** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,DC 20549**

 

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**FORM 10-Q**

 

**(Mark one)**

**ý****                                 QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended October 2, 2004**

 

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

 

**For thetransition period from              to                         .**

** **

**Commissionfile number: 0-23633**

** **

**1-800 CONTACTS, INC.**

(Exactname of registrant as specified in its charter)

 

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

 

| **(801) 924-9800**                                         |
|------------------------------------------------------------|
| (Registrant’s  telephone number, including area code) |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during 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 markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange act).

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

 

As of November 5,2004, the Registrant had 13,288,593 shares of Common Stock, par value $0.01 pershare, outstanding.

 

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**1-800CONTACTS, INC.**

 

**INDEX**

 
| **PART I.**                    | **FINANCIAL INFORMATION**                                                                                                         |   |
|--------------------------------|-----------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.                        | Financial Statements                                                                                                              |   |
|                           | Condensed  Consolidated Balance Sheets as of January 3, 2004 and October 2, 2004                                                  |   |
|                           | Condensed  Consolidated Statements of Operations for the Quarter and Three Quarters  Ended September 27, 2003 and October 2, 2004 |   |
|                           | Condensed  Consolidated Statements of Cash Flows for the Three Quarters Ended September  27, 2003 and October 2, 2004             |   |
|                           | Notes  to Condensed Consolidated Financial Statements                                                                             |   |
| Item  2.                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                       |   |
| Item  3.                       | Quantitative  and Qualitative Disclosures about Market Risk                                                                  |   |
| Item 4.                        | Controls and Procedures                                                                                                           |   |
| **PART II. OTHER INFORMATION** |                                                                                                                              |
| Item 1.                        | Legal Proceedings                                                                                                                 |   |
| Item  2.                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                 |   |
| Item 3.                        | Defaults upon  Senior Securities                                                                                                  |   |
| Item  4.                       | Submission  of Matters to a Vote of Security Holders                                                                              |   |
| Item 5.                        | Other Information                                                                                                                 |   |
| Item  6.                       | Exhibits                                                                                                                          |   |

 

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**PART 1. FINANCIAL INFORMATION**

**Item 1. Financial Statements**

 

**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands)**

**(unaudited)**

 

**ASSETS**

 
| ** **                                           | ** ** | **January 3, 2004** | ** ** | **October 2, 2004** | ** ** |
|------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| CURRENT ASSETS:                                      |       |                |       |                |       |
| Cash                                                 |       | $                   | 1,075      |                | $          | 373 |   |
| Accounts receivable, net                             |       | 944                 |       | 1,638               |       |
| Inventories, net                                     |       | 24,127              |       | 23,832              |       |
| Prepaid income taxes                                 |       | 797                 |       | —              |       |
| Deferred income taxes                                |       | 548                 |       | 971                 |       |
| Other current assets                                 |       | 1,752               |       | 3,158               |       |
| Total current assets                                 |       | 29,243              |       | 29,972              |       |
| PROPERTY, PLANT AND EQUIPMENT, net                   |       | 13,183              |       | 18,078              |       |
| DEFERRED INCOME TAXES                                |       | 710                 |       | 723                 |       |
| GOODWILL                                             |       | 33,853              |       | 33,937              |       |
| DEFINITE-LIVED INTANGIBLE ASSETS, net                |       | 9,207               |       | 18,400              |       |
| OTHER ASSETS                                         |       | 735                 |       | 1,070               |       |
| Total assets                                         |       | $                   | 86,931     |                | $          | 102,180 |   |
|                                                 |       |                |       |                |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**        |
| CURRENT LIABILITIES:                                 |       |                |       |                |       |
| Current portion of long-term debt                    |       | $                   | 3,381      |                | $          | 1,426 |   |
| Current portion of capital lease obligations         |       | 191                 |       | 108                 |       |
| Accounts payable                                     |       | 8,558               |       | 7,721               |       |
| Accrued liabilities                                  |       | 4,847               |       | 9,618               |       |
| Total current liabilities                            |       | 16,977              |       | 18,873              |       |
| LONG-TERM LIABILITIES:                               |       |                |       |                |       |
| Line of credit                                       |       | —              |       | 16,351              |       |
| Long-term debt, less current portion                 |       | 14,683              |       | 8,295               |       |
| Capital lease obligations, less current portion      |       | 64                  |       | 54                  |       |
| Deferred income tax liabilities                      |       | —              |       | 2,071               |       |
| Total long-term liabilities                          |       | 14,747              |       | 26,771              |       |
| STOCKHOLDERS’ EQUITY                            |       |                |       |                |       |
| Common stock, 13,113 and 13,288 issued, respectively |       | 131                 |       | 133                 |       |
| Additional paid-in capital                           |       | 42,346              |       | 45,799              |       |
| Retained earnings                                    |       | 12,834              |       | 10,833              |       |
| Accumulated other comprehensive loss                 |       | (104                | )          | (229                | )          |
| Total stockholders’ equity                      |       | 55,207              |       | 56,536              |       |
| Total liabilities and stockholders’ equity      |       | $                   | 86,931     |                | $          | 102,180 |   |
|                                                      |            |                     |            |                     |            |  |  |  |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                           | ** ** | **Quarter Ended** | ** ** | **Three Quarters Ended** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|--------------------------|------------|
| ** **                                           | ** ** | **September 27,** | ** ** | **October 2,**           | ** ** | **September 27,** | ** ** | **October 2,** | ** ** |
| ** **                                           | ** ** | **2003**          | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2004** | ** ** |
| NET SALES                                            |       | $                 | 48,400     |                     | $          | 56,893 |   | $ | 141,416 |   | $ | 157,713 |   |
| COST OF GOODS SOLD                                   |       | 29,489            |       | 34,889                   |       | 88,629 |   | 97,140 |   |
| Gross profit                                         |       | 18,911            |       | 22,004                   |       | 52,787 |   | 60,573 |   |
| OPERATING EXPENSES:                                  |       |              |       |                     |       |   |   |   |   |
| Advertising                                          |       | 7,171             |       | 6,533                    |       | 14,551 |   | 22,572 |   |
| Legal and professional                               |       | 1,601             |       | 1,026                    |       | 4,977 |   | 4,207 |   |
| Research and development                             |       | 777               |       | 567                      |       | 2,777 |   | 1,902 |   |
| Purchased in-process research and development        |       | —            |       | —                   |       | — |   | 83 |   |
| Other operating                                      |       | 9,316             |       | 10,789                   |       | 28,069 |   | 31,437 |   |
| Total operating expenses                             |       | 18,865            |       | 18,915                   |       | 50,374 |   | 60,201 |   |
| INCOME FROM OPERATIONS                               |       | 46                |       | 3,089                    |       | 2,413 |   | 372 |   |
| OTHER EXPENSE, net                                   |       | (161              | )          | (216                     | )          | (984 | ) | (1,271 | ) |
| INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES      |       | (115              | )          | 2,873                    |       | 1,429 |   | (899 | ) |
| PROVISION FOR INCOME TAXES                           |       | (513              | )          | (1,520                   | )          | (1,985 | ) | (1,102 | ) |
| NET INCOME (LOSS)                                    |       | $                 | (628       | )                        | $          | 1,353 |   | $ | (556 | ) | $ | (2,001 | ) |
|                                                 |       |              |       |                     |       |   |   |   |   |
| PER SHARE INFORMATION:                               |       |              |       |                     |       |   |   |   |   |
| Basic and diluted net income (loss) per common share |       | $                 | (0.05      | )                        | $          | 0.10 |   | $ | (0.04 | ) | $ | (0.15 | ) |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                       | ** ** | **Three Quarters Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                       | ** ** | **September 27,**        | ** ** | **October 2,** | ** ** |
| ** **                                                                       | ** ** | **2003**                 | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                            |       |                     |       |   |   |
| Net loss                                                                         |       | $                        | (556       | ) | $ | (2,001 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities: |       |                     |       |   |   |
| Depreciation and amortization                                                    |       | 4,617                    |       | 5,630 |   |
| Amortization of debt issuance costs and discounts                                |       | 142                      |       | 247 |   |
| Amortization of restricted stock grant                                           |       | —                   |       | 8 |   |
| Purchased in-process research and development                                    |       | —                   |       | 83 |   |
| Unrealized foreign currency exchange (gain) loss                                 |       | (46                      | )          | 27 |   |
| Loss on sale of property and equipment                                           |       | 7                        |       | 89 |   |
| Stock-based compensation                                                         |       | 731                      |       | — |   |
| Deferred income taxes, net of effects of acquisition                             |       | (206                     | )          | (1,439 | ) |
| Changes in operating assets and liabilities, net of effects of  acquisitions:    |       |                     |       |   |   |
| Accounts receivable, net                                                         |       | (554                     | )          | (671 | ) |
| Inventories, net                                                                 |       | 10,815                   |       | 695 |   |
| Other current assets                                                             |       | (242                     | )          | (1,110 | ) |
| Accounts payable                                                                 |       | (3,554                   | )          | (1,621 | ) |
| Accrued liabilities                                                              |       | 1,969                    |       | 2,856 |   |
| Income taxes payable / prepaid income taxes                                      |       | 1,611                    |       | 2,170 |   |
| Net cash provided by operating activities                                        |       | 14,734                   |       | 4,963 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                            |       |                     |       |   |   |
| Purchase of property and equipment                                               |       | (2,138                   | )          | (5,996 | ) |
| Proceeds from sale of property and equipment                                     |       | 33                       |       | 3 |   |
| Purchase of intangible assets                                                    |       | (85                      | )          | (3,997 | ) |
| Cash paid for acquisitions                                                       |       | (7,012                   | )          | (3,776 | ) |
| Deposits and other                                                               |       | (316                     | )          | (289 | ) |
| Net cash used in investing activities                                            |       | $                        | (9,518     | ) | $ | (14,055 | ) |

 

5

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)**

**(in thousands)**

**(unaudited)**

** **
| ** **                                          | ** ** | **Three Quarters Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------|------------|
| ** **                                          | ** ** | **September 27,**        | ** ** | **October 2,** | ** ** |
| ** **                                          | ** ** | **2003**                 | ** ** | **2004** | ** ** |
| CASH FLOWS FROM FINANCING ACTIVITIES:               |       |                     |       |   |   |
| Proceeds from exercise of common stock options      |       | $                        | 803        |   | $ | 159 |   |
| Proceeds from international government grant        |       | —                   |       | 873 |   |
| Net (repayments) borrowings on line of credit       |       | (3,242                   | )          | 16,351 |   |
| Debt issuance costs                                 |       | —                   |       | (196 | ) |
| Principal payments on capital lease obligations     |       | (294                     | )          | (219 | ) |
| Principal payments on long-term debt                |       | (1,891                   | )          | (8,511 | ) |
| Net cash (used in) provided by financing activities |       | (4,624                   | )          | 8,457 |   |
| EFFECT OF FOREIGN EXCHANGE RATES ON CASH            |       | (32                      | )          | (67 | ) |
|                                                |       |                     |       |   |   |
| NET INCREASE (DECREASE) IN CASH                     |       | 560                      |       | (702 | ) |
| CASH AT BEGINNING OF PERIOD                         |       | 259                      |       | 1,075 |   |
| CASH AT END OF PERIOD                               |       | $                        | 819        |   | $ | 373 |   |
|                                                |       |                     |       |   |   |
| SUPPLEMENTAL CASH FLOW INFORMATION:                 |       |                     |       |   |   |
| Cash paid for interest                              |       | $                        | 821        |   | $ | 964 |   |
| Cash paid for income taxes                          |       | 580                      |       | 370 |   |

 

SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:

 

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

 

During the second quarter of 2003, the performance guarantee was metrelating to 700,000 shares of the Company’s restricted common stock held inescrow as partial consideration for the July 2002 acquisition of ClearLab. TheCompany recorded additional purchase consideration of approximately $16,980 forthese shares. The Company recorded this as goodwill, net of a contingentconsideration liability recorded at the purchase date. The amount of goodwillas of September 27, 2003 was $11,205.

 

During the first quarter of 2004, the Company purchased the stock ofVisionTec (subsequently renamed ClearLab UK, Ltd.).The purchase considerationincluded cash of $3,776 and common stock with a fair value of $3,200 (see Note6).

 

See accompanying notes tocondensed consolidated financial statements.

 

6

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**1-800 CONTACTS, INC.**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

# **NOTE 1. PRESENTATION OF CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

                Theaccompanying condensed consolidated financial statements have been prepared bythe Company, without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to such rules and regulations. Thesecondensed consolidated financial statements reflect all adjustments (consistingonly of normal recurring adjustments), which in the opinion of management, arenecessary to present fairly the results of operations of the Company for theperiods presented. It is suggested that these condensed consolidated financialstatements be read in conjunction with the audited financial statements and thenotes thereto included in the Company’s Annual Report on Form 10-K for the yearended January 3, 2004.

 

# **NOTE 2. INVENTORIES**

 

                Inventoriesare recorded at the lower of cost (using the first-in, first-out method) ormarket value.Inventories consisted of the following (in thousands):

 
| ** **                    | ** ** | **January 3,** | ** ** | **October 2,** | ** ** |
|-------------------------------|------------|----------------|------------|----------------|------------|
| ** **                    | ** ** | **2004**       | ** ** | **2004**       | ** ** |
| Purchased contact lenses      |       | $              | 20,943     |           | $          | 18,618 |   |
| Manufactured inventories:     |       |           |       |           |       |
| Raw materials                 |       | 429            |       | 664            |       |
| Work in process               |       | 2,681          |       | 4,394          |       |
| Finished goods contact lenses |       | 74             |       | 156            |       |
| Total                         |       | $              | 24,127     |           | $          | 23,832 |   |
|                               |            |                |            |                |            |  |  |  |

 

 

                Provisionis made to reduce excess and obsolete inventories to their estimated netrealizable values. As of January 3, 2004 and October 2, 2004, reserves forexcess and obsolete inventories were $623,000 and $1,072,000, respectively.

 

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

** **

**               **Basic net income (loss) per common share(“Basic EPS”) excludes dilution and is computed by dividing net income (loss)by the weighted-average number of common shares outstanding during the period. Dilutednet income (loss) per common share (“Diluted EPS”) reflects the potentialdilution that could occur if stock options or other common stock equivalentswere exercised or converted into common stock. The computation of Diluted EPSdoes not assume exercise or conversion of securities that would have anantidilutive effect on net income (loss) per common share. For the quarter andthree quarters ended October 2, 2004, options to purchase 956,071 and 1,257,476shares of common stock, respectively, were not included in the computation ofDiluted EPS because the effect would be antidilutive. For the quarter and threequarters ended September 27, 2003, options to purchase 686,852 and 835,261,shares of common stock, respectively, were not included in the computation ofDiluted EPS because the effect would be antidilutive.

 

7

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                The following is areconciliation of the numerator and denominator used to calculate Basic andDiluted EPS (in thousands, except per share amounts): 
| ** **              | ** ** | **Quarter Ended September 27, 2003** | ** ** | **Quarter Ended October 2, 2004** | ** ** |
|-------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|
| ** **              | ** ** | **Net Loss**                         | ** ** | **Shares**                        | ** ** | **Per-Share Amount** | ** ** | **Net Income** | ** ** | **Shares** | ** ** | **Per-Share Amount** | ** ** |
| Basic EPS               |       | $                                    | (628       | )                                 | 13,103     |   | $ | (0.05 | ) | $ | 1,353 |   | 13,287 |   | $ | 0.10 |   |
| Effect of stock options |       |                                 |       | —                            |       |   |   |   |   | 86 |   |   |   |
| Diluted EPS             |       | $                                    | (628       | )                                 | 13,103     |   | $ | (0.05 | ) | $ | 1,353 |   | 13,373 |   | $ | 0.10 |   |

 

 
| ** **              | ** ** | **Three Quarters Ended September 27, 2003** | ** ** | **Three Quarters Ended October 2, 2004** | ** ** |
|-------------------------|------------|---------------------------------------------|------------|------------------------------------------|------------|
| ** **              | ** ** | **Net Loss**                                | ** ** | **Shares**                               | ** ** | **Per-Share Amount** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per-Share Amount** | ** ** |
| Basic EPS               |       | $                                           | (556       | )                                        | 12,547     |   | $ | (0.04 | ) | $ | (2,001 | ) | 13,254 |   | $ | (0.15 | ) |
| Effect of stock options |       |                                        |       | —                                   |       |   |   |   |   | — |   |   |   |
| Diluted EPS             |       | $                                           | (556       | )                                        | 12,547     |   | $ | (0.04 | ) | $ | (2,001 | ) | 13,254 |   | $ | (0.15 | ) |

 

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

 

                Comprehensive income (loss) forthe quarter and three quarters ended September 27, 2003 and October 2, 2004consists of the following components (in thousands):

 
| ** **                   | ** ** | **Quarter Ended**        | ** ** | **Three Quarters Ended** | ** ** |
|------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                   | ** ** | **September 27,   2003** | ** ** | **October 2,  2004**     | ** ** | **September 27,   2003** | ** ** | **October 2,  2004** | ** ** |
| Net income (loss)            |       | $                        | (628       | )                        | $          | 1,353 |   | $ | (556 | ) | $ | (2,001 | ) |
| Foreign currency translation |       | 97                       |       | 45                       |       | (205 | ) | (125 | ) |
| Comprehensive income (loss)  |       | $                        | (531       | )                        | $          | 1,398 |   | $ | (761 | ) | $ | (2,126 | ) |

 

                The foreign currency translationresults primarily from changes in exchange rates relative to the U.S. dollarfrom the translation of the Company’s Singapore and United Kingdom subsidiaries’financial statements.

 

**NOTE 5. STOCK-BASED COMPENSATION**

 

                The Company applies AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees,”and related interpretations and uses the intrinsic method of accounting for itsstock option grants to employees and directors. No compensation expense hasbeen recognized for stock option awards granted at or above fair market valueof the stock on the date of grant.

 

                Under Statement of FinancialAccounting Standards (“SFAS”) No. 123, “Accounting for Stock-BasedCompensation,” compensation expense is recognized for the fair market value ofeach option as estimated on the date of grant using the Black-Scholesoption-pricing model. SFAS No. 148, “Accounting for Stock-Based Compensation —Transition and Disclosure,” amends SFAS No. 123, to provide alternative methodsof transition for a voluntary change to the fair market value based method ofaccounting for stock-based employee compensation. In addition, SFAS No. 148amends the disclosure requirements of SFAS No. 123 to require new prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. The Company has elected to adopt the “disclosure only”provisions of SFAS No. 148.

 

8

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                If compensation expense for allstock options had been determined consistent with SFAS No. 123, the Company’snet income (loss) and basic and diluted net income (loss) per common sharewould have been as follows (in thousands, except per share amounts):

 
| ** **                                           | ** ** | **Quarter Ended**       | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **September 27,  2003** | ** ** | **October 2,  2004** | ** ** |
| Net income (loss):                                   |       |                    |       |   |   |
| As reported                                          |       | $                       | (628       | ) | $ | 1,353 |   |
| Fair-value based compensation, net of tax            |       | (382                    | )          | (380 | ) |
| Pro forma                                            |       | $                       | (1,010     | ) | $ | 973 |   |
|                                                 |       |                    |       |   |   |
| Basic and diluted net income(loss) per common share: |       |                    |       |   |   |
| As reported                                          |       | $                       | (0.05      | ) | $ | 0.10 |   |
| Pro forma                                            |       | $                       | (0.08      | ) | $ | 0.07 |   |

 
| ** **                                   | ** ** | **Three Quarters Ended** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|
| ** **                                   | ** ** | **September 27,  2003**  | ** ** | **October 2,  2004** | ** ** |
| Net loss:                                    |       |                     |       |   |   |
| As reported                                  |       | $                        | (556       | ) | $ | (2,001 | ) |
| Fair-value based compensation, net of tax    |       | (921                     | )          | (1,208 | ) |
| Pro forma                                    |       | $                        | (1,477     | ) | $ | (3,209 | ) |
|                                         |       |                     |       |   |   |
| Basic and diluted net loss per common share: |       |                     |       |   |   |
| As reported                                  |       | $                        | (0.04      | ) | $ | (0.15 | ) |
| Pro forma                                    |       | $                        | (0.12      | ) | $ | (0.24 | ) |

 

                Theweighted average per share fair value of options granted during the quartersended September 27, 2003 and October 2, 2004 and the three quarters endedSeptember 27, 2003 and October 2, 2004 was $14.07 and $6.77, and $13.92 and$11.69, respectively. The fair value of each option grant has been estimated onthe grant date using the Black-Scholes option-pricing model with the followingweighted average assumptions:

 
| ** **              | ** ** | **Quarter Ended**       | ** ** | **Three Quarters Ended** | ** ** |
|-------------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **              | ** ** | **September 27,  2003** | ** ** | **October 2,  2004**     | ** ** | **September 27,  2003** | ** ** | **October 2,  2004** | ** ** |
| Risk-free interest rate |       | 2.7                     | %          | 3.6                      | %          | 2.7 | % | 3.2 | % |
| Expected dividend yield |       | 0.0                     | %          | 0.0                      | %          | 0.0 | % | 0.0 | % |
| Volatility              |       | 74.8                    | %          | 65.9                     | %          | 77.0 | % | 67.6 | % |
| Expected life           |       | 5  years                |       | 5  years                 |       | 5  years |   | 5  years |   |

 

**NOTE 6. RECENT ACQUISITIONS**

 

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

 

    OnMarch 13, 2003, the Company signed a letter of intent with VisionTec, adeveloper and manufacturer of contact lenses based in the United Kingdom, andcertain of its shareholders. The Company agreed to pay VisionTec anon-refundable sum equal to $1.5 million to be used by the entity for researchand development activities relating to contact lenses. Of the total, $0.7million was paid on March 14, 2003, and the remaining $0.8 million was paid onJune 13, 2003. In addition, the Company was granted a six-month option toeither: (1) acquire all of the shares of common stock of the entity; or (2)acquire from the entity a worldwide license to manufacture, market, sell orotherwise use or exploit specific technology developed by the entity. Asconsideration for this option, the Company paid $0.1 million to VisionTec onMarch 14, 2003. In the event that the Company did not exercise the option topurchase the shares of VisionTec, the Company agreed to pay the entity anadditional $0.8 million. The Company

 

9

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also reimbursed VisionTec and its shareholdersapproximately $0.2 million for legal and financial expenses incurred by theentity in connection with the agreement.

On September 12, 2003,the Company exercised the option to acquire all of the shares of common stockof VisionTec. During the period between September 12, 2003 and the closing ofthe acquisition on February 24, 2004, the Company continued to pay certain feesand expenses of the entity related to the entity’s research and development activities.The Company paid approximately $2.1 million to VisionTec from September 12,2003 through January 3, 2004 and $0.5 million from January 3, 2004 throughFebruary 24, 2004, for such research and development activities.

In connection with theagreement, and the transactions discussed above, the Company expensed a totalof approximately $3.9 million from March 13, 2003 through January 3, 2004 (inclusiveof the $0.2 million in reimbursed costs) related to these research anddevelopment initiatives and $0.5 million in the first quarter of fiscal 2004ended April 3, 2004.

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

The Company filed aregistration statement with the Securities and Exchange Commission (“SEC”)covering the resale of the 155,084 shares by the former stockholders ofVisionTec.

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

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

 

Thefollowing table sets forth the preliminary allocation of the purchase price tothe net tangible and intangible assets acquired (in thousands):

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

 

                Coretechnologies and patents are definite-lived intangible assets that are beingamortized over twelve years.

 

**NOTE 7. COMMON STOCK TRANSACTIONS**

 

**               **During the three quartersended October 2, 2004, employees exercised stock options to purchase 20,689shares of common stock for a total of approximately $158,733. The Companyrecorded an increase in additional paid-in capital of approximately $87,415 asa result of the income tax benefit related to these stock option exercises.

 

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                Duringthe three quarters ended October 2, 2004, the Company granted nonqualifiedstock options to purchase 137,478 shares of common stock to employees anddirectors of the Company. The exercise price of the options was $22.00 pershare, which was not less than the quoted fair market value at the grant date.The options vest equally over a four-year period and expire in five years.

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

 

**NOTE 8.DEBT OBLIGATIONS**

 

      Effective February 27, 2004 and modified on June 25, 2004, theCompany executed a restated loan agreement with its existing U.S. bank,providing for a revolving credit facility for borrowings of up to $28 millionthrough June 1, 2004, and reducing thereafter on the first day of eachSeptember, December, March and June by $0.4 million until the maturity date ofFebruary 27, 2007.  Additionally, the agreement provides for letters ofcredit up to a maximum of $15 million outstanding or payable at any time. The executed restated loan agreement specifies that if the maximumleverage ratio, as defined in the restated loan agreement, is greater than 2.5,then the amounts outstanding on the revolving credit facility together with theamount of all outstanding letters of credit can at no time exceed the Company’sbook value of inventory.  As of October 2, 2004, the Company was subjectto this restriction and could only borrow up to the $23.8 million book value ofits inventory. Outstanding borrowings on the revolving credit facility bearinterest at a floating rate equal to the lender’s prime interest rate plus amargin or the lender’s LIBOR rate plus a margin. The interest rate is adjustedquarterly and ranges between prime plus 0.0 percent and prime plus 1.25 percentor between the applicable LIBOR rate plus 2.0 percent and the applicable LIBORrate plus 3.25 percent, depending on the Company’s maximum leverage ratio. Asof October 2, 2004 the prime rate margin is 1.25 percent and the LIBOR ratemargin is 3.25 percent. Interest is payable monthly. As of October 2, 2004, theCompany’s outstanding borrowings on the credit facility, including bankoverdrafts, were $16.4 million. Of this amount, $12.0 million bore interest atthe lender’s LIBOR rate plus 3.25 percent (5.08% at October 2, 2004) and theremaining $4.4 million bore interest at the lender’s prime rate plus 1.25percent (6.00% at October 2, 2004).  The facility requires the quarterlypayment of an unused credit fee which ranges from 0.38 percent to 0.5 percent,depending on the Company’s maximum leverage ratio.

 

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

 

The Company’sSingapore bank term loan contains various financial covenants includingminimums on net worth and shareholders’ funds of the Singapore operations. 1-800CONTACTS, INC. has guaranteed this term loan.

 

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Cross default clauses exist such that if the Companywere in default on its U.S. debt, the Company would also be in default on itsSingapore debt. If the Company were in default on its Singapore bank term loan,the Company would also be in default on its note payable to the parent of IGELand its restated loan agreement with its U.S. bank.

 

**NOTE 9.COMMITMENTS AND CONTINGENCIES**

** **

***Legal Matters***

*** ***

              The sale and delivery of contactlenses are governed by both federal and state laws and regulations, includingthe recently enacted federal Fairness to Contact Lens Consumer Act (“FCLCA”). TheFCLCA requires that contact lenses only be sold to consumers based on a validprescription. Satisfying this prescription requirement obligates the sellereither to obtain a copy of the prescription itself or to verify theprescription by direct communication with the customer’s prescriber. Consistentwith this requirement, the Company’s current operating practice is to requireall customers to provide either a valid copy of their prescription or thecontact information for their prescribers so that the Company can verify theirprescriptions by direct communication with their prescribers. If the Companydoes not have a valid copy of the customer’s prescription, the Company directlycommunicates to the customer’s prescriber the precise prescription informationreceived from the customer and informs the prescriber that it will proceed withthe sale based on this prescription information unless the prescriber advisesit within eight business hours that such prescription information is expired orotherwise invalid. If the prescriber properly advises the Company within thistime period that the customer’s prescription is expired or otherwise invalid,the Company’s practice is to cancel the customer’s order. On the other hand, ifthe prescriber either advises the Company that the prescription is valid orfails to properly respond within the communicated time period, the Company’spractice is to complete the sale based on the prescription informationcommunicated to the prescriber, as expressly permitted by the FCLCA. TheCompany retains copies of the written prescriptions that it receives andmaintains records of its communications with its customers’ prescribers.

 

                On April 7, 1999, the Kansas Board of Examiners inOptometry commenced a civil action against the Company in the District Court ofShawnee County, Kansas. The complaint was amended on May 28, 1999, and allegesthat “on one or more occasions” the Company sold contact lenses in the state ofKansas without receipt of a prescription. After a series of orders and appeals,by order dated April 30, 2004, the Kansas district court reinstated apreviously imposed injunction prohibiting the Company from selling contactlenses without a valid prescription under K.S.A. 65-1504b unless and until adetermination is made that the FCLCA preempts its enforcement.

 

                On September 24, 2004, the Kansas District courtentered its order which addressed the Company’s motion to clarify or, in thealternative, to alter or amend the Kansas district court’s April 30, 2004order. The Kansas District court found that its April 30, 2004 order addressedthe Company’s concerns regarding federal preemption by allowing stateenforcement, “while acknowledging that if such enforcement is preempted by the ‘Fairnessto Contact Lens Consumers Act’, that the injunction has no effect”. Since theKansas district court’s September 24, 2004 order affirms that its previousorder granting injunctive relief has no effect if preempted by the FCLCA, andsince the FTC has issued a rule confirming that the FCLCA preempts state lawsthat purport to require stricter prescription verification procedures or thatare otherwise inconsistent with the FCLCA, the Company has decided not topursue any further appeals of the order granting injunction relief. Theinjunction, as clarified by the Kansas district court’s September 24, 2004order, permits the Company to continue to comply with the federal FCLCA, asopposed to any more burdensome requirement set forth in the Kansas law, and assuch, the Company shall continue to comply with all FCLCA requirements inconnection with contact lens sales to its Kansas customers. Accordingly, theCompany does not believe that K.S.A. 65-1504 does or can require it to changeits existing business practices in any way. However, should any claim orinterpretation regarding K.S.A. 65-1504 be advanced to the contrary, theCompany is prepared to vigorously contest any such claim or interpretation.

 

From time to time the Company isinvolved in other legal matters generally incidental to its business.  Itis the opinion of management, after consultation with legal counsel, that,except for legal and professional fees that the Company incurs from time totime, the ultimate dispositions of these matters will not have a materialimpact on the financial position, liquidity, or results of operations of theCompany.  However, there can be no assurance that the

 

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Company will be successful in its efforts to satisfactorilyresolve these matters and the ultimate outcome could result in a material negativeimpact on the Company’s financial position, liquidity, or results ofoperations.

 

***Advertising Commitments***

 

                As of October 2, 2004, theCompany had entered into certain noncancelable commitments with variousadvertising companies that will require the Company to pay approximately $2.7million and $6.0 million for advertising during the remainder of 2004 and in2005, respectively.

 

**NOTE 10. SEGMENT INFORMATION**

 

                As a result of the acquisitionof IGEL (ClearLab International) in the third quarter of fiscal 2002 and therecently acquired VisionTec (ClearLab UK), the Company has two operatingsegments. These operating segments represent components of the Company forwhich separate financial information is available and evaluated regularly bymanagement in determining resource allocation and performance assessment. TheCompany’s U.S. Retail segment includes the operations of 1-800 CONTACTS and theoperations from the Lens Express and Lens 1st acquisitions. TheCompany’s International segment includes the operations of ClearLabInternational and ClearLab UK, both of which are developers and manufacturersof contact lenses. Operating segment information for the quarter and threequarters ended September 27, 2003 and October 2, 2004 are as follows (inthousands):

 
| ** **                    | ** ** | **Quarter Ended**      | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **September 27, 2003** | ** ** | **October 2, 2004** | ** ** |
| ** **                    | ** ** | **U.S. Retail**        | ** ** | **International** | ** ** | **Total** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
| Net sales                     |       | $                      | 46,923     |   | $ | 1,477 |   | $ | 48,400 |   | $ | 54,966 |   | $ | 1,927 |   | $ | 56,893 |   |
| Gross profit (loss)           |       | 18,191                 |       | 720 |   | 18,911 |   | 22,235 |   | (231 | ) | 22,004 |   |
| Research and development      |       | 618                    |       | 159 |   | 777 |   | — |   | 567 |   | 567 |   |
| Other operating expense       |       | 8,600                  |       | 716 |   | 9,316 |   | 9,701 |   | 1,088 |   | 10,789 |   |
| Income (loss) from operations |       | 322                    |       | (276 | ) | 46 |   | 5,179 |   | (2,090 | ) | 3,089 |   |
|                               |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                   | ** ** | **Three Quarters Ended** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|
| ** **                                   | ** ** | **September 27, 2003**   | ** ** | **October 2, 2004** | ** ** |
| ** **                                   | ** ** | **U.S. Retail**          | ** ** | **International** | ** ** | **Total** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
| Net sales                                    |       | $                        | 136,755    |   | $ | 4,661 |   | $ | 141,416 |   | $ | 153,159 |   | $ | 4,554 |   | $ | 157,713 |   |
| Gross profit (loss)                          |       | 50,984                   |       | 1,803 |   | 52,787 |   | 60,990 |   | (417 | ) | 60,573 |   |
| Research and development                     |       | 2,527                    |       | 250 |   | 2,777 |   | 536 |   | 1,366 |   | 1,902 |   |
| Purchased in-process research anddevelopment |       | —                   |       | — |   | — |   | — |   | 83 |   | 83 |   |
| Other operating expense                      |       | 25,217                   |       | 2,852 |   | 28,069 |   | 28,276 |   | 3,161 |   | 31,437 |   |
| Income (loss) from operations                |       | 3,988                    |       | (1,575 | ) | 2,413 |   | 5,865 |   | (5,493 | ) | 372 |   |
|                                              |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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                Identifiablesegment assets are as follows (in thousands):

 
| ** **             | ** ** | **January 3, 2004** | ** ** | **October 2, 2004** | ** ** |
|------------------------|------------|---------------------|------------|---------------------|------------|
| ** **             | ** ** | **U.S. Retail**     | ** ** | **International**   | ** ** | **Total** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
| Long-lived assets, net |       | $                   | 30,615     |                | $          | 25,628 |   | $ | 56,243 |   | $ | 33,909 |   | $ | 36,506 |   | $ | 70,415 |   |
| Total assets           |       | 56,274              |       | 30,657              |       | 86,931 |   | 58,149 |   | 44,031 |   | 102,180 |   |
|                        |            |                     |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

              The Company enters intoarrangements to receive cash consideration from certain of its vendors. Thearrangements include manufacturer rebates and cooperative marketing programreimbursements. Cash consideration for some vendor agreements is dependent uponreaching minimum purchase thresholds. The Company evaluates the likelihood ofreaching purchase thresholds using past experience and current year forecasts.When rebates can be reasonably estimated, the Company records a portion of therebate as it makes progress towards the purchase threshold. In accordance with EITF 02-16, it is generallypresumed that amounts received from vendors are a reduction of the prices paidfor their products. Therefore, that cash consideration is reflected as areduction of cost of goods sold if the inventory has been sold by the Companyor a reduction of inventory if the product inventory is still on hand at thereporting date. When the Company receives reimbursements for specific,incremental, identifiable advertising costs incurred for advertising thevendors’ products the cash consideration received is recorded as a reduction toadvertising expense in the Company’s consolidated statements of operations.

 

 

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

*** ***

**Overview**

** **

                TheCompany is a leading direct marketer of replacement contact lenses and alsoconducts contact lens manufacturing, development, and distribution operationsin Singapore and the United Kingdom.  TheCompany sells all of the popular brands of contact lenses, including thosemanufactured by Johnson & Johnson Vision Care, CIBA Vision, Bausch &Lomb, Ocular Sciences and CooperVision.

 

***International Operations (ClearLab)*****.**  On July 24, 2002, the Company completed theacquisition of certain net assets and the majority of the business operationsof IGEL (subsequently renamed ClearLab International), a developer andmanufacturer of contact lenses based in Singapore.  ClearLab Internationalis the principal marketing organization for the Company’s internationalwholesale manufacturing and distribution business, focusing on the marketing ofcontact lens products to major retailers and distributors, as well as providingcontract manufacturing capacity for other contact lens manufacturers. ClearLab International manufactures a range of frequent replacement sphericaland toric lenses and is focused on developing new lens materials.

 

On February 24, 2004, theCompany acquired VisionTec, a developer and manufacturer of daily contactlenses based in the United Kingdom.  VisionTec has developed a method forlow cost, high quality production of daily disposable contact lenses using aunique proprietary material.  VisionTec has subsequently been renamedClearLab UK Ltd (“ClearLab UK”).  The business operates as a research anddevelopment and manufacturing affiliate of ClearLab International.  TheCompany began shipping its daily disposable contact lenses in the first quarterof fiscal 2004 and is currently expanding its production capabilities in theU.K.  The Company will increase itsproduct offerings to the international markets throughout the remainder offiscal 2004 from its production facilities in Singapore and the U.K.

 

ClearLab International’s andClearLab UK’s development and manufacturing capabilities also provide theCompany with greater access to future contact lens products for the U.S. retailmarket.  This is critical to the Company’sstrategy should the Company’s access to contact lenses from the major contactlens manufacturers be disrupted, curtailed or otherwise negatively impacted, orif the manufacturers do not provide the Company with contact lenses atcompetitive pricing and with competitive marketing support.

 

***Johnson & Johnson Vision CareAgreement.***  In December2002, the Company announced that it had reached an agreement with Johnson &Johnson Vision Care to become an authorized retailer of Johnson & JohnsonVision Care contact lenses.  The Companymodified its operating systems in connection with this agreement. The Companyimplemented new prescription verification procedures for Johnson & JohnsonVision Care by geographic region based on time zone.  The Company began this implementation inFebruary 2003 and completed it in April 2003. These verification procedures were subsequently changed during thecurrent quarter in keeping with the federal regulations and guidelinescontained in the FCLCA.

 

The Company began buyingdirect from Johnson & Johnson Vision Care during March 2003.  This direct relationship with Johnson &Johnson Vision Care has lowered the Company’s product acquisition costs andallowed it to offer rebates and other incentives not previously available toits customers who wear Johnson & Johnson Vision Care lenses. The Companyhas also been able to reduce its inventory investment by purchasing a morebalanced mix of products at lower prices than it has historically been able toobtain through indirect sources. This agreement also resolved long-standingdisputes.

 

***Cole National Marketing Agreement.******* On June 30, 2003, the Companyand Cole National Corporation (“Cole”) announced that they had signed anagreement under which the Company’s customers can receive discounted eye examsand value pricing on eyeglasses, sunglasses and other vision products that theCompany does not sell from a network of doctors contracted with Cole ManagedVision and associated with more than 1,500 Pearle Vision, Pearle VisionCare,Sears Optical and Target Optical stores in the U.S.  During the second quarter of fiscal 2004, theCompany and Cole extended this agreement through March 31, 2005.  Under this agreement, Cole is offering itsnetwork of doctors to the Company to be used for contact lens exam referralsand the Company retains the contact lens business of customers referred to Colestores.

 

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

 

***Lens Express / Lens 1st****.*  On January 30, 2003, the Companyacquired certain assets and assumed certain liabilities of Lens Express LLC andCamelot Ventures/CJ, L.L.C. d/b/a Lens 1st (collectively, the “Seller”),two leading U.S. mail order contact lens retailers. The assets acquiredincluded databases, customer information, web sites and Internet addresses ordomain names, telephone numbers, certain specified contracts and intellectualproperty rights. 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.

 

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

 

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

 

# **RegulatoryConsiderations**

 

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

 

The FCLCA also requires thatcontact lenses only be sold to consumers based on a valid prescription.  Satisfying this prescription requirementobligates the seller either to obtain a copy of the prescription itself or toverify the prescription by direct communication with the customer’sprescriber.  Consistent with thisrequirement, the Company’s current operating practice is to require allcustomers to provide either a valid copy of their prescription or the contactinformation for their prescriber so that the Company can verify theirprescription by direct communication with their prescriber.  If the Company does not have a valid copy ofthe customer’s prescription, the Company directly communicates to the customer’sprescriber the precise prescription information received from the customer andinforms the prescriber that it will proceed with the sale based on thisprescription information unless the prescriber advises it within eight businesshours that such prescription information is expired or otherwise invalid.  If the prescriber properly advises theCompany within this time period that the customer’s prescription is expired orotherwise invalid, the Company’s practice is to cancel the customer’sorder.  On the other hand, if theprescriber either advises the Company that the prescription is valid or failsto respond properly within the required time period, the Company’s practice isto complete the sale based on the prescription information communicated to

 

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the prescriber, as expressly permitted by theFCLCA.  The Company retains copies of thewritten prescriptions that it receives and maintains records of itscommunications with the customer’s prescriber.

 

Net sales for fiscal 2003and the first three quarters of fiscal 2004 were negatively impacted bycanceled orders due to the Company’s implementation of its prescriptionverification procedures, including, most significantly, those implemented aspart of the Johnson & Johnson Vision Care agreement in 2003, and therevisions to the Company’s prescription verification procedures instituted inresponse to the FCLCA. The Company is taking steps to recover these canceledorders.  The Company is uncertain as tothe ultimate impact its revised prescription verification procedures will haveon future net sales, and the Company is also uncertain as to the number of canceledorders that can subsequently be recovered. The FCLCA provides several means of direct communication with eye carepractitioners, and the Company may alter its prescription verificationprocedures from time to time in keeping with the FCLCA and FTC guidelines.

 

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**Results of Operations**

 

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

 

                The following table presents theCompany’s results of operations expressed as a percentage of net sales for theperiods indicated:
| ** **                                      | ** ** | **Quarter Ended**   | ** ** | **Three Quarters Ended** | ** ** |
|-------------------------------------------------|------------|---------------------|------------|--------------------------|------------|
| ** **                                      | ** ** | **Sept. 27,  2003** | ** ** | **Oct. 2,  2004**        | ** ** | **Sept. 27,  2003** | ** ** | **Oct. 2,  2004** | ** ** |
| NET SALES                                       |       | 100.0               | %          | 100.0                    | %          | 100.0 | % | 100.0 | % |
| COST OF GOODS SOLD                              |       | 60.9                |       | 61.3                     |       | 62.7 |   | 61.6 |   |
| Gross profit                                    |       | 39.1                |       | 38.7                     |       | 37.3 |   | 38.4 |   |
|                                            |       |                |       |                     |       |   |   |   |   |
| OPERATING EXPENSES:                             |       |                |       |                     |       |   |   |   |   |
| Advertising                                     |       | 14.8                |       | 11.4                     |       | 10.3 |   | 14.3 |   |
| Legal and professional                          |       | 3.3                 |       | 1.8                      |       | 3.5 |   | 2.7 |   |
| Research and development                        |       | 1.6                 |       | 1.0                      |       | 2.0 |   | 1.2 |   |
| Purchased in-process research and development   |       | —              |       | -                        |       | — |   | 0.1 |   |
| Other operating                                 |       | 19.3                |       | 19.0                     |       | 19.8 |   | 19.9 |   |
| Total operating expenses                        |       | 39.0                |       | 33.2                     |       | 35.6 |   | 38.2 |   |
| INCOME FROM OPERATIONS                          |       | 0.1                 |       | 5.5                      |       | 1.7 |   | 0.2 |   |
| OTHER EXPENSE, net                              |       | (0.3                | )          | (0.4                     | )          | (0.7 | ) | (0.8 | ) |
| INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES |       | (0.2                | )          | 5.1                      |       | 1.0 |   | (0.6 | ) |
| PROVISION FOR INCOME TAXES                      |       | (1.1                | )          | (2.7                     | )          | (1.4 | ) | (0.7 | ) |
| NET INCOME (LOSS)                               |       | (1.3%               | )          | 2.4                      | %          | (0.4% | ) | (1.3% | ) |

 

***                Net sales***.  Net sales for the quarter ended October 2,2004 increased 17.5% to $56.9 million from $48.4 million for the quarter endedSeptember 27, 2003.   For the threequarters ended October 2, 2004, net sales increased 11.4% to $157.7 millionfrom $141.4 million for the three quarters ended September 27, 2003.  Net sales for the Company’s U.S. Retailoperations, for the third quarter of fiscal 2004 and the first three quartersof fiscal 2004 were $55.0 million and $153.2 million, respectively, compared to$46.9 million and $136.8 million, respectively, for the quarter and threequarters ended September 27, 2003.  Theincrease in net sales is mainly due to increased advertising and rebateprograms instituted during the year for select products, as well as a retailprice increase principally on phone orders in the second quarter of fiscal2004.  Net sales were negatively impactedduring the first three quarters of fiscal 2004 due to a substantial increase inthe number and percentage of orders the Company canceled as a result of theprescription verification procedures implemented as part of the Johnson &Johnson Vision Care agreement during the period February through April 2003 andthe revisions to the Company’s prescription verification procedures institutedon February 4, 2004 in compliance with the FCLCA (see “RegulatoryConsiderations”).  These verificationprocedures were subsequently changed during the current quarter in keeping withfederal regulations and guidelines contained in the FCLCA.  The Company’s cancellation rate for the thirdquarter of fiscal 2004 was approximately 16%, which is a decrease from thecancellation rate of approximately 20% in the second quarter of fiscal2004.  The canceled order rate in thethird quarter of fiscal 2004 was approximately the same as the canceled orderrate in the same quarter in the previous year.

 

                The Company believes the ordercancellation rate will decrease further in the fourth quarter as the Companyincreases its efficiency in communicating with eye care providers, and as moreof the Company’s customers become accustomed to the federal prescriptionverification requirements and eye care practitionersbecome accustomed to the Company’s prescription verification procedures.

 

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                Net sales for the Company’sinternational operations (ClearLab), for the third quarter of fiscal 2004 andthe first three quarters of fiscal 2004 were $1.9 million and $4.5 million, respectively.  Net sales for ClearLab for the third quarterand first three quarters of fiscal 2003 were $1.5 million and $4.7 million,respectively.  The Company expectsClearLab sales to increase internationally during the fourth quarter of fiscal2004 due to the scale-up of ClearLab’s production and research and developmentefforts in order to capitalize on increasing demand for ClearLab’s productsduring the fourth quarter of fiscal 2004.

 

                ***Grossprofit.***  Consolidatedgross profit as a percentage of net sales for the quarter and three quartersended October 2, 2004 was 38.7% and 38.4%, respectively, compared to 39.1% and37.3%, respectively, for the quarter and three quarters ended September 27,2003.  Gross profit as a percentage ofnet sales for the Company’s U.S. Retail operations increased to 40.5% for thequarter ended October 2, 2004 from 38.8% for the quarter ended September 27,2003.  For the three quarters endedOctober 2, 2004, gross profit as a percentage of net sales for the U.S. Retailoperations increased to 39.8% from 37.3% for the three quarters ended September27, 2003.  The majority of the grossprofit improvement in the current year was due to the Company’s U.S. Retailoperations continuing to realize the expected benefits of a decrease inwholesale prices paid for Johnson & Johnson Vision Care products as well asthe continued benefits being received from a retail price increase principallyon phone orders in the second quarter fiscal 2004.  The Company expects gross profit as apercentage of net sales for its U.S. Retail operations to remain relativelyconstant during the remainder of fiscal 2004.

 

                During the third quarter offiscal 2004, the Company continued to recognize a negative gross margin atClearLab due to the start-up nature of its U.K. operations which were acquiredduring the latter part of the first quarter of fiscal 2004.   The Company expects this trend to reverseand to record a positive gross margin during 2005 as ClearLab sales increaseinternationally.

 

                ***Advertisingexpense. ***Advertisingexpense for the quarter ended October 2, 2004 was $6.5 million, a decrease of$0.7 million from the quarter ended September 27, 2003.  As a percentage of net sales, advertisingexpense decreased to 11.4% for the third quarter of fiscal 2004 from 14.8% forthe third quarter of fiscal 2003.  For thethree quarters ended October 2, 2004, advertising expense was $22.6 million, anincrease of $8.0 million from the three quarters ended September 27, 2003.  The Company expects total advertising expenseincurred will be approximately $27 million for all of fiscal 2004.  However, if opportunities present themselves,the Company may increase advertising spending above currently plannedlevels.  The Company’s experience hasbeen that increases in advertising expenditures have a direct impact on thegrowth of net sales not only in the current period but also in futureperiods.  The Company expects a reductionin advertising in the fourth quarter of fiscal 2004 as compared to the thirdquarter of fiscal 2004, consistent with the Company’s strategy since inception.  The Company generally decreases advertisingspending during the holiday season when advertising costs typically increaseand response rates tend to decline.

 

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

 

                ***Legaland professional fees.*** Legal and professional fees for the quarter ended October 2, 2004decreased $0.6 million from the quarter ended September 27, 2003 to $1.0million.  As a percentage of net sales,legal and professional fees decreased to 1.8% for the third quarter of fiscal2004 from 3.3% for the third quarter of fiscal 2003. For the three quartersended October 2, 2004, legal and professional fees decreased $0.8 million fromthe three quarters ended September 27, 2003 to $4.2 million.  As a percentage of net sales, legal andprofessional fees decreased to 2.7% for the first three quarters of fiscal 2004from 3.5% for the first three quarters of fiscal 2003.

 

                During the quarter, the Companyinvested in legal and professional fees for Sarbanes-Oxley compliance,continued compliance with federal rules and regulations, as well as other initiatives.   Although the Fairness to Contact Lens Consumer Act (“FCLCA”) became effectiveFebruary 4, 2004, the Company invested considerable effort during the firstfiscal quarter of 2004 preparing comments for the Federal Trade Commission (“FTC”)relating

 

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tofinal rules associated with the FCLCA. The Company will continue to focus its efforts on compliance withfederal rules and regulations and expects to incur additional legal andprofessional fees of approximately $0.5 million to $1.0 million during thefourth quarter of fiscal 2004.  However,legal and professional fees are subject to change as circumstances warrant.

 

***Research and development expenses.***  Research and development expenses for thequarter ended October 2, 2004 decreased to $0.6 million, or 1.0% of net sales,from $0.8 million, or 1.6% of net sales, for the quarter ended September 27,2003.  For the three quarters endedOctober 2, 2004, research and development expenses were $1.9 million, or 1.2%of net sales compared to $2.8 million, or 2.0% of net sales for the threequarters ended September 27, 2003.  Theseexpenses were principally to fund research and development efforts for ClearLab’soperations.  The Company’s U.S. Retailoperations funded $0.5 million during the first fiscal quarter of 2004 forresearch and development activities performed by VisionTec prior to the Company’sacquisition of the entity on February 24, 2004. During the first three quarters of fiscal 2003, the Company’s U.S.Retail operations expensed approximately $2.8 million for research anddevelopment activities performed by VisionTec. The Company expects to incur total consolidated research and developmentexpenses of approximately $2.5 million in fiscal 2004, the majority of which isrelated to ClearLab’s operations.

 

***Other operating expenses.***  Other operating expenses for the quarterended October 2, 2004 increased $1.5 million from the quarter ended September27, 2003.  As a percentage of net sales,the Company’s other operating expenses decreased to 19.0% for the third quarterof fiscal 2004 from 19.3% for the third quarter of fiscal 2003.  During the third quarter of fiscal 2004, theCompany’s U.S. Retail business incurred other operating expenses of $9.7million, or 17.6% of net sales, compared to $8.6 million, or 18.3% of netsales, for the third quarter of fiscal 2003. The Company’s U.S. Retail other operating expenses increased byapproximately $1.1 million for the quarter ended October 2, 2004 from thequarter ended September 27, 2003 as the Company added to its management teamand continued to enhance new functions within the organization, such as thedoctor referral network department, added to the Company’s prescriptionverification staff, and incurred other variable costs due to higher net sales.  ClearLab represented approximately $0.4million of the increase in consolidated other operating expenses.

 

For the three quarters endedOctober 2, 2004, other operating expenses increased $3.3 million to $31.4million.  As a percentage of net sales,other operating expenses increased to 19.9% for the first three quarters offiscal 2004 from 19.8% for the first three quarters of fiscal 2003.  Other operating expenses for the Company’sU.S. Retail operations increased $3.1 million to $28.3 million.  A majority of this increase related to thecontinued enhancement of its operating infrastructure and management team tomeet the demands of the business and variable costs associated with higher netsales and the requirements of the FCLCA. The Company also incurred approximately $0.2 million in costs related tothe consolidation of the operations of Lens 1st from Michigan toUtah, just over $0.1 million for recruiting costs relating to key informationtechnology and marketing positions and an additional $0.3 million for severanceand other employee costs related to the elimination of one senior operatingposition.  ClearLab representedapproximately $0.3 million of the increase in consolidated other operatingexpenses.

 

The Company expects otheroperating expenses to fluctuate as a percentage of net sales as the Companycontinues to grow and expand its U.S. and international operations.

 

***Other expense, net.***  Other expense remained consistent for thequarters ended October 2, 2004 and September 27, 2003 at approximately $0.2million.  For the three quarters endedOctober 2, 2004, other expense increased approximately $0.3 million from thethree quarters ended September 27, 2003 to $1.3 million.  For the third quarter of fiscal 2004, otherexpense consisted mainly of interest expense, offset by unrealized foreignexchange transaction gains of approximately $0.1 million.  For the three quarters ended October 2, 2004,other expense consisted mainly of interest expense of approximately $1.2million and unrealized foreign exchange transaction losses of less than $0.1million.  The interest expense resultedfrom the use of the revolving credit facility and debt related to theacquisitions of VisionTec (ClearLab UK, Ltd.) and ClearLab International. Forthe first three quarters of fiscal 2003, other expense consisted mainly ofinterest expense of approximately $1.0 million, offset slightly by unrealizedforeign exchange transaction gains incurred by the Company.  The unrealized foreign exchange differencesrelated primarily to the intercompany loans to ClearLab.

 

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***Income taxes. ***The Company istaxed in three separate jurisdictions - U.S., Singapore and the UnitedKingdom.  The Company’s effective U.S.income tax rate for the three quarters ended October 2, 2004 was 39.0% comparedto 51.9% for the three quarters ended September 27, 2003.  The Company records quarterly income taxes atthe effective tax rate expected for the year. The decrease in the effective income tax rate primarily results from theestimated annual decrease in permanent nondeductible expenses; including thoserelating to the Company’s lobbying efforts. During the first three quarters of fiscal 2004, the Company did notrecord a tax benefit for the loss from the operations of ClearLab Internationaldue to the uncertainty with respect to the realization of a tax benefit inSingapore.  As of the third quarter offiscal 2004, the Company provided a valuation allowance for the full amount ofthe deferred income tax assets in Singapore.  For the first three quarters of fiscal 2004, the Company recorded a taxbenefit for the loss from operations of ClearLab UK using an effective tax rateof 28.0%.  The Company did not provide avaluation allowance for the deferred income tax assets in the United Kingdombecause the deferred tax liabilities recorded as of the date of acquisition ofClearLab UK were in excess of the deferred tax assets generated by the lossfrom operations during the first three quarters of fiscal 2004, which operatingloss can be carried forward indefinitely. The Company’s estimated effective U.S. and United Kingdom income taxrates may change as facts and circumstances change.

 

**Liquidity and Capital Resources**

** **

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

 

The Company believes thatits cash on hand, together with cash generated from operating activities andthe borrowings available through the credit facility, will be sufficient tosupport planned operations through the foreseeable future.  Should the Company’s plans or expectationschange, the Company may be required to seek additional sources of funds andthere can be no assurance that such funds will be available on satisfactoryterms.  Failure to obtain such financingcould delay or prevent the Company’s planned growth, which could adverselyaffect the Company’s business, financial condition, liquidity and results ofoperations.

 

                As a result of regulatoryrequirements, the Company’s liquidity, capital resources and results ofoperations may be negatively impacted in the future if the Company incursincreased costs (including legal fees) or fines, is prohibited from selling itsproducts or experiences losses of a substantial portion of the Company’scustomers for whom the Company is unable to obtain or verify a prescription dueto the enforcement of requirements by regulatory agencies.

 

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

 

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

 

      **Renewed Loan Agreement** - EffectiveFebruary 27, 2004 and modified on June 25, 2004, the Company executed arestated loan agreement with its existing U.S. bank, providing for a revolvingcredit facility for borrowings of up to $28 million through June 1, 2004, andreducing thereafter on the first day of each September, December, March andJune by $0.4 million until the maturity date of February 27, 2007. Additionally, the agreement provides for letters of credit up to a maximum of$15 million outstanding or payable at any time.  The

 

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executed restated loan agreement specifies that if themaximum leverage ratio, as defined in the restated loan agreement, is greaterthan 2.5, then the amounts outstanding on the revolving credit facilitytogether with the amount of all outstanding letters of credit can at no timeexceed the Company’s book value of inventory.   As of October 2, 2004, the Company wassubject to this restriction and could only borrow up to the $23.8 million bookvalue of its inventory.  Outstandingborrowings on the revolving credit facility bear interest at a floating rateequal to the lender’s prime interest rate plus a margin or the lender’s LIBORrate plus a margin.  The interest rate isadjusted quarterly and ranges between prime plus 0.0 percent and prime plus1.25 percent or between the applicable LIBOR rate plus 2.0 percent and theapplicable LIBOR rate plus 3.25 percent, depending on the Company’s maximumleverage ratio.  As of October 2, 2004the prime rate margin is 1.25 percent and the LIBOR rate margin is 3.25percent.  Interest is payable monthly.  As of October 2, 2004, the Company’soutstanding borrowings on the credit facility, including bank overdrafts, were$16.4 million.  Of this amount, $12.0million bore interest at the lender’s LIBOR rate plus 3.25 percent (5.08% atOctober 2, 2004) and the remaining $4.4 million bore interest at the lender’sprime rate plus 1.25 percent (6.00% at October 2, 2004).  The facilityrequires the quarterly payment of an unused credit fee which ranges from 0.38percent to 0.5 percent, depending on the Company’s maximum leverage ratio.

 

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

 

As of October 2,2004, the Company was in compliance with all applicable covenants as modifiedand clarified by the U.S. bank.

*** ***

***Cash flows from o******perating activities.***  For the three quarters ended October 2, 2004and September 27, 2003, net cash provided by operating activities wasapproximately $5.0 million and $14.7 million, respectively.  In the fiscal 2004 period, cash was providedprimarily by a decrease in inventories offset by increases in accountsreceivable and other current assets. Also in the 2004 period, cash was provided by an increase in variousaccrued liabilities partially offset by a decrease in accounts payable.  In the fiscal 2003 period, cash was providedprimarily by a decrease in inventories partially offset by a decrease inaccounts payable.

 

***Cash flows from investingactivities.***  The Companyused approximately $14.1 million and $9.5 million for investing activities inthe three *quarters* ended October 2, 2004 andSeptember 27, 2003, respectively.  In thefiscal 2004 period, the Company paid approximately $3.8 million in cash(including $0.6 million in transaction costs) in connection with the acquisitionof VisionTec.  The Company also purchasedapproximately $4.0 million of intangible assets during the fiscal 2004period.  In the fiscal 2003 period, theCompany paid approximately $7.0 million in cash (including $0.5 million intransaction costs) in connection with the acquisition of Lens Express and Lens1st.

 

Capital expenditures forinfrastructure improvements for the first three quarters ended October 2, 2004and September 27, 2003 were approximately $6.0 million and $2.1 million,respectively.  Of those amounts,approximately $3.5 million and $1.2 million related to the ClearLab operations,respectively.  The Company anticipatescontinued funding during the remaining quarter of fiscal 2004 for property andequipment at its ClearLab operations. These funds will primarily be used for the expansion of its daily lenscapacity in response to international customer demand.  The Company also anticipates additionalcapital expenditures throughout the remainder of fiscal 2004 for infrastructureas it continues to expand and improve operating facilities, telecommunicationssystems and management information systems in order to handle future U.Soperations.

 

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***Financing activities.***  During the three quarters ended October 2,2004 and September 27, 2003, net cash provided by (used in) financingactivities was approximately $8.5 million and $(4.6) million,respectively.  In the fiscal 2004 period,the Company had net borrowings on its credit facility of approximately $16.4million and made principal payments on debt obligations and capital leaseobligations of approximately $8.7 million and incurred approximately $0.2million in debt issuance costs.  TheCompany also received a governmental regional development grant in the U.K. ofapproximately $0.9 million.  This grantwas designed to assist in employment creation while the amount of the grant isbased on ClearLab UK capital expenditures.  During the fiscal 2003 period, the Company had net repayments on itscredit facility of approximately $3.2 million and made principal payments ondebt obligations and capital lease obligations of approximately $2.2 million,which were partially offset by proceeds of $0.8 million from the exercise ofcommon stock options.

 

The Company’s Board ofDirectors authorized the repurchase of up to 3,000,000 shares of the Company’sCommon Stock.  A purchase of the full3,000,000 shares would equal approximately 23 percent of the total sharesissued as of October 2, 2004.  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.  From inception of its authorized repurchaseprograms through October 2, 2004, the Company had repurchased 1,706,500 sharesfor a total cost of approximately $22.1 million.  No shares were repurchased by the Companyduring fiscal 2003 or the first three quarters of fiscal 2004 and the Companyis currently prohibited by its restated loan agreement from purchasing anyadditional shares until January 1, 2006. A majority of the repurchased shares were used to acquire ClearLabInternational and Lens 1st/Lens Express.

 

At October 2, 2004, theCompany had an unsecured, non-interest bearing note to ClearLab International’schief technology officer with a principal balance of SGD$2,125,000(USD$1,257,000). The note payable is discounted at 7%.  Payments are due in equal monthlyinstallments through July 2007.

 

At October 2, 2004, the Company had a termloan payable to a Singapore bank with a principal balance of SGD$7,860,000(USD$4,648,000) that bears interest at 6.75% and is secured by substantiallyall of the assets of ClearLab International. Interest payments are due monthly. Principal payments are due in monthly installments from January 2003through December 2007.  This note alsocontains various financial covenants including minimums on net worth andshareholders’ funds.  As of October 2, 2004, the Company was in compliancewith these covenants.  1-800 CONTACTS,INC. has guaranteed this term loan.

 

At October 2, 2004, the Company also had anote payable to the former parent of ClearLab International with a principalbalance of SGD$6,892,000 (USD$4,076,000) that bears interest at 6% and has asubordinated position to the term loan payable to the Singapore bank.  The note payable is discounted at 7%.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed thisnote.

 

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

 

The Company leasesvarious manufacturing and other equipment from financing companies undercapital lease arrangements.  All of theequipment is maintained at the Singapore and United Kingdom facilities.  The majority of the leases were assumed inconnection with the Company’s acquisitions of ClearLab International andVisionTec (ClearLab UK, Ltd.).  As of October 2, 2004, the present value offuture minimum lease payments was approximately USD$0.2 million with a majorityof payments scheduled through fiscal 2004.

 

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**ContractualObligations and Commitments**

** **

              Subsequent to January 3, 2004,there have been no material changes to the Company’s contractual obligationsand commitments, outside the normal course of business, other than the renewedloan agreement with the Company’s existing U.S. bank.

 

**CriticalAccounting Policies**

** **

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

 

                Salesare generally recognized when products are shipped and the customer takesownership and assumes risk of loss, collection of the related receivable isprobable, persuasive evidence of an arrangement exists and the sales price isfixed or determinable.  Net sales consistof product sales less provisions for sales returns and allowances and estimatedcustomer rebates.  The Company accrues anestimated amount for unclaimed customer rebates and sales returns andallowances based on historical information, adjusted for current economictrends.  To the extent actual returns andallowances vary from historical experience, revisions to the allowances may berequired.

 

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

 

                TheCompany has significant long-lived tangible and intangible assets consisting ofproperty, plant and equipment, goodwill and definite-lived intangibles.  These assets are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountsof such assets may not be recoverable. In addition, the Company performs an impairment test related to goodwillat least annually.  An impairmentanalysis related to long-lived tangible and definite-lived intangible assetsrequires the assessment of expected future undiscounted cash flows over theremaining useful life of the asset.  Animpairment analysis of goodwill requires the use of a fair-value basedanalysis.  All of the goodwill and asignificant portion of the other long-lived assets were generated from theCompany’s recent acquisitions of ClearLab International, ClearLab UK, Ltd.,Lens Express and Lens 1st.  Ifforecasts and assumptions used to support the realizability of long-livedassets change in the future, significant impairment charges could result thatwould adversely affect the Company’s results of operations and financialposition.

 

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

 

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

 

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**Forward-LookingStatements**

** **

                Except for the historicalinformation contained herein, the matters discussed in this Form 10-Q areforward-looking statements within the meaning of Section 21E of the SecuritiesExchange Act of 1934, as amended, and Section 27A of the Securities Act of1933, as amended.  These forward-lookingstatements involve risks and uncertainties and often depend on assumptions,data or methods that may be incorrect or imprecise.  The Company’s future operating results maydiffer materially from the results discussed in, or implied by, forward-lookingstatements made by the Company.  Factorsthat may cause such differences include, but are not limited to, thosediscussed below and the other risks detailed in the Company’s other reportsfiled with the Securities and Exchange Commission.  Words such as “believes,” “anticipates,” “expects,”“future,” “intends,” “would,” “may,” and similar expressions are intended toidentify forward-looking statements.  TheCompany undertakes no obligation to revise any of these forward-lookingstatements to reflect events or circumstances after the date hereof.

 

*Factorsthat may affect future results include, but are not limited to the following:*

 

•                                          The Company may encounter unforeseendifficulties in managing its future growth;

 

•                                          A significant portion of the Company’s sales may befound not to comply with state laws and regulations concerning the delivery andsale of contact lenses;

 

•                                          Because the Company does not manufacture most of thecontact lenses that it sells, the Company cannot ensure that all of the contactlenses it sells meet all federal regulatory requirements;

 

•                                          It is possible that the FDA could consider certain ofthe contact lenses the Company sells to be misbranded;

 

•                                          The Company currently purchases a portion of itsproducts from unauthorized distributors and is not an authorized distributorfor some of the products that it sells;

 

•                                          The Company obtains a large percentage of itsinventory from a limited number of suppliers, with a single manufactureraccounting for 46 percent, 35 percent and 23 percent of the Company’s inventorypurchases in fiscal 2001, 2002 and 2003, respectively.  In addition, the Company’s top threesuppliers accounted for 70 percent, 63 percent and 59 percent of the Company’sinventory purchased in fiscal 2001, 2002 and 2003, respectively;

 

•                                          The Company may continue to incur significant legaland professional fees related to its legal matters and its efforts toproactively influence the industry on behalf of itself and consumers;

 

•                                          The Company’s quarterly results are likely to varybased upon the level of sales and marketing activity in any particular quarter;

 

•                                          The Company is dependent on its telephone, Internetand management information systems for the sale and distribution of contactlenses;

 

•                                          The retail sale of contact lenses is highlycompetitive and certain of the Company’s competitors are large, nationaloptical chains that have greater resources than the Company;

 

•                                          The demand for contact lenses could be substantiallyreduced if alternative technologies to permanently correct vision gain inpopularity;

 

•                                          The Company does not have any property rights in the1-800 CONTACTS telephone number or the Internet addresses that it uses;

 

•                                          Increases in the cost of shipping, postage or creditcard processing could harm the Company’s business;

 

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•                                          The Company’s business could be harmed if it isrequired to collect state sales tax on the sale of all products;

 

•                                          The Company faces an inherent risk of exposure toproduct liability claims in the event that the use of the products itmanufacturers or sells results in personal injury;

 

•                                          The Company conducts its retail operations through asingle distribution facility;

 

•                                          The Company’s success is dependent, in part, oncontinued use of the Internet;

 

•                                          Government regulation and legal uncertainties relatingto the Internet and online commerce could negatively impact the Company’sbusiness operations;

 

•                                          Changing technology could adversely affect theoperation of the Company’s website;

 

•                                          The Company may not be able to develop and manufacturea viable, high quality contact lens for sale to consumers that meets allfederal regulatory requirements;

 

•                                          The Company may not be able to fully integrate theoperations of its acquisitions into its business;

 

•                                          Consumer acceptance of the Company’s manufacturedproducts may not meet the Company’s expectations;

 

•                                          The Company’s intellectual property rights may bechallenged;

 

•                                          The Company may encounter legal, regulatory andgovernment agency oversight risks with foreign operations;

 

•                                          The Company may not be able to establish a sufficientnetwork of eye care practitioners to prescribe the products manufactured by theCompany;

 

•                                          The Company may not be able to adequately manage itsforeign currency risk;

 

•                                          The Company may incur unforeseen costs or not realizeall of the anticipated benefits from its relationships with Johnson &Johnson Vision Care, CIBA Vision and Cole;

 

•                                          The Company may be required to reduce the carryingvalue of its intangible assets if events and circumstances indicate theremaining balance of intangible assets may not be recoverable; and

 

•                                          The Company may incur an increase in ordercancellations due to the prescription verification requirements of the Fairnessto Contact Lens Consumers Act.

 

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**Item 3.      *Quantitative andQualitative Disclosures About Market Risk***

** **

                Interest RateRisk. As of October 2, 2004, the Company was exposed to changes in interestrates relating to its renewed credit facility and other debt obligations. Therenewed credit facility bears interest at a variable rate based on the U.S.prime rate or LIBOR. The Company’s outstanding borrowings on the creditfacility, including bank overdrafts, were approximately $16.4 million as ofOctober 2, 2004. The remainder of the Company’s interest bearing debtobligations, including capital lease obligations, is denominated in Singaporedollars and British Pounds and bear interest at a fixed rate. As of October 2,2004, the face amounts of the outstanding borrowings on these fixed rate debtobligations were approximately $8.9 million.

 

***Foreign Currency Risk.***  The Company faces foreign currency risksprimarily as a result of its acquired Singapore and United Kingdom operationsand the intercompany balances between its U.S. and these internationaloperations.  The functional currency ofthe Company’s Singapore operations is the Singapore dollar, however, most ofthe sales of the Singapore operations and some of the expenses are denominatedin U.S. dollars.  The Company has debtand other long-term obligations of approximately $10.2 million that aredenominated in Singapore dollars and mature over the next six years.  Fluctuations in exchange rates between theU.S. dollar and the Singapore dollar could lead to additional currency exchangelosses or gains on the intercompany balances and transactions denominated incurrencies other than the functional currency. If the U.S. dollar weakens relative to the Singapore dollar, additionalfunds may be required to meet these obligations if the debt cannot beadequately serviced from the Singapore operations.  From the date of the ClearLab Internationalacquisition, July 24, 2002, through November 5, 2004 the exchange rate hasfluctuated approximately 5.5 percent (weakening of the U.S. dollar).

 

The functional currencyof the Company’s United Kingdom operations is the British pound.  Fluctuations in exchange rates between theU.S. dollar and the British pound could lead to currency exchange losses orgains on any intercompany balances and transactions denominated in currenciesother than the functional currency.  Fromthe date of the ClearLab UK acquisition, February 24, 2004, through November 5,2004, the exchange rate has fluctuated approximately 1.2 percent (strengtheningof the U.S. dollar).

 

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

 

**Item 4.                    *Controls andProcedures***

 

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

 

***(b) Changes in internal controls.***  There were no significant changes in theCompany’s internal controls or in other factors that could significantly affectthe Company’s disclosure controls and procedures subsequent to the EvaluationDate.  As a result, no corrective actionswere taken.

 

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**PART II.            OTHERINFORMATION**

 

**Item 1.                *Legal Proceedings***

 

See notes to condensed consolidated financialstatements.

 

**Item 2.                *Unregistered Sales ofEquity Securities and Use of Proceeds***

 

None.

 

**Item 3.                *Defaults upon SeniorSecurities***

 

None.

 

**Item 4.                *Submission of Matters to aVote of Security Holders***

 

None. 

 

**Item 5.                *Other Information***

 

From time to time the Company receives notices,inquiries, or other correspondence from states or other regulatory bodiescharged with overseeing the sale of contact lenses.  The Company’s practice is to review suchnotices with legal counsel to determine the appropriate response on acase-by-case basis.  It is the opinion ofmanagement, after discussion with legal counsel, that the Company is taking theappropriate steps to address the various notices received. 

 

**Item 6.                *Exhibits***

 

**(A) Exhibits**

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

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

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

 

 

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