company generally carries a higher level of inventorythan if it were able to purchase directly from all contact lens manufacturers. 

 

***Investing activities.***  The Company used approximately $8.7 millionand $2.0 million for investing activities in the two quarters ended June 28,2003 and June 29, 2002, respectively. In the fiscal 2003 period, the Company paid approximately$7.0 million in cash (including $0.5 million in transaction costs) inconnection with the acquisition of Lens Express and Lens 1st.  The remaining consideration consisted of900,000 shares of restricted Common Stock of the Company and the assumption ofapproximately $4.1 million of current liabilities. 

 

Capitalexpenditures for infrastructure improvements for the two quarters ended June28, 2003 and June 29, 2002 were approximately $1.7 million and $0.9 million,respectively.  Of the fiscal 2003amount, approximately $0.6 million related to the Singapore operations.  The Company anticipates additional capitalexpenditures in fiscal 2003 for infrastructure as it continues to expand andimprove operating facilities, telecommunications systems and managementinformation systems in order to handle future operations of both its U.S. andSingapore operations. 

 

***Financing activities.***  During the two quarters ended, June 28, 2003and June 29, 2002, net cash (used in) provided by financing activities wasapproximately ($2.7 million) and $4.4 million. During the fiscal 2003 period, the Company had net repayments on itscredit facility of approximately $1.9 million and made principal payments ondebt obligations and capital lease obligations of approximately $1.5million.  In fiscal 2003, these amountswere offset by proceeds from the exercise of common stock options.               During the fiscal 2002 period, theCompany repurchased 200,000 shares of its common stock for a total cost ofapproximately $2.2 million and increased net borrowings on its credit facilityby approximately $6.5 million. 

 

The Company’sBoard of Directors has authorized the repurchase of up to 3,000,000 shares ofthe Company’s Common Stock.  A purchaseof the full 3,000,000 shares would equal approximately 23 percent of the totalshares issued as of June 28, 2003.  Therepurchase of common stock is subject to market conditions and is accomplishedthrough periodic purchases at prevailing prices on the open market, by blockpurchases or in privately negotiated transactions.  The repurchased shares were retained as treasury stock to be usedfor corporate purposes.  As of June 28,2003, no shares remain in treasury given the use of such shares in connectionwith the ClearLab and Lens 1st/Lens Express acquisitions.  From inception of its authorized repurchaseprograms through June 28, 2003, the Company had repurchased 1,706,500 sharesfor a total cost of approximately $22.1 million.  No shares were repurchased by the Company during the two quartersended June 28, 2003.

 

Effective July 22,2002, the Company entered into a loan agreement with a U.S. Bank, providing forboth a $10 million term loan and a revolving credit facility for borrowings upto $20 million.  The amounts outstandingon both the term loan and the revolving credit facility are limited to apercentage of eligible inventory.  As ofthe effective date, the percentage was 75% and is reduced by 1.25% eachcalendar quarter beginning September 30, 2002 until the percentage is 50%.  The percentage as of June 28, 2003 was71.25%.  The outstanding borrowings aresecured by substantially all of the Company’s U.S. assets including a portionof the Company’s common stock ownership in ClearLab.  The agreement contains various financial covenants including acapital expenditure limit, a minimum working capital requirement, a leverageratio and a minimum net income requirement. Also, if the Company were unable tocure a default on its Singapore debt within 30 days of occurrence, the Companywould be in default on this debt.  As ofDecember 28, 2002, the Company was not in compliance with the minimum netincome covenant or the leverage ratio covenant.  However, the Company obtained waivers through July 30, 2004.  These waivers also established certain newfinancial covenants.  The Company was incompliance with these modified covenants and all other applicable covenants asof June 28, 2003. 

 

The U.S. Bank termloan bears interest at a floating rate equal to the bank’s prime interest rateplus 0.50 percent or 3.0 percent above the bank’s LIBOR for the applicableperiod.  As of June 28, 2003, the U.S.bank term 

 

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loan interest rate was fixed at the 180-day LIBOR rate plus 3% (4.14%at June 28, 2003) until December 3, 2003. Interest is payable monthly.  Principal payments are due quarterly untilmaturity on June 30, 2007.  As of June28, 2003, the Company’s outstanding balance on the term loan was approximately$8.7 million.

 

Outstandingborrowings on the revolving credit facility bear interest at a floating rateequal to the lender’s prime interest rate plus 0.25 percent (4.25 percent atJune 28, 2003) or 2.75 percent above the lender’s LIBOR for the applicableperiod.  As of June 28, 2003, theinterest rate on the outstanding borrowings was based on the lender’s primeinterest rate plus 0.25 percent. Interest is payable monthly. The credit facility also includes an unusedcredit fee equal to one-eighth of one percent, payable quarterly.  As of June 28, 2003, the remainingavailability on the credit facility was $7.8 million. The credit facility wasscheduled to expire on April 30, 2003, however the Company obtained anextension of the maturity date to November 1, 2003.  The Company is in the process of renewing the creditfacility.  The Company expects that thecredit facility will be renewed prior to the expiration of the extension;however, there can be no assurance that the facility will be renewed withsimilar terms.

 

At June 28, 2003, the Company had an unsecured, non-interestbearing note to ClearLab’s president and chief technology officer with aprincipal balance of SGD$3,063,000 (USD$1,744,000). The note payable isdiscounted at 7%.  Payments are due inequal monthly installments through July 2007. 

 

At June 28, 2003,the Company had a term loan payable to a Singapore bank with a principalbalance of SGD$8,640,000 (USD$4,921,000) that bears interest at 6.75% and issecured by substantially all of the assets of ClearLab.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2003 through December 2007.  This note also contains various financial covenants includingminimums on net worth and shareholders’ funds. As of December 28, 2002, the Company was not in compliance with the networth and shareholders’ funds covenants. However, the Company obtained waivers through July 31, 2004.  1-800 CONTACTS, INC. has guaranteed thisterm loan.  

 

At June 28, 2003,the Company also had a note payable to the parent of IGEL with a principalbalance of SGD$6,892,000 (USD$3,926,000) that bears interest at 6% and has asubordinated position to the term loan payable to the Singapore bank.  The note payable is discounted at 7%.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed this note.  

 

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

 

The Company leasesvarious manufacturing and other equipment from financing companies undercapital lease arrangements.  All of theequipment is maintained at the Singapore facility.  The majority of the leases were assumed in connection with theCompany’s acquisition of IGEL.  As ofJune 28, 2003, the present value of future minimum lease payments wasapproximately SGD$717,000 (USD$408,000) with a majority of payments scheduledthrough fiscal 2004.  

 

On March 13, 2003,the Company signed a letter of intent to pay a non-refundable sum equal to $1.5million to be used by an entity for research and development activitiesrelating to contact lenses.  Of theamount, $700,000 was paid on March 14, 2003 and the remaining $800,000 was paidon June 13, 2003.  In addition, theCompany was granted a six-month option to acquire this entity or acquire aworldwide license for $100,000.  In theevent that the Company does not exercise the option to acquire the entity, theCompany agreed to pay an additional $800,000. The Company also agreed toreimburse the entity and its shareholders $161,000 for legal and financialexpenses reasonably incurred by the entity in connection with the transactionscontemplated by the letter of intent. During the first two quarters of fiscal 2003, the Company paid$1,761,000 related to this agreement which includes the $100,000 payment forthe option and the $161,000 of legal and financial costs.  The Company expects to fund any futureamounts payable under this arrangement through borrowings under its revolvingcredit facility.  

 

Subsequent to June28, 2003, the Company entered into a five-year license and royalty agreementrequiring minimum payments aggregating to $400,000 over the term of theagreement.

 

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The Companybelieves that its cash on hand, together with cash generated from operationsand the borrowings available through the credit facility, will be sufficient tosupport current operations through the next year. The Company may be requiredto seek additional sources of funds for accelerated growth or continued growthbeyond that point, and there can be no assurance that such funds will beavailable on satisfactory terms. Failure to obtain such financing could delay or prevent the Company’splanned growth, which could adversely affect the Company’s business, financialposition, liquidity, and results of operations.

 

As a result ofstate regulatory requirements, the Company’s liquidity, capital resources, andresults of operations may be negatively impacted in the future if the Companyincurs increased costs (including legal fees) or fines, is prohibited fromselling its products in a particular state(s), or experiences losses of asubstantial portion of the Company’s customers for whom the Company is unableto obtain or verify a prescription due to the enforcement of requirements bystate regulatory agencies.

 

**ContractualObligations and Commitments**

 

Subsequent toDecember 28, 2002 there have been no material changes to the Company’scontractual obligations and commitments, outside the normal course of business,other than the letter of intent signed on March 13, 2003.  The letter of intent, as described above,committed the Company to pay a non-refundable sum equal to $1.5 million to beused by the entity for research and development activities relating to contactlenses.  The entire amount has been paidas of June 28, 2003.  The Companyalso  reimbursed the entity and its shareholders$161,000 for legal and financial expenses incurred by the entity in connectionwith the transactions contemplated by the letter of intent. 

 

**RecentlyIssued Accounting Standards**

 

In July 2002, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 146, “Accountingfor Costs Associated with Exit or Disposal Activities.”  Under SFAS No. 146, a company will record aliability for a cost associated with an exit or disposal activity when thatliability is incurred and can be measured at fair value.  A liability is incurred when an eventobligates a company to transfer or use assets (i.e., when an event leaves thecompany little or no discretion to avoid transferring or using the assets inthe future).  Under previous accountingrules, if a company’s management approved an exit plan, the company generallycould record the costs of that plan as a liability on the approval date, evenif the company did not incur the costs until a later date. Under SFAS No. 146,some of those costs might qualify for immediate recognition, others might bespread over one or more quarters, and still others might not be recorded untilincurred in a much later period.  SFASNo. 146 became effective prospectively for periods after December 31,2002.  The Company adopted thisstatement during the first quarter of 2003. There was no impact on the financial statements of the Company. 

 

In December 2002,the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation –Transition and Disclosure – an amendment to FASB Statement No. 123, Accountingfor Stock-Based Compensation.”  SFAS No.148 provides alternative methods of transition for a voluntary change to thefair value based method of accounting for stock-based employee compensation. Inaddition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 torequire more prominent and more frequent disclosures in financial statementsabout the effects of stock-based compensation. The Company has elected tocontinue using the intrinsic method of accounting for employee stock-basedcompensation and has adopted the interim disclosure provisions.  

 

In November 2002,the FASB issued Interpretation No. 45 (“FIN No. 45”), “Guarantor’s Accountingand Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others,” which expands previously issued accounting guidanceand disclosure requirements for certain guarantees.  FIN No. 45 requires recognition of an initial liability for thefair value of an obligation assumed by issuing a guarantee.  Guarantees are required to be disclosed inthe notes to the financial statements for periods ending after December 15,2002. For certain guarantees issued after December 31, 2002, the fair value ofthe obligation must be reported on the balance sheet. The adoption of thisinterpretation had no impact on the financial statements of the Company.

 

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In January 2003,the FASB issued Interpretation No. 46 (“FIN No. 46”), “Consolidation ofVariable Interest Entities, an Interpretation of ARB No. 51,” which addressesthe consolidation by business enterprises of variable interest entities asdefined therein and applies immediately to variable interests in variableinterest entities created or obtained after January 31, 2003.  The adoption of this interpretation had noimpact on the Company’s financial statements. 

 

In May 2003, theFASB issued SFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity.”  The new statement establishes standards for how an issuerclassifies and measures certain financial instruments with characteristics ofboth debt and equity.  The provisions ofSFAS No. 150 apply to the classification and disclosure requirements for thefollowing three types of financial instruments:  Mandatorily Redeemable Instruments, Instruments with RepurchaseObligations, and Instruments with Obligations to Issue a Variable Number ofSecurities.  The new reporting anddisclosure requirements for SFAS No. 150 become effective for the first interimperiod beginning after June 15, 2003 or for any covered instruments entered intoor modified subsequent to May 31, 2003. Management does not expect the adoption of SFAS No. 150 to have amaterial impact on the Company’s financial position, results of operations orliquidity.

 

**Critical Accounting Policies andEstimates**

 

Accounting policesthat require significant judgments and estimates include revenue recognition(including sales returns and allowances); excess and obsolete inventories;realizability of long-lived assets (including intangible assets); realizabilityof deferred income tax assets; accounting for the acquisitions of ClearLab andLens Express and Lens 1st; stock-based compensation; and legal andregulatory contingencies.  Judgments andestimates are based on historical experience as well as relevant facts andcircumstances known at each reporting date. Actual results may differ from these estimates. 

 

Sales aregenerally recognized at the time of shipment to the customer.  Net sales consist of product sales lessprovisions for sales returns and allowances, which provisions are made at thetime of sale.  The Company accrues anestimated amount for sales returns and allowances based on historicalinformation, adjusted for current economic trends.  To the extent actual returns and allowances vary from historicalexperience, revisions to the allowances may be required.  

 

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

 

The Company hassignificant long-lived tangible and intangible assets consisting of property,plant and equipment, goodwill and definite-lived intangibles.  These assets are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountsof such assets may not be recoverable. An impairment analysis requires the use of expected future undiscountedcash flows over the remaining useful life of the asset.  As of June 28, 2003, the Company determinedthat no impairment existed.  All of thegoodwill and a significant portion of the total long-lived assets weregenerated from the Company’s recent acquisitions of IGEL (ClearLab) and LensExpress and Lens 1st. If forecasts and assumptions used to supportthe realizability of long-lived assets change in the future, significantimpairment charges could result that would adversely affect the Company’sresults of operations and financial position.

 

Deferred incometax assets are assessed for recoverability and valuation allowances areprovided as necessary to reduce deferred income tax assets to amounts expectedto be realized.  Should expectations oftaxable income change in future periods, it may become necessary to change thevaluation allowance, which could affect the Company’s results of operations inthe period such determination is made. The Company records an income tax provision or benefit at a rate that isbased on expected results for the fiscal year. If future changes in market conditions cause actual results to be moreor less favorable, adjustments to the effective income tax rate on a quarterlybasis could be required.

 

The Companyrecords liabilities for legal and regulatory matters when the contingency isboth probable and reasonably estimable. The Company is involved in several legal and regulatory matters.  The Company, after 

 

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consultation with legal counsel, believes that the ultimate dispositionsof these matters will not have a material impact on its financial position,liquidity, or results of operations. However, there can be no assurance that the Company will be successfulin its efforts to satisfactorily resolve these matters and the ultimate outcomecould result in a material negative impact on the Company’s financial position,liquidity, or results of operations. 

 

**Forward-Looking Statements**

 

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

 

*FactorsThat May Affect Future Results*

 
| • |   | The Company’s sales  growth will not continue at historical rates and it may encounter unforeseen  difficulties in managing its future growth;                                                                                             |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                            |
| • |   | A significant portion  of the Company’s sales may be found not to comply with state laws and  regulations concerning the delivery and sale of contact lenses;                                                                              |
|   |   |                                                                                                                                                                                                                                            |
| • |   | Because the Company  does not manufacture most of the contact lenses that it sells, the Company  cannot ensure that all of the contact lenses it sells meet all federal regulatory  requirements;                                               |
|   |   |                                                                                                                                                                                                                                            |
| • |   | It is possible that the  FDA could consider certain of the contact lenses the Company sells to be  misbranded;                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                            |
| • |   | The Company currently  purchases a portion of its products from unauthorized distributors and is not  an authorized distributor for some of the products that it sells;                                                                         |
|   |   |                                                                                                                                                                                                                                            |
| • |   | The Company obtains a  large percentage of its inventory from a limited number of suppliers, with a  single distributor accounting for 35%, 46% and 35% of the Company’s inventory  purchases in fiscal 2000, 2001 and 2002, respectively; |
|   |   |                                                                                                                                                                                                                                            |
| • |   | The Company may  continue to incur significant legal and professional fees related to its  legal matters and its increased efforts to proactively influence the industry  on behalf of itself and consumers;                                    |
|   |   |                                                                                                                                                                                                                                            |
| • |   | The Company’s quarterly  results are likely to vary based upon the level of sales and marketing  activity in any particular quarter;                                                                                                       |
|   |   |                                                                                                                                                                                                                                            |
| • |   | The Company is  dependent on its telephone, Internet and management information systems for  the sale and distribution of contact lenses;                                                                                                       |
|   |   |                                                                                                                                                                                                                                            |
| • |   | The retail sale of  contact lenses is highly competitive; certain of the Company’s competitors  are large, national optical chains that have greater resources than the  Company;                                                          |
|   |   |                                                                                                                                                                                                                                            |
| • |   | The demand for contact  lenses could be substantially reduced if alternative technologies to  permanently correct vision gain in popularity;                                                                                                    |

 

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| • |   | The Company does not  have any property rights in the 1-800 CONTACTS telephone number or the  Internet addresses that it uses;                                                               |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                         |
| • |   | Increases in the cost  of shipping, postage or credit card processing could harm the Company’s  business;                                                                               |
|   |   |                                                                                                                                                                                         |
| • |   | The Company’s business  could be harmed if it is required to collect state sales tax on the sale of  products;                                                                          |
|   |   |                                                                                                                                                                                         |
| • |   | The Company faces an  inherent risk of exposure to product liability claims in the event that the  use of the products it manufacturers or sells results in personal injury;                 |
|   |   |                                                                                                                                                                                         |
| • |   | The Company conducts  its retail operations through a single distribution facility;                                                                                                          |
|   |   |                                                                                                                                                                                         |
| • |   | The Company’s success  is dependent, in part, on continued use of the Internet;                                                                                                         |
|   |   |                                                                                                                                                                                         |
| • |   | Government regulation  and legal uncertainties relating to the Internet and online commerce could  negatively impact the Company’s business operations;                                 |
|   |   |                                                                                                                                                                                         |
| • |   | Changing technology  could adversely affect the operation of the Company’s website;                                                                                                     |
|   |   |                                                                                                                                                                                         |
| • |   | The Company may not be  able to develop and manufacture a viable, high quality contact lens for sale  to consumers that meets all federal regulatory requirements;                           |
|   |   |                                                                                                                                                                                         |
| • |   | The Company may not be  able to fully integrate the operations of its acquisitions into its business;                                                                                        |
|   |   |                                                                                                                                                                                         |
| • |   | Consumer acceptance of  the Company’s manufactured products may not meet the Company’s expectations;                                                                               |
|   |   |                                                                                                                                                                                         |
| • |   | The Company’s  intellectual property rights may be challenged;                                                                                                                          |
|   |   |                                                                                                                                                                                         |
| • |   | The Company may  encounter legal, regulatory and government agency oversight risks with  foreign operations;                                                                                 |
|   |   |                                                                                                                                                                                         |
| • |   | The Company may not be  able to establish a sufficient network of eye care practitioners to prescribe  the products manufactured by the Company;                                             |
|   |   |                                                                                                                                                                                         |
| • |   | The Company may not be  able to adequately manage its foreign currency risk;                                                                                                                 |
|   |   |                                                                                                                                                                                         |
| • |   | The Company may incur  unforeseen costs or not realize all of the anticipated benefits from its new  relationships with Vistakon and Cole; and                                               |
|   |   |                                                                                                                                                                                         |
| • |   | The Company may be  required to reduce the carrying value of its intangible assets if events and  circumstances indicate the remaining balance of intangible assets may not be  recoverable. |

 

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**Item 3.****           *Quantitative and Qualitative Disclosures About MarketRisk***

 

***Interest Rate Risk***.  As of June 28, 2003, the Company was exposedto changes in interest rates relating to its revolving credit facility andother debt obligations.  The revolvingcredit facility and U.S. bank term loan bear interest at a variable rate basedon the U.S. prime rate or LIBOR. The Company’s outstanding borrowings on thecredit facility, including bank overdrafts, and U.S. bank term loan wereapproximately $12.5 million as of June 28, 2003. The remainder of the Company’sinterest bearing debt obligations, including capital lease obligations, isdenominated in Singapore dollars and bears interest at a fixed rate.  As of June 28, 2003, the face amounts of theoutstanding borrowings on these fixed rate debt obligations were approximately$9.3 million.  If interest rates were tochange by one full percentage point, the net impact on interest expense wouldbe approximately $0.1 million per year.

 

***Foreign Currency Risk.***  The Company faces foreign currency risksprimarily as a result of its Singapore operations and the intercompany balancesbetween its U.S. and Singapore operations. The functional currency of the Company’s Singapore operations is theSingapore dollar, however, most of the sales of the Singapore operations andsome of the expenses are denominated in U.S. dollars.  The Company has debt and other long-term obligations ofapproximately $11.1 million that are denominated in Singapore dollars andmature over the next seven years.  Forthe two quarters ended June 28, 2003, the Company recorded a foreign currencytransaction loss of approximately $77,000. Fluctuations in exchange rates between the U.S. dollar and the Singaporedollar could lead to additional currency exchange losses or gains on theintercompany balances and transactions denominated in currencies other than thefunctional currency.  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.  The exchange ratebetween the U.S. dollar and the Singapore dollar has fluctuated approximately1.3 percent (strengthening of the U.S. dollar) from December 29, 2002 throughAugust 1, 2003.  From the date ofacquisition, July 24, 2002, through August 1, 2003 the exchange rate hasfluctuated approximately 0.6 percent (strengthening of the U.S. dollar).  If the Singapore dollar weakens against theU.S. dollar by an additional 10 percent, the Company would record an additional$867,000 foreign currency loss on the intercompany balances that exist as ofJune 28, 2003.  The Company has notentered into any foreign currency derivative financial instruments; however, itmay choose to do so in the future in an effort to manage or hedge its foreigncurrency risk.  

 

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

 

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

 

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

 

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

 

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

 

See notes tocondensed consolidated financial statements.

 

**Item 2****.****                                                           *Changes in Securities and Use of Proceeds***

 

None.

 

**Item 3****.****                                                           *Defaults upon Senior Securities***

 

None.

 

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

 

The annual meetingof stockholders of the Company was held on May 30, 2003.  The stockholders approved the followingmatters: 

 
| • |   | The election as directors of E. Dean Butler, David  B. Katzman and Stephen A. Yacktman to serve until the annual meeting of  stockholders in 2006 and until their respective successors are elected and  qualified. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

|                 |   | **Votes Cast** |   |
|----------------------|--------|----------------|--------|
|                 |   | **For**        |   | **Against** |   |
| E. Dean Butler       |   | 10,389,703     |   | 42,735 |   |
| David B. Katzman     |   | 10,389,703     |   | 42,735 |   |
| Stephen A.  Yacktman |   | 10,389,703     |   | 42,735 |   |

 
|   |   | The other directors of  the Company include the following persons:   (i) Jonathan C. Coon, Jason S. Subotky, and Bradley T. Knight, who are  serving until the annual meeting of stockholders in 2004 and (ii) John F.  Nichols and Thomas H. Boggs who are serving until the annual meeting of  stockholders in 2005. |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                        |
| • |   | Ratification of  appointment of KPMG LLP as independent auditors to audit the Company’s books  and accounts for the fiscal year ending January 3, 2004.                                                                                                                                                                |

 
| Votes Cast: |   |       |   |
|-------------|--------|------------|--------|
| For         |   | 10,423,412 |   |
| Against     |   | 5,936      |   |
| Abstained   |   | 3,090      |   |
| Unvoted     |   | —     |   |

 

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

 

From time to timethe Company receives notices, inquiries or other correspondence from states orits regulatory bodies charged with overseeing the sale of contact lenses.  The Company’s practice is to review such noticeswith legal counsel to determine the appropriate response on a case-by-casebasis.  It is the opinion of management,after discussion with legal counsel, that the Company is taking the appropriatesteps to address the various notices received.

 

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**Item 6.****                                                           *Exhibits and Reports on Form 8-K***

 

**(A) Exhibits**

 
| **Exhibit  No.** |   | **Description of Exhibit**                                                         |
|------------------|--------|------------------------------------------------------------------------------------|
| 10.1             |   | Employment Agreement between the Company and David  M. Saylor.                     |
| 31.1             |   | Certification Required Pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
| 31.2             |   | Certification Required Pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
| 32.1             |   | Certification Required Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |
| 32.2             |   | Certification Required Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |

 

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

** **
| Current Report on Form 8-K/A filed April 15, 2003,  filing of Financial Information for Acquisition of Assets.                                                 |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Current Report on Form 8-K filed May 7, 2003, filing  of Press Release Announcing Operating and Financial Results for the First  Quarter Ended March 29, 2003. |

 

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**SIGNATURES**

 

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

 
|                          | **1-800  CONTACTS, INC.** |
|-------------------------------|---------------------------|
|                          |                      |
| Dated:   August 12, 2003 | By:                       | /s/ Jonathan C. Coon |   |
|                          | Name:                     | Jonathan C. Coon |
|                          | Title:                    | President and Chief Executive Officer |
|                          |                      |
|                          | By:                       | /s/ Brian W. Bethers |   |
|                          | Name:                     | Brian W. Bethers |
|                          | Title:                    | Chief Financial Officer |

 

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