**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC  20549**

 

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**FORM 10-Q**

 

**(Mark one)**

| **ý** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                              |
|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                                                                                                                                           |
|       | **For the quarterly  period ended September 27, 2003**                                                                                                                                                                                                                                    |
|       |                                                                                                                                                                                                                                                                                           |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                             |
|       |                                                                                                                                                                                                                                                                                           |
|       | **For the transition  period from**                    **to**                    **.** |
|       |                                                                                                                                                                                                                                                                                           |
|       | **Commission file number:  0-23633**                                                                                                                                                                                                                                                      |
|            |                                                                                                                                                                                                                                                                                                |  |

 

**1-800CONTACTS, INC.**

(Exact name of registrant as specified in itscharter)

 

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

 

Indicate by 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 thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.

ý  Yes                                  o  No

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange act).

o  Yes                                  ý  No

 

As ofNovember 4, 2003, the Registrant had 13,106,228 shares of Common Stock,par value $0.01 per share, outstanding.

 

 

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**1-800CONTACTS, INC.**

 

**INDEX**

 
| **PART I.  FINANCIAL INFORMATION** |
|-----------------------------------------|
| Item 1.                                 | Financial Statements |
|                                    | Condensed Consolidated Balance Sheets as of  December 28, 2002 and September 27, 2003 |
|                                    | Condensed Consolidated Statements of  Operations for the Quarters and Three Quarters Ended September 28, 2002  and September 27, 2003 |
|                                    | Condensed Consolidated Statements of Cash  Flows for the Three Quarters Ended September 28, 2002 and  September 27, 2003 |
|                                    | Notes to Condensed Consolidated Financial  Statements |
| Item 2.                                 | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
| Item 3.                                 | Quantitative and Qualitative Disclosures  About Market Risk |
| Item 4.                                 | Controls and Procedures |
|                                    |   |
| **PART II.  OTHER INFORMATION**    |
| Item 1.                                 | Legal Proceedings |
| Item 2.                                 | Changes in Securities and Use of  Proceeds |
| Item 3.                                 | Defaults upon Senior Securities |
| Item 4.                                 | Submission of Matters to a Vote of Security  Holders |
| Item 5.                                 | Other Information |
| Item 6.                                 | Exhibits and Reports on Form 8-K |

 

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**PARTI.   FINANCIAL INFORMATION**

 

**Item1.     *FinancialStatements***

 

**1-800 CONTACTS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands)**

**(unaudited)**

 
|                                                         |   | **December 28,  2002** |   | **September 27,  2003** |   |
|--------------------------------------------------------------|--------|-----------------------------|--------|------------------------------|--------|
| **ASSETS**                                                   |   |                        |   |                         |   |
| CURRENT ASSETS:                                              |   |                        |   |                         |   |
| Cash                                                         |   | $                           | 259    |                         | $      | 819 |   |
| Accounts receivable                                          |   | 655                         |   | 970                          |   |
| Inventories, net                                             |   | 37,785                      |   | 29,723                       |   |
| Prepaid income taxes                                         |   | 769                         |   | —                       |   |
| Deferred income taxes                                        |   | 756                         |   | 691                          |   |
| Other current assets                                         |   | 1,095                       |   | 1,183                        |   |
| Total current assets                                         |   | 41,319                      |   | 33,386                       |   |
| PROPERTY, PLANT AND EQUIPMENT, net                           |   | 12,862                      |   | 13,258                       |   |
| DEFERRED INCOME TAXES                                        |   | 365                         |   | 636                          |   |
| GOODWILL                                                     |   | —                      |   | 33,674                       |   |
| DEFINITE-LIVED INTANGIBLE ASSETS, net                        |   | 7,089                       |   | 9,966                        |   |
| OTHER ASSETS                                                 |   | 369                         |   | 888                          |   |
| Total assets                                                 |   | $                           | 62,004 |                         | $      | 91,808 |   |
|                                                         |   |                        |   |                         |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                |   |                        |   |                         |   |
| CURRENT LIABILITIES:                                         |   |                        |   |                         |   |
| Line of credit                                               |   | $                           | 5,770  |                         | $      | 2,528 |   |
| Current portion of long-term debt                            |   | 2,349                       |   | 2,856                        |   |
| Current portion of note payable to a  related party          |   | 504                         |   | 343                          |   |
| Current portion of capital lease  obligations                |   | 372                         |   | 261                          |   |
| Accounts payable                                             |   | 8,597                       |   | 8,199                        |   |
| Accrued liabilities                                          |   | 3,327                       |   | 6,280                        |   |
| Unearned revenue                                             |   | 403                         |   | 191                          |   |
| Total current liabilities                                    |   | 21,322                      |   | 20,658                       |   |
| LONG-TERM LIABILITIES:                                       |   |                        |   |                         |   |
| Long-term debt, less current portion                         |   | 15,988                      |   | 14,151                       |   |
| Note payable to a related party, less  current portion       |   | 1,377                       |   | 1,111                        |   |
| Capital lease obligations, less current  portion             |   | 250                         |   | 67                           |   |
| Liability related to contingent  consideration               |   | 5,470                       |   | —                       |   |
| Total long-term liabilities                                  |   | 23,085                      |   | 15,329                       |   |
| STOCKHOLDERS’ EQUITY:                                   |   |                        |   |                         |   |
| Common stock, 12,861 and 13,106 shares  issued, respectively |   | 129                         |   | 131                          |   |
| Additional paid-in capital                                   |   | 24,013                      |   | 42,257                       |   |
| Retained earnings                                            |   | 14,272                      |   | 13,716                       |   |
| Treasury stock at cost, 1,473 and 0 shares,  respectively    |   | (20,739                     | )      | —                       |   |
| Accumulated other comprehensive loss                         |   | (78                         | )      | (283                         | )      |
| Total stockholders’ equity                              |   | 17,597                      |   | 55,821                       |   |
| Total liabilities and stockholders’ equity              |   | $                           | 62,004 |                         | $      | 91,808 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

3

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**1-800 CONTACTS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
|                                                |   | **Quarter  Ended**           |   | **Three  Quarters Ended**    |   |
|-----------------------------------------------------|--------|------------------------------|--------|------------------------------|--------|
|                                                |   | **September 28,  2002** |   | **September 27,  2003** |   | **September 28,  2002** |   | **September 27,  2003** |   |
| NET SALES                                           |   | $                            | 44,316 |                         | $      | 48,400 |   | $ | 128,130 |   | $ | 141,416 |   |
| COST OF GOODS SOLD                                  |   | 30,659                       |   | 29,489                       |   | 89,356 |   | 88,629 |   |
| Gross profit                                        |   | 13,657                       |   | 18,911                       |   | 38,774 |   | 52,787 |   |
| SELLING, GENERAL AND  ADMINISTRATIVE EXPENSES:      |   |                         |   |                         |   |   |   |   |   |
| Advertising expense                                 |   | 3,175                        |   | 7,171                        |   | 9,784 |   | 14,551 |   |
| Legal and professional  fees                        |   | 1,044                        |   | 1,601                        |   | 3,444 |   | 4,977 |   |
| Research and development  expenses                  |   | —                       |   | 777                          |   | — |   | 2,777 |   |
| Purchased in-process research  and development      |   | 7,789                        |   | —                       |   | 7,789 |   | — |   |
| Other selling, general and  administrative expenses |   | 6,239                        |   | 9,316                        |   | 17,153 |   | 28,069 |   |
| Total selling, general and  administrative expenses |   | 18,247                       |   | 18,865                       |   | 38,170 |   | 50,374 |   |
| INCOME (LOSS) FROM  OPERATIONS                      |   | (4,590                       | )      | 46                           |   | 604 |   | 2,413 |   |
| OTHER EXPENSE, net                                  |   | (575                         | )      | (161                         | )      | (898 | ) | (984 | ) |
| INCOME (LOSS) BEFORE  PROVISION FOR INCOME TAXES    |   | (5,165                       | )      | (115                         | )      | (294 | ) | 1,429 |   |
| PROVISION FOR INCOME TAXES                          |   | (1,202                       | )      | (513                         | )      | (3,130 | ) | (1,985 | ) |
| NET LOSS                                            |   | $                            | (6,367 | )                            | $      | (628 | ) | $ | (3,424 | ) | $ | (556 | ) |
|                                                |   |                         |   |                         |   |   |   |   |   |
| PER SHARE INFORMATION:                              |   |                         |   |                         |   |   |   |   |   |
| Basic and diluted net loss  per common share        |   | $                            | (0.56  | )                            | $      | (0.05 | ) | $ | (0.30 | ) | $ | (0.04 | ) |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

4

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**1-800 CONTACTS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
|                                                                             |   | **Three  Quarters Ended**    |   |
|----------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                             |   | **September 28,  2002** |   | **September 27,  2003** |   |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                           |   |                         |   |   |   |
| Net loss                                                                         |   | $                            | (3,424 | ) | $ | (556 | ) |
| Adjustments to reconcile  net loss to net cash provided by operating activities: |   |                         |   |   |   |
| Depreciation and  amortization                                                   |   | 1,597                        |   | 4,617 |   |
| Amortization of debt  issuance costs and discounts                               |   | 34                           |   | 142 |   |
| Purchased in-process  research and development                                   |   | 7,789                        |   | — |   |
| Unrealized foreign  currency exchange loss                                       |   | 142                          |   | (46 | ) |
| (Gain) loss on sale of  property and equipment                                   |   | (2                           | )      | 7 |   |
| Stock-based compensation                                                         |   | 3                            |   | 731 |   |
| Deferred income taxes                                                            |   | 109                          |   | (206 | ) |
| Changes in operating  assets and liabilities, net of effects of acquisition:     |   |                         |   |   |   |
| Accounts receivable                                                              |   | (637                         | )      | (554 | ) |
| Inventories, net                                                                 |   | 2,526                        |   | 10,815 |   |
| Other current assets                                                             |   | 23                           |   | (242 | ) |
| Accounts payable                                                                 |   | (3,472                       | )      | (3,554 | ) |
| Accrued liabilities                                                              |   | (534                         | )      | 2,181 |   |
| Income taxes payable /  prepaid income taxes                                     |   | (440                         | )      | 1,611 |   |
| Unearned revenue                                                                 |   | (115                         | )      | (212 | ) |
| Net cash provided by  operating activities                                       |   | 3,599                        |   | 14,734 |   |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                           |   |                         |   |   |   |
| Purchase of property and  equipment                                              |   | (1,223                       | )      | (2,138 | ) |
| Proceeds from sale of  property and equipment                                    |   | 15                           |   | 33 |   |
| Purchase of intangible  assets                                                   |   | (13                          | )      | (85 | ) |
| Cash paid for acquisition                                                        |   | (6,589                       | )      | (7,012 | ) |
| Note receivable related to  acquisition                                          |   | (550                         | )      | — |   |
| Proceeds from settlement  of notes receivable related to acquisition             |   | 250                          |   | — |   |
| Deposits and other                                                               |   | (82                          | )      | (316 | ) |
| Net cash used in investing  activities                                           |   | (8,192                       | )      | (9,518 | ) |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                           |   |                         |   |   |   |
| Common stock repurchases                                                         |   | (2,213                       | )      | — |   |
| Proceeds from exercise of  common stock options                                  |   | 38                           |   | 803 |   |
| Net borrowings  (repayments) on line of credit                                   |   | (2,603                       | )      | (3,242 | ) |
| Principal payments on  capital lease obligations                                 |   | (81                          | )      | (294 | ) |
| Debt issuance costs                                                              |   | (156                         | )      | — |   |
| Proceeds from long-term  debt                                                    |   | 10,000                       |   | — |   |
| Principal payments on  long-term debt                                            |   | (14                          | )      | (1,891 | ) |
| Net cash provided by (used  in) financing activities                             |   | 4,971                        |   | (4,624 | ) |
| EFFECT OF FOREIGN EXCHANGE  RATES ON CASH                                        |   | (67                          | )      | (32 | ) |
|                                                                             |   |                         |   |   |   |
| NET INCREASE IN CASH                                                             |   | 311                          |   | 560 |   |
| CASH AT BEGINNING OF  PERIOD                                                     |   | 36                           |   | 259 |   |
| CASH AT END OF PERIOD                                                            |   | $                            | 347    |   | $ | 819 |   |
|                                                                             |   |                         |   |   |   |
| SUPPLEMENTAL CASH FLOW  INFORMATION:                                             |   |                         |   |   |   |
| Cash paid for interest                                                           |   | $                            | 655    |   | $ | 821 |   |
| Cash paid for income taxes                                                       |   | 3,462                        |   | 580 |   |

 

SUPPLEMENTALDISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:

 

Duringthe first quarter of 2003, the Company purchased certain assets and assumedcertain liabilities of Lens Express and Lens 1st.  The purchase consideration included cash of $7,012, common stockwith a fair value of $19,859 and assumed operating liabilities of $4,099 (seeNote 6).

 

Duringthe second quarter of 2003, the performance guarantee was met relating to700,000 shares of the Company’s restricted common stock held in escrow aspartial consideration for the July 2002 acquisition of ClearLab.  The Company recorded additional purchaseconsideration of approximately $16,980 for these shares.  The Company recorded this as goodwill, netof a contingent consideration liability recorded at the purchase date (see Note6).

 

Seeaccompanying notes to condensed consolidated financial statements.

 

5

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**1-800CONTACTS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

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

 

The accompanying condensed consolidated financial statements have beenprepared by the Company, without audit, pursuant to the rules and regulationsof the Securities and Exchange Commission. Certain information and disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America have been condensed or omitted pursuant to suchrules and regulations.  These condensedconsolidated financial statements reflect all adjustments (consisting only ofnormal recurring adjustments), which in the opinion of management, arenecessary to present fairly the financial position as of September 27,2003 and the results of operations and cash flows of the Company for theperiods presented.  These condensedconsolidated financial statements should be read in conjunction with the auditedfinancial statements and the notes thereto included in the Company’s AnnualReport on Form 10-K for the year ended December 28, 2002.

 

The results of operations for the fiscal 2003 interim periods are notnecessarily indicative of the results that may be expected for the fiscal yearending January 3, 2004.

 

# **NOTE2.  INVENTORIES**

 

Inventories are recorded at the lower of cost (usingthe first-in, first-out method) or market.  Inventories, net of reserves for excess and obsolete items, as ofDecember 28, 2002 and September 27, 2003 consisted of the following(in thousands):

 
|                           |   | **December 28,  2002** |   | **September 27,  2003** |   |
|--------------------------------|--------|-----------------------------|--------|------------------------------|--------|
| Purchased contact  lenses      |   | $                           | 36,571 |                         | $      | 27,698 |   |
| Manufactured  inventories:     |   |                        |   |                         |   |
| Raw materials                  |   | 109                         |   | 327                          |   |
| Work in process                |   | 210                         |   | 1,119                        |   |
| Finished goods contact  lenses |   | 895                         |   | 579                          |   |
| Total                          |   | $                           | 37,785 |                         | $      | 29,723 |   |

 

**NOTE3.  NET INCOME (LOSS) PER COMMON SHARE**

 

Basic netincome (loss) per common share (“Basic EPS”) excludes dilution and is computedby dividing net income (loss) by the weighted-average number of common sharesoutstanding 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 EPS does not assume exercise or conversion ofcommon stock equivalents that would have an antidilutive effect on net income(loss) per common share. As of September 28, 2002 and September 27,2003, options to purchase 1,150,673 and 686,852 shares of common stock,respectively, were not included in the computation of Diluted EPS because theexercise prices of the options were greater than the average market price ofthe common shares and because the Company incurred losses during the respectiveperiods.  For the quarter and threequarters ended September 27, 2003, Basic and Diluted EPS include theweighted-average impact of 700,000 shares of restricted common stock placed inescrow because the necessary performance conditions were satisfied inJune 2003 (see Note 6).

 

6

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The following is a reconciliation of the numerator and denominator usedto calculate Basic and Diluted EPS (in thousands, except per share amounts): 

 
|                     |   | **Quarter  Ended September 28, 2002** |   | **Quarter  Ended September 27, 2003** |   |
|--------------------------|--------|--------------------------------------------|--------|--------------------------------------------|--------|
|                     |   | **Net Loss**                               |   | **Shares**                                 |   | **Per-Share  Amount** |   | **Net Loss** |   | **Shares** |   | **Per-Share  Amount** |   |
|                     |   |                                       |   |                                       |   |   |   |   |   |   |   |   |   |
| Basic EPS                |   | $                                          | (6,367 | )                                          | 11,382 |   | $ | (0.56 | ) | $ | (628 | ) | 13,103 |   | $ | (0.05 | ) |
| Effect of  stock options |   |                                       |   | —                                     |   |   |   |   |   | — |   |   |   |
| Diluted EPS              |   | $                                          | (6,367 | )                                          | 11,382 |   | $ | (0.56 | ) | $ | (628 | ) | 13,103 |   | $ | (0.05 | ) |

 
|                     |   | **Three  Quarters Ended September 28, 2002** |   | **Three  Quarters Ended September 27, 2003** |   |
|--------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|
|                     |   | **Net Loss**                                      |   | **Shares**                                        |   | **Per-Share  Amount** |   | **Net Loss** |   | **Shares** |   | **Per-Share  Amount** |   |
|                     |   |                                              |   |                                              |   |   |   |   |   |   |   |   |   |
| Basic EPS                |   | $                                                 | (3,424 | )                                                 | 11,428 |   | $ | (0.30 | ) | $ | (556 | ) | 12,547 |   | $ | (0.04 | ) |
| Effect of  stock options |   |                                              |   | —                                            |   |   |   |   |   | — |   |   |   |
| Diluted EPS              |   | $                                                 | (3,424 | )                                                 | 11,428 |   | $ | (0.30 | ) | $ | (556 | ) | 12,547 |   | $ | (0.04 | ) |

 

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

 

Comprehensive income (loss) for the quarters and three quarters endedSeptember 28, 2002 and September 27, 2003 consists of the followingcomponents (in thousands):

 
|                         |   | **Quarter  Ended**             |   | **Three  Quarters Ended**    |   |
|------------------------------|--------|--------------------------------|--------|------------------------------|--------|
|                         |   | **September   28,  2002** |   | **September 27,  2003** |   | **September 28,  2002** |   | **September 27,  2003** |   |
| Net loss                     |   | $                              | (6,367 | )                            | $      | (628 | ) | $ | (3,424 | ) | $ | (556 | ) |
| Foreign currency translation |   | 87                             |   | 97                           |   | 85 |   | (205 | ) |
| Comprehensive loss           |   | $                              | (6,280 | )                            | $      | (531 | ) | $ | (3,339 | ) | $ | (761 | ) |

 

 

The foreign currency translation adjustment results primarily fromchanges in exchange rates relative to the U.S. dollar from the translation ofthe Company’s Singapore subsidiary financial statements.

 

**NOTE 5.  STOCK-BASED COMPENSATION**

 

The Company applies Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees,” and related interpretations anduses the intrinsic method of accounting for its stock option grants toemployees and directors.  Accordingly,no compensation expense has been recognized for these stock option grants.

 

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

 

7

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Ifcompensation expense for all stock options had been determined consistent withSFAS No. 123, the Company’s net loss and basic and diluted net loss per commonshare would have been as follows (in thousands, except per share amounts):

 
|                                          |   | **Quarter  Ended**                  |   |
|-----------------------------------------------|--------|-------------------------------------|--------|
|                                          |   | **September   28,  2002** |   | **September 27,  2003** |   |
| Net loss:                                     |   |                                |   |   |   |
| As reported                                   |   | $                                   | (6,367 | ) | $ | (628 | ) |
| Fair-value based compensation, net of tax     |   | (217                                | )      | (382 | ) |
| Pro forma                                     |   | $                                   | (6,584 | ) | $ | (1,010 | ) |
|                                          |   |                                |   |   |   |
| Basic and diluted net loss per common  share: |   |                                |   |   |   |
| As reported                                   |   | $                                   | (0.56  | ) | $ | (0.05 | ) |
| Pro forma                                     |   | $                                   | (0.58  | ) | $ | (0.08 | ) |

 
|                                          |   | **Three Quarters  Ended**    |   |
|-----------------------------------------------|--------|------------------------------|--------|
|                                          |   | **September 28,  2002** |   | **September 27,  2003** |   |
| Net loss:                                     |   |                         |   |   |   |
| As reported                                   |   | $                            | (3,424 | ) | $ | (556 | ) |
| Fair-value based compensation, net of tax     |   | (618                         | )      | (921 | ) |
| Pro forma                                     |   | $                            | (4,042 | ) | $ | (1,477 | ) |
|                                          |   |                         |   |   |   |
| Basic and diluted net loss per common  share: |   |                         |   |   |   |
| As reported                                   |   | $                            | (0.30  | ) | $ | (0.04 | ) |
| Pro forma                                     |   | $                            | (0.35  | ) | $ | (0.12 | ) |

 

The weighted average per share fair value of options granted during thequarters ended September 28, 2002 and September 27, 2003 was $5.25and $14.07, respectively.  For the threequarters ended September 28, 2002 and September 27, 2003, theweighted average per share fair value of options granted was $6.61 and $13.92,respectively.  The fair value of eachoption grant has been estimated on the grant date using the Black-Scholes option-pricingmodel with the following weighted average assumptions:

 
|                    |   | **Quarter  Ended**      |   | **Three  Quarters Ended** |   |
|-------------------------|--------|-------------------------|--------|---------------------------|--------|
|                    |   | **September  28, 2002** |   | **September  27, 2003**   |   | **September  28, 2002** |   | **September  27, 2003** |   |
| Risk-free interest rate |   | 4.0                     | %      | 2.7                       | %      | 4.0 | % | 2.7 | % |
| Expected dividend yield |   | 0.0                     | %      | 0.0                       | %      | 0.0 | % | 0.0 | % |
| Volatility              |   | 73.1                    | %      | 74.8                      | %      | 74.3 | % | 77.0 | % |
| Expected life           |   | 5 years                 |   | 5 years                   |   | 5 years |   | 5 years |   |

 

8

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**NOTE 6.  RECENT ACQUISITIONS**

 

***IGEL (ClearLab)***

 

On July 24, 2002, the Company completed the acquisition of certainnet assets and the majority of the business operations of IGEL, a developer andcontract manufacturer of contact lenses based in Singapore.  The acquisition was effected through awholly owned subsidiary of the Company, IGEL Acquisition Co. Pte Ltd(subsequently renamed ClearLab Pte Ltd), and included the purchase of assets ofIgel C.M. Laboratory Pte Ltd andInternational Vision Laboratories Pte Ltd, both subsidiaries of Igel Visioncare Pte Ltd, as well as certainother assets from Sinduchajana Sulistyo and Stephen D. Newman. The assetsacquired included principally thelong-term leasehold interests in the land and building where the manufacturingfacility is located, as well as equipment, inventories, and certain intellectualproperty rights, including patents key to the operation of the acquiredbusiness.  ClearLab has developed a newbrand of contact lens that is expected to provide the Company increased controlof inventory and the flexibility to make a variety of offers to its customersto enhance its capability to provide high quality, cost-effectiveproducts.  The Company accounted forthis transaction under the purchase method in accordance with SFAS No. 141.  The results of operations of ClearLab areincluded in the consolidated results of the Company from the date of theacquisition.

 

The consideration paid by the Companyconsisted of approximately $6.6 million in cash (which includes $1.2 million intransaction costs), $8.9 million in assumed building and business loans to bepaid over 7 years from the acquisition date, $0.7 million in assumed capitallease obligations, a non-interest bearing note payable of  $2.1 million to be paid over 5 years fromthe acquisition date, 700,000 shares of restricted common stock of the Company,and 270,000 common stock options of the Company in three tranches of 90,000each with exercise prices of $15, $25 and $35 per share, respectively.    The Company obtained a $10 million,five-year term loan from a U.S. bank to provide partial financing for thisasset purchase. 1-800 CONTACTS, INC. also executed guarantees for the buildingand business loans assumed in the transaction.

 

The 700,000 shares of restricted common stockwere placed in escrow, subject to a performance guarantee, and vest over atwo-year schedule with no shares released from escrow for a minimum of oneyear from the acquisition date.  OnJune 6, 2003, the performance guarantee  was met relating to these shares and 175,000 shares were released on July 24, 2003, in accordance with the vesting provisions.  The remainder of the shares held in escrowwill be released as follows:  437,500 onJanuary 24, 2004 and 87,500 on July 24, 2004 based on an onOctober 14, 2003 amendment to the escrow agreement.  For financial reporting purposes, all sharesheld in escrow are treated as outstanding as of June 6, 2003, the date theperformance guarantee was met, and the Company reflected additional purchaseconsideration for the estimated fair value of these shares of approximately$17.0 million.  The fair value was basedupon the closing market price of the Company’s common stock on the date theperformance guarantee was met, reduced by an approximate 9% discount due to therestrictions associated with the vesting period of the common stock held inescrow.  This discount was determined byan independent third party appraisal.

 

The $17.0 million of additional purchaseconsideration, net of the contingent consideration liability recorded at thepurchase date in accordance with SFAS No. 141, was recorded as goodwill.  At September 27, 2003, goodwill relatedto this transaction amounted to $11.4 million.

 

The value of the options to purchase 270,000shares of common stock will be determined and recorded as additional purchaseconsideration at the applicable vesting dates. These options vest equally at the end of the third, fourth and fifthyears from the acquisition date.

 

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

 

***Lens Express andLens 1st***

 

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

 

The consideration paid by the Company consisted of approximately$7.0 million in cash (including $0.5 million in transaction costs),900,000 shares of restricted common stock of the Company with a fair value of$19.9 million and the assumption of approximately $4.1 million of theaforementioned liabilities. The 900,000 shares of restricted common stock aresubject to a lock-up period of 12 months after the acquisition date ofJanuary 30, 2003.  In connectionwith the acquisition, the Company entered into a registration rights agreementpursuant to which the Company granted the Seller certain piggyback registrationrights with respect to the 900,000 shares of restricted common stock.  The following sets forth the considerationpaid by the Company (in thousands, except per share amounts):

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

 

For purposes of computing the purchase price, the value of the restrictedcommon stock was determined by taking the average closing price of theCompany’s common stock as quoted on NASDAQ for the two days before, the day ofand the two days following the announcement of the signing of a letter ofintent to acquire Lens Express and Lens 1st.  This average price was then reduced by a 15percent discount (as determined by a third party appraisal) due to therestriction provisions associated with the common shares issued.

 

The following table sets forth the allocation of the purchase price tothe tangible and intangible assets acquired (in thousands):

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

 

The unaudited pro forma information below sets forth summary results ofoperations as if the acquisitions of ClearLab and Lens 1st and LensExpress had taken place at the beginning of 2002, after giving effect tocertain adjustments, including amortization of intangibles, depreciation,interest expense and other adjustments directly

 

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attributable to thetransaction.  The following pro formainformation has been prepared for comparative purposes only and does not purportto be indicative of what would have occurred had the acquisitions occurred atthe beginning of fiscal 2002 or of results which may occur in the future (inthousands, except per share amounts):

 
|                                        |   | **Quarter  Ended**           |   | **Three  Quarters Ended**    |   |
|---------------------------------------------|--------|------------------------------|--------|------------------------------|--------|
|                                        |   | **September 28,  2002** |   | **September 28,  2002** |   | **September 27,  2003** |   |
|                                        |   |                         |   |                         |   |   |   |
| Net sales                                   |   | $                            | 56,369 |                         | $      | 165,649 |   | $ | 144,825 |   |
| Net loss                                    |   | (6,820                       | )      | (8,399                       | )      | (442 | ) |
| Basic and diluted net loss per common share |   | $                            | (0.56  | )                            | $      | (0.68 | ) | $ | (0.04 | ) |

 

**NOTE 7.  COMMON STOCK TRANSACTIONS**

 

During the three quarters ended September 27, 2003, employees anddirectors exercised stock options to purchase 117,744 shares of common stockfor a total of approximately $803,000. The Company recorded an increase in additional paid-in capital ofapproximately $600,000 for the income tax benefit related to these stock optionexercises.

 

During the three quarters ended September 27, 2003, the Companygranted nonqualified stock options to purchase 282,303 shares of common stockto employees and directors of the Company. The exercise prices of the options range from $18.30 to $27.50 pershare, which prices were not less than the quoted fair market values at thegrant dates. The options vest equally over a four-year period and expire infive to seven years.

 

The Company’sBoard of Directors has authorized the repurchase of up to 3,000,000 shares ofthe Company’s Common Stock.  A purchaseof the full 3,000,000 shares would equal approximately 23 percent of the totalshares issued as of September 27, 2003. The repurchase of common stock is subject to market conditions and isaccomplished through periodic purchases at prevailing prices on the openmarket, by block purchases or in privately negotiated transactions.  From inception of its authorized repurchaseprograms through September 27, 2003, the Company had repurchased 1,706,500shares for a total cost of approximately $22.1 million.  No shares were repurchased by the Companyduring the three quarters ended September 27, 2003. The repurchased shareswere retained as treasury stock to be used for corporate purposes.  As of September 27, 2003, no sharesremain in treasury given the use of such shares in connection with the ClearLaband Lens 1st/Lens Express acquisitions

 

During the three quartersended September 27, 2003, the Company issued 900,000 shares of restrictedcommon stock as a portion of the consideration for the acquisition of LensExpress and Lens 1st (see Note 6).  Ofthe 900,000 shares, 772,655 were issued from treasury stock. The 900,000 sharesof restricted common stock are subject to a lock-up period of 12 monthsafter the acquisition date of January 30, 2003.  In connection with the acquisition, the Company entered into aregistration rights agreement pursuant to which the Company granted the Sellercertain piggyback registration rights with respect to the 900,000 shares ofrestricted common stock.

 

During the quarter endedJune 28, 2003, the performance conditions were met on the 700,000 sharesof restricted common stock placed in escrow as part of the purchaseconsideration for the ClearLab acquisition. Additionally, the Company recorded compensation expense and additionalpaid-in capital of $0.7 million due to the transfer of shares owned byClearLab’s chief technology officer to key employees of ClearLab (see Note 6).

 

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On June 11, 2003,the Company’s Board of Directors approved and adopted, subject to stockholderapproval, which will sought in fiscal 2004, certain amendments to the Company’sstock option plan to provide for an increase in the number of shares of commonstock reserved for issuance under the plan from 1,240,000 to 1,590,000.

 

**NOTE 8. DEBT OBLIGATIONS**

 

EffectiveJuly 22, 2002, the Company entered into a loan agreement, providing forboth a $10 million term loan and a revolving credit facility for borrowings ofup to $20 million.  The amountsoutstanding on both the term loan and the revolving credit facility are limitedto a percentage of eligible inventory. As of the effective date, the percentage was 75% and is reduced by 1.25%each calendar quarter beginning September 30, 2002 until the percentage is50%.  The percentage as ofSeptember 27, 2003 was 70%.  Theoutstanding borrowings are secured by substantially all of the Company’s U.S.assets including a portion of the Company’s common stock ownership inClearLab.  The agreement containsvarious financial covenants including a capital expenditure limit, a minimumworking capital requirement, a leverage ratio and a minimum net incomerequirement. Also, if the Company were unable to cure a default on itsSingapore debt within 30 days of occurrence, the Company would be in default onthis debt.  As of December 28,2002, the Company was not in compliance with the minimum net income covenant orthe leverage ratio covenant.  However,the Company obtained waivers through October 3, 2004.  These waivers also established certain newfinancial covenants.  The Company was incompliance with these modified covenants and all other applicable covenants asof September 27, 2003.

 

Outstanding borrowings on the revolving credit facility bear interestat a floating rate equal to the lender’s prime interest rate plus 0.25 percent(4.25 percent at September 27, 2003) or 2.75 percent above the lender’s LIBORfor the applicable period.  As ofSeptember 27, 2003, the interest rate on the outstanding borrowings wasbased on the lender’s prime interest rate plus 0.25 percent.  Interest is payable monthly. The creditfacility also includes an unused credit fee equal to one-eighth of one percent,payable quarterly.  As ofSeptember 27, 2003, the remaining availability on the credit facility was$8.2 million. The credit facility was scheduled to expire on April 30,2003; however, the Company obtained an extension of the maturity date toJanuary 2, 2004.  The Company is inthe process of renewing the credit facility. The Company expects that the credit facility will be renewed prior tothe expiration of the extension; however, there can be no assurance that the facilitywill be renewed with similar terms.

 

As of September 27, 2003, the U.S. bank term loan interest ratewas fixed at the 180-day LIBOR rate plus 3% (4.14% at September 27, 2003)until December 3, 2003.

 

The Company’s Singapore bank term loan contains various financialcovenants including minimums on net worth and shareholders’ funds.  As of September 27, 2003, the Companywas in compliance with all applicable covenants.

 

Cross default clauses exist such that if the Company were in default onits U.S. debt, the Company 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.

** **

**NOTE9.  LEGAL MATTERS**

 

OnApril 7, 1999, the Kansas Board of Examiners in Optometry (“KBEO”)commenced a civil action against the Company. The action was filed in the District Court of Shawnee County, Kansas,Division 6.  The complaint was amendedon May 28, 1999.  The amendedcomplaint alleges that “on one or more occasions” the Company sold contactlenses in the state of Kansas without receipt of a prescription.  The amended complaint seeks an orderenjoining the Company from further engaging in the alleged activity.  The amended complaint does not seek monetarydamages.  The Company filed an answer tothe amended complaint and, at the request of the Court, filed a motion forsummary judgment.  InNovember 2000, the Court issued an order denying the summary judgmentmotion, finding that there were factual issues regarding whether the KBEO canmeet the requirements necessary to obtain injunctive relief, and whether theKansas law violates the Commerce Clause of the United States Constitution. OnJune 18, 2002, the court granted a summary judgment motion in favor of theKBEO.  However, the court made nofindings of any violations of Kansas law. Further, the court based its decision on a Kansas optometry law that has

 

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been repealed and amended bythe Kansas legislature.  To preserve theissues for appeal, on July 2, 2002, the Company filed a motion to alter oramend judgment, asking the court to reverse its decision, and to enter summaryjudgment in favor of defendant, or to dismiss the KBEO’s lawsuit as moot basedon the new law. The court denied the motion on September 12, 2002, findingthat no new evidence had been presented to persuade the court to change itsprior ruling.  The court made no newfindings of fact and did not change its conclusions of law.  On October 11, 2002, the Company filedits Notice of Appeal with the Kansas Court of Appeals; the Docketing Statementwas filed on October 30, 2002.  Allpleadings in this appeal have been filed and oral argument was held onAugust 27, 2003.  The Kansas Courtof Appeals should render a decision within the next few weeks.

 

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

 

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

 

**NOTE 10. COMMITMENTS AND CONTINGENCIES**

 

***Letterof Intent****.*  On March 13, 2003, the Company signed aletter of intent with a developer and manufacturer of contact lenses, andcertain of its shareholders.  TheCompany agreed to pay the developer and manufacturer of contact lenses 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, $700,000 was paid onMarch 14, 2003, and the remaining $800,000 was paid on June 13,2003.  Because the Company wascontractually committed to the payments, the monies were designated forresearch and development activities, and the contact lens developer had nosubstantive operations, the entire amount of these payments was expensed asresearch and development in March 2003. In the event that the contact lens technologies are successfullycommercialized, the Company will have the right to acquire contact lensproducts based on the developed technologies on terms no less favorable thanthose granted or available to any other customer, licensee or other thirdparty.  In addition, the Company wasgranted a six-month option to either: (1) acquire all of the shares of commonstock of the entity; or, (2) acquire from the entity a worldwide license tomanufacture, market, sell or otherwise use or exploit specific technologydeveloped by the entity.  Asconsideration for this option, the Company paid $100,000 to the entity onMarch 14, 2003, which was also expensed as research and development.  In the event that the Company did notexercise the option to purchase the shares of the entity, the Company agreed topay the entity an additional $800,000. The Company also reimbursed the entity and its shareholders $161,000 forlegal and financial expenses incurred by the entity in connection with theagreement.

 

On September 12, 2003, the Company exercised the option to acquireall of the shares of common stock of the entity.  The acquisition of the shares is expected to close within 120days following September 12, 2003. As consideration for the shares, the Company will pay approximately $3.2million in cash and $3.2 million in shares of the Company’s common stock, buthas the option to pay the entire purchase price in cash.  In addition, the Company has agreed to pay,for ten years, a per unit royalty to the shareholders of the entity.  During the period between September 12,2003 and the closing of the acquisition, the Company will continue to pay certainfees and expenses of the entity related to the entity’s research anddevelopment activities.   The Companypaid $500,000 to the entity on September 15, 2003 for such research anddevelopment activities.

 

In connection with the agreement, and the transactions discussed above,the Company has expensed a total of approximately $2.3 million fromMarch 13, 2003 through September 27, 2003 (inclusive of the $161,000in costs) related to these research and development initiatives.

 

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***AdvertisingCommitments***

 

As of September 27, 2003, the Company had entered into certainnoncancelable commitments with various advertising companies that will requirethe Company to pay approximately $2.8 million during the remainder of fiscal2003 and $15 million in fiscal 2004.

 

**NOTE 11. SEGMENT INFORMATION**

 

As a result of the acquisition of IGEL (ClearLab), beginning in thethird quarter of fiscal 2002, the Company has two operating segments.  These operating segments representcomponents of the Company for which separate financial information is availableand evaluated regularly by management in determining resource allocation andperformance assessment.  The Company’sU.S. segment includes the operations of 1-800 CONTACTS and the operations fromthe Lens Express and Lens 1st acquisitions.  The Company’s Singapore segment includes theoperations of ClearLab, a developer and contract manufacturer of contactlenses.  Operating segment informationfor the quarter and three quarters ended September 28, 2002 andSeptember 27, 2003 are as follows (in thousands):

 
|                                 |   | **Quarter  Ended September 28, 2002**        |    | **Quarter  Ended September 27, 2003**        |   |
|--------------------------------------|--------|---------------------------------------------------|---------|---------------------------------------------------|--------|
|                                 |   | **U.S.**                                          |    | **Singapore**                                     |   | **Total** |   | **U.S.** |   | **Singapore** |   | **Total** |   |
| Net sales                            |   | $                                                 | 43,401  |                                              | $      | 915 |   | $ | 44,316 |   | $ | 46,923 |   | $ | 1,477 |   | $ | 48,400 |   |
| Gross profit                         |   | 13,445                                            |    | 212                                               |   | 13,657 |   | 18,191 |   | 720 |   | 18,911 |   |
| Income (loss)  from  operations |   | 3,305                                             |    | (7,895                                            | )      | (4,590 | ) | 322 |   | (276 | ) | 46 |   |
|                                 |   |                                              |    |                                              |   |   |   |   |   |   |   |   |   |
|                                 |   | **Three  Quarters Ended September 28, 2002** |    | **Three  Quarters Ended September 27, 2003** |   |
|                                 |   | **U.S.**                                          |    | **Singapore**                                     |   | **Total** |   | **U.S.** |   | **Singapore** |   | **Total** |   |
| Net sales                            |   | $                                                 | 127,215 |                                              | $      | 915 |   | $ | 128,130 |   | $ | 136,755 |   | $ | 4,661 |   | $ | 141,416 |   |
| Gross profit                         |   | 38,562                                            |    | 212                                               |   | 38,774 |   | 50,984 |   | 1,803 |   | 52,787 |   |
| Income (loss)  from  operations |   | 8,499                                             |    | (7,895                                            | )      | 604 |   | 3,988 |   | (1,575 | ) | 2,413 |   |

 

Identifiable segment assets as of September 27, 2003 are asfollows (in thousands):

 
|                   |   | **U.S.** |   | **Singapore** |   | **Total** |   |
|------------------------|--------|----------|--------|---------------|--------|-----------|--------|
| Long-lived assets, net |   | $        | 31,539 |          | $      | 25,359    |   | $ | 56,898 |   |
| Total assets           |   | 62,234   |   | 29,574        |   | 91,808    |   |
|                        |        |          |        |               |        |           |        |  |  |  |

 

**NOTE 13. RELATED PARTY TRANSACTIONS**

 

During the three fiscal quarters ended September 27, 2003, theCompany incurred combined expenses of approximately $690,000 to legal firms inwhich members of the Company’s Board of Directors are partners.  These fees represent the total amountincurred subsequent to the individuals joining the Company’s Board ofDirectors.

 

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

 

**Overview**

 

The Company isa leading direct marketer of replacement contact lenses and also conductscontact lens manufacturing and development operations in Singapore.  The Company sells all of the popular brandsof contacts lenses, including those manufactured by Johnson & JohnsonVision Care, CIBA Vision, Bausch & Lomb, Ocular Sciences and CooperVision.The Company was formed in February 1995 and is the successor to the mailorder business founded by the Company’s Vice President of Trade Relations inMarch 1991.

 

***IGEL (ClearLab).***** **On July 24, 2002, the Companycompleted the acquisition of certain net assets and the majority of thebusiness operations of IGEL, a developer and contract manufacturer of contactlenses based in Singapore.  Theacquisition was effected through a wholly owned subsidiary of the Company, IGELAcquisition Co. Pte Ltd (subsequently renamed ClearLab Pte Ltd).  The results of operations of ClearLab areincluded in the consolidated results of the Company from the date of theacquisition.

 

ClearLab currently manufactures injection cast molded soft contactslenses on a contract basis for various contact lens manufacturers.  ClearLab also manufactures and distributesbranded and private label contact lenses via distributors and other saleschannels.  ClearLab currently has thecapacity to produce in excess of 40 million lenses annually, which is enough toservice approximately one million two-week disposable contact lenswearers.  ClearLab has developed a newbrand of contact lens that is expected to provide the Company increased controlof inventory and the flexibility to make a variety of offers to its customersto enhance its capability to provide high quality, cost-effective products.

 

The Companyexpects to begin marketing lenses made by ClearLab to its customers in selecttest markets during the fourth quarter of fiscal 2003 and expects to marketthese lenses nationally to its customers during 2004.  Based on previous conducted test marketing, the Company believesthat its customers are receptive to an offer from the Company to try both a newproduct and a new eye care practitioner.  The Company believesthat a more active role in theproduct/provider decision may help it address the policies of certainmanufacturers that continue to refuse to sell their brands to the Company andseek to sell their brands exclusively to eyecare practitioners.  TheCompany’s first preference is to sell the customer the lens she is alreadywearing.  In cases where manufacturersor eye care practitioners stand in the way of the customer’s choice to purchasefrom the Company, the Company will be able to offer the customer theopportunity to try an alternative eye care provider and an alternative product.

 

***Johnson &Johnson Vision Care Agreement.***  In December 2002, the Company announcedthat it had reached an agreement with Johnson & Johnson Vision Care, tobecome an authorized retailer of Johnson & Johnson Vision Care contactlenses.  The Company has modified itsoperating systems in connection with this agreement. The Company implementednew procedures for Johnson & Johnson Vision Care by geographic region basedon time zone.  The Company began thisimplementation in February 2003 and completed it in April 2003. TheCompany began buying direct from Johnson & Johnson Vision Care duringMarch 2003.

 

This direct relationship with Johnson & Johnson Vision Care haslowered the Company’s product acquisition costs and allowed it to offer rebatesand other incentives not previously available to its customers who wear Johnson& Johnson Vision Care lenses. The Company has also been able to reduce itsinventory investment by purchasing a more balanced mix of products at lowerprices than it has historically been able to obtain through indirect sources.This agreement also resolves long-standing disputes.

 

Net sales for the first three quarters of fiscal 2003 were negativelyimpacted by canceled orders due to prescription verification proceduresincluding most significantly those implemented as part of the Johnson &Johnson Vision Care agreement.  TheCompany is taking steps to recover these canceled orders, including creating adoctor network through the Cole agreement (discussed below) and establishing adoctor network department to help customers schedule eye exams in order toobtain prescriptions.  The Company isuncertain of the ultimate impact these prescription verification procedureswill have on future net sales.

 

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

 

The considerationpaid by the Company consisted of approximately $7.0 million in cash(including $0.5 million in transaction costs), 900,000 shares of restrictedCommon Stock of the Company with a fair value of $19.9 million and theassumption of approximately $4.1 million of the aforementioned liabilities. The900,000 shares of restricted Common Stock are subject to a lock-up period of12 months after the acquisition date of January 30, 2003. Inconnection with the acquisition, the Company entered into a registration rightsagreement granting the Seller certain piggyback registration rights withrespect to the 900,000 shares of restricted Common Stock.  The Company funded the cash considerationportion of the asset purchase from its revolving credit facility.

 

***Letter of Intent****.* On March 13, 2003, the Company signed a letter of intent with adeveloper and manufacturer of contact lenses, and certain of itsshareholders.  The Company agreed to paythe developer and manufacturer of contact lenses a non-refundable sum equal to$1.5 million to be used by the entity for research and development activitiesrelating to contact lenses.  Of thetotal, $700,000 was paid on March 14, 2003, and the remaining $800,000 waspaid on June 13, 2003.  Because theCompany was contractually committed to the payments, the monies were designatedfor research and development activities and the contact lens developer had nosubstantive operations, the entire amount of these payments was expensed asresearch and development in March 2003. In the event that the contact lens technologies are successfullycommercialized, the Company will have the right to acquire contact lensproducts based on the developed technologies on terms no less favorable thanthose granted or available to any other customer, licensee or other thirdparty.  In addition, the Company wasgranted a six-month option to either: (1) acquire all of the shares of commonstock of the entity; or, (2) acquire from the entity a worldwide license tomanufacture, market, sell or otherwise use or exploit specific technologydeveloped by the entity.  Asconsideration for this option, the Company paid $100,000 to the entity onMarch 14, 2003, which was also expensed as research and development.  In the event that the Company did notexercise the option to purchase the shares of the entity, the Company agreed topay the entity an additional $800,000 at the end of the option period. TheCompany also reimbursed the entity and its shareholders $161,000 for legal andfinancial expenses incurred by the entity in connection with the agreement.

 

On September 12,2003, the Company exercised the option to acquire all of the shares of commonstock of the entity.  The acquisition ofthe shares is expected to close within 120 days following September 12,2003.  As consideration for the shares,the Company will pay approximately $3.2 million in cash and $3.2 million inshares of the Company’s common stock, but has the option to pay the entirepurchase price in cash.  In addition,the Company has agreed to pay, for ten years, a per unit royalty to theshareholders of the entity.  During theperiod between September 12, 2003 and the closing of the acquisition, theCompany will continue to pay certain fees and expenses of the entity related tothe entity’s research and development activities.   The Company paid $500,000 to the entity on September 15,2003 for such research and development activities.

 

In connection with the agreement, and the transactions discussed above,the Company has expensed a total of approximately $2.3 million fromMarch 13, 2003 through September 27, 2003 (inclusive of the $161,000in costs) related to these research and development initiatives.  The Company funded these payments from itsrevolving credit facility and cash generated from operating activities.

 

***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

 

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Vision, Pearle VisionCare,Sears Optical and Target Optical stores in the U.S.  Cole will offer its network of doctors for at least oneyear.  The Company will retain the contactlens business of customers referred to Cole stores.

 

As part of the agreement, the Company and Cole are also workingtogether on a variety of cross-marketing programs and promotions of theirrespective products in select test markets. The goal of these cross-marketing programs is to find other ways thatthe Company and Cole can help create value together.

 

# **RegulatoryConsiderations**

 

The sale anddelivery of contact lenses are governed by both federal and state laws andregulations.  The Company sells tocustomers in all 50 states, and each sale is likely to be subject to the lawsof the state where the customer is located. In some states, the Company operates according to agreements it hasentered into with local regulatory authorities or medical boards or agencies.The Company’s current general operating practice is to obtain a copy of thecustomer’s prescription or to passively verify each customer’s prescriptionwith his/her eye care practitioner.  Ifthe customer does not have a copy of his/her prescription, the Company asks thecustomer for his/her exact prescription specifications and then directlycontacts the customer’s eye care practitioner to passively verify thecustomer’s prescription.  The Companydirectly communicates to the eye care practitioner the prescription specificationsreceived from the customer and informs the eye care practitioner that it willproceed to complete the sale based on such information unless the eye carepractitioner advises it that such information is expired or incorrect.  If the eye care practitioner does not advisethe Company that such information is expired or incorrect within a minimumperiod, the Company’s general practice is to complete the sale and ship thelenses based on the information communicated to the eye care practitioner.  If the Company is unable to obtain a copy ofthe customer’s prescription or passively verify the prescription with thecustomer’s eye care practitioner, the Company’s policy is not to proceed withthe sale.  The Company retains copies ofthe written prescriptions that it receives and maintains records of itscommunications with the customer’s prescriber.

 

The Company has modifiedits operating systems to give eye care practitioners a minimum of eightbusiness hours to respond to its prescription verification requests for Johnson& Johnson Vision Care products.  Eyecare practitioners have the option of receiving these requests by fax. If theeye care practitioner notifies the Company within this time period that thecustomer’s prescription is expired or otherwise invalid, the Company will notship the order. Absent such notification from the eye care practitioner, theCompany will proceed with the sale based on the prescription that wascommunicated to the eye care practitioner. This system applies to Johnson &Johnson Vision Care orders nationwide with the exception of a few states wherethe Company has pre-existing agreements to employ more stringent procedures.

 

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**Results of Operations**

 

The Company’s fiscal year consists of a 52/53-week period ending on theSaturday nearest to December 31. Fiscal 2003 is a 53-week year and willend on January 3, 2004.  The fourthquarter of fiscal 2003 will consist of 14 weeks.

 

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

 
|                                                |   | **Quarter Ended**        |   | **Three Quarters Ended** |   |
|-----------------------------------------------------|--------|--------------------------|--------|--------------------------|--------|
|                                                |   | **September  28,  2002** |   | **September  27,  2003** |   | **September  28,  2002** |   | **September  27,  2003** |   |
| NET SALES                                           |   | 100.0                    | %      | 100.0                    | %      | 100.0 | % | 100.0 | % |
| COST OF GOODS SOLD                                  |   | 69.2                     |   | 60.9                     |   | 69.7 |   | 62.7 |   |
| Gross profit                                        |   | 30.8                     |   | 39.1                     |   | 30.3 |   | 37.3 |   |
| SELLING, GENERAL AND ADMINISTRATIVE  EXPENSES:      |   |                     |   |                     |   |   |   |   |   |
| Advertising expense                                 |   | 7.2                      |   | 14.8                     |   | 7.6 |   | 10.3 |   |
| Legal and professional fees                         |   | 2.3                      |   | 3.3                      |   | 2.7 |   | 3.5 |   |
| Research and development expenses                   |   | —                   |   | 1.6                      |   | — |   | 2.0 |   |
| Purchased in-process research and  development      |   | 17.6                     |   | —                   |   | 6.1 |   | — |   |
| Other selling, general and administrative  expenses |   | 14.1                     |   | 19.3                     |   | 13.4 |   | 19.8 |   |
| Total selling, general and administrative  expenses |   | 41.2                     |   | 39.0                     |   | 29.8 |   | 35.6 |   |
| INCOME (LOSS) FROM OPERATIONS                       |   | (10.4                    | )      | 0.1                      |   | 0.5 |   | 1.7 |   |
| OTHER EXPENSE, net                                  |   | (1.3                     | )      | (0.3                     | )      | (0.7 | ) | (0.7 | ) |
| INCOME (LOSS) BEFORE PROVISION FOR INCOME  TAXES    |   | (11.7                    | )      | (0.2                     | )      | (0.2 | ) | 1.0 |   |
| PROVISION FOR INCOME TAXES                          |   | (2.7                     | )      | (1.1                     | )      | (2.5 | ) | (1.4 | ) |
| NET LOSS                                            |   | (14.4                    | )%     | (1.3                     | )%     | (2.7 | )% | (0.4 | )% |

 

***Net sales***.  Net sales for the quarter endedSeptember 27, 2003 increased 9.2% to $48.4 million from $44.3 million forthe quarter ended September 28, 2002. For the three quarters ended September 27, 2003, net salesincreased 10.4% to $141.4 million from $128.1 million for the three quartersended September 28, 2002.  Netsales (excluding ClearLab) for the third quarter and the first three quartersof fiscal 2003 were $46.9 million and $136.8 million, respectively.  For the third quarter and first threequarters of fiscal 2002, net sales (excluding ClearLab) were $43.4 million and$127.2 million, respectively. The increase in net sales is mainly due to theacquisition of Lens Express and Lens 1st on January 30, 2003,although the Company has realized fewer incremental sales from customers ofthese operations than it had originally expected. Also, the increase in netsales is partially due to an increase in advertising.

 

Net sales for the first three quarters of fiscal 2003 were negativelyimpacted by canceled orders due to prescription verification proceduresimplemented as part of the Johnson & Johnson Vision Care agreement and inresponse to changes in some state laws. The Company is taking steps to recover these canceled orders, includingdevelopment of a doctor network through the Cole agreement and establishing adoctor network department to help customers schedule eye exams in order toobtain prescriptions.  The Company isuncertain of the ultimate impact these prescription verification procedureswill have on future net sales.

 

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The Company plans to spend about $6 million on advertising during thefourth quarter of fiscal 2003, including a variety of cross-marketing programsand promotions with Cole in select test markets.

 

On August 1, 2003, the Company lowered its retail prices to itscustomers on Johnson & Johnson Vision Care products.  The Company had increased its retail priceson select Johnson & Johnson Vision Care products during December 2001and has now lowered the prices to levels similar to those prior to theDecember 2001 increase.  During thethird quarter of fiscal 2003, Johnson & Johnson Vision Care productsaccounted for approximately 40% of the Company’s net sales.

 

***Gross profit.***  Gross profit as a percentage of net salesincreased to 39.1% for the quarter ended September 27, 2003 from 30.8% forthe quarter ended September 28, 2002. For the three quarters ended September 27, 2003, gross profit as apercentage of net sales increased to 37.3% from 30.3% for the three quartersended September 28, 2002.  Duringthe first three quarters of fiscal 2003, the Company realized the expectedbenefits of a decrease in wholesale prices paid for Johnson & JohnsonVision Care products, partially offset by the lowering of the retail price toits customers on Johnson & Johnson Vision Care products as mentioned above.

 

The Company expects gross profit as a percentage of net sales for thefourth quarter of 2003 to remain at about the same level as achieved during thethird quarter of fiscal 2003.  TheCompany anticipates higher gross profit margins during 2004 as a result ofimproved pricing from vendors.

 

***Advertisingexpense. ***Advertisingexpense for the quarter ended September 27, 2003 increased $4.0 million,or 125.9%, from the quarter ended September 28, 2002.  As a percentage of net sales, advertisingexpense increased to 14.8% for the third quarter of fiscal 2003 from 7.2% forthe third quarter of fiscal 2002.  Forthe three quarters ended September 27, 2003, advertising expense increased$4.8 million, or 48.7% from the three quarters ended September 28,2002.  As a percentage of net sales,advertising expense increased from 7.6% for the first three quarters of fiscal2002 to10.3% for the first three quarters of fiscal 2003.  Advertising spending for the fourth quarterof fiscal 2003 is expected to be about $6 million.  However, if opportunities present themselves, the Company mayincrease advertising spending above currently planned levels.  The Company’s experience has been thatincreases in advertising expenditures have a direct impact on the growth of netsales not only in the current period but also in future periods.

 

The Company expenses all advertising costs when the advertising firsttakes place.  As a result,quarter-to-quarter comparisons are impacted within and between quarters by thetiming of television, radio and Internet advertisements and by the mailing ofthe Company’s printed advertisements. The volume of mailings and otheradvertising may vary in different quarters and from year to year depending onthe Company’s assessment of prevailing market opportunities.

 

***Legal andprofessional fees.***  Legal and professional fees for the quarter ended September 27,2003 increased $0.6 million, or 53.4%, from the quarter endedSeptember 28, 2002.  As apercentage of net sales, legal and professional fees increased to 3.3% for thethird quarter of fiscal 2003 from 2.3% for the third quarter of fiscal2002.  For the three quarters endedSeptember 27, 2003, legal and professional fees increased $1.5 million, or44.5%, from the three quarters ended September 28, 2002.  As a percentage of net sales, legal andprofessional fees increased to 3.5% for the first three quarters of fiscal 2003from 2.7% for the first three quarters of fiscal 2002.  During the first three quarters of fiscal2003, the Company incurred significant legal and professional fees related toits legal matters and its increased efforts, including significant lobbyingactivities, to overcome the anticompetitive barriers in the industry on behalfof itself and consumers to improve consumers’ choice and access toprescriptions.  The Company expects tocontinue to incur significant legal and professional fees as it continues thisproactive approach until these anticompetitive barriers are eliminated.

 

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***Research anddevelopment expenses.***  Research and development expenses for the quarter endedSeptember 27, 2003 were $0.8 million, or 1.6% of net sales.  For the three quarters endedSeptember 27, 2003, research and development expenses were $2.8 million,or 2.0% of net sales.  The Company didnot have any research and development expenses in the first three quarters offiscal 2002.  The majority of thisamount relates to outsourced research and development activities with adeveloper and manufacturer of contact lenses.  During the third fiscal quarter of 2003, the Company exercised an optionto acquire all of the shares of common stock of the developer and manufacturerof contact lenses.  The acquisition ofthe shares is expected to close within 120 days following September 12,2003.  During the period betweenSeptember 12, 2003 and the closing of the acquisition, the Company willcontinue to pay certain fees and expenses of the entity related to the entity’sresearch and development activities.

 

***Other selling,general and administrative expenses.***  Other selling, general and administrativeexpenses for the quarter ended September 27, 2003 increased $3.1 million,or 49.3%, from the quarter ended September 28, 2002.  As a percentage of net sales, other selling,general and administrative expenses increased to 19.3% for the third quarter offiscal 2003 from 14.1% for the third quarter of fiscal 2002.  ClearLab accounted for about $0.4 million ofthe increase for the third quarter of fiscal 2003.    The Company also incurred approximately $0.5 million inincremental amortization related to the acquired Lens Express and Lens 1stcustomer database definite-lived intangible assets and $0.4 million relating toongoing operations of facilities acquired from Lens 1st.  The Company’s employee costs for its mainU.S. operations increased by approximately $1.3 million due to increasing salesand the enhancement of its management and administrative team to meet thecurrent and future demands of the business. The Company’s other operating expenses increased due to the increasedlevel of business activity.

 

For the three quarters ended September 27, 2003, other selling,general and administrative expenses increased $10.9 million, or 63.6%, from thethree quarters ended September 28, 2002. As a percentage of net sales, other selling, general and administrativeexpenses increased to 19.8% for the first three quarters of fiscal 2003 from13.4% for the first three quarters of fiscal 2002.  ClearLab accounted for about $2.5 million of the increase for thefirst three quarters of fiscal 2003. ClearLab’s results include non-cash compensation expense ofapproximately $0.7 million relating to the grant of shares of 1-800 CONTACTS’common stock owned by ClearLab’s chief technology officer to key employees ofClearLab.  The Company also incurred approximately$0.3 million in integration costs related to the acquisition of Lens Expressand Lens 1st, $1.3 million in incremental amortization related tothe acquired Lens Express and Lens 1st customer databasedefinite-lived intangible assets and $1.3 million relating to operations offacilities acquired from Lens 1st. The Company incurredapproximately $0.2 million related to a former executive officer’s severanceagreement and approximately $0.3 in recruiting expenses due to executivemanagement searches.  The Company’semployee costs for its main U.S. operations increased by approximately $3.1million due to increasing sales and the enhancement of its management andadministrative team to meet the current and future demands of the business. TheCompany’s other operating expenses increased due to the increased level ofbusiness activity.

 

***Other expense, net.***  Other expense was approximately $0.2 millionand $1.0 million for the quarter and three quarters ended September 27,2003, respectively, compared to approximately $0.6 million and $0.9 million forthe quarter and three quarters ended September 28, 2002,respectively.  The decrease in otherexpense for the third quarter of fiscal 2003 from the third quarter of fiscal2002 is mainly due to lower interest expense resulting from decreased use ofthe revolving credit facility during the third quarter of 2003.  For the first three quarters of fiscal 2003and 2002, other expense consisted mainly of interest expense, resulting fromuse of the revolving credit facility and debt related to the acquisition ofIGEL.  In addition, during the firstthree quarters of fiscal 2003, the Company recorded a foreign exchange gain,relating primarily to an intercompany loan to ClearLab, of approximately $0.1million compared to a $(0.1) million foreign exchange loss during the firstthree quarters of fiscal 2002.

 

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***Income taxes. ***For the threequarters ended September 27, 2003, the Company recorded an effectiveincome tax rate (excluding ClearLab) of 51.9% compared to 39.5% for the threequarters ended September 28, 2002. The Company records quarterly income taxes at the effective tax rateexpected for the year.  The increase inthe effective income tax rate results from the estimated annual increase innondeductible expenses, including those relating to the Company’s lobbyingefforts, in relation to the estimated pre tax income.  ClearLab is taxed separately in its tax jurisdiction ofSingapore.  During the first threequarters of fiscal 2003, the Company did not record a tax benefit for the lossfrom ClearLab’s operations due to the uncertainty with respect to therealization of a tax benefit in Singapore. As of September 27, 2003, the Company provided a valuation allowancefor the full amount of the deferred income tax assets in Singapore.    The Company anticipates that its fiscal2003 effective income tax rate will be approximately 52.0% for its U.S.operations and that no tax benefit will be recorded for ClearLab’s operations.  If future changes cause actual results forthe year to be more or less favorable than those expected, adjustments to theeffective income tax rate could be required.

 

**Liquidityand Capital Resources**

 

***Operatingactivities.*** For the three quarters ended September 27, 2003 andSeptember 28, 2002, net cash provided by operating activities wasapproximately $14.7 million and $3.6 million, respectively.  In the fiscal 2003 period, cash was providedprimarily by a decrease in inventories partially offset by a decrease inaccounts payable.  In the fiscal 2002period, cash was provided primarily by net income from the U.S. Operations anda decrease in inventories partially offset by decreases in accounts payable andaccruals and the build up of accounts receivable in ClearLab.  Historically, the Company has maintainedhigher levels of inventory to ensure a sufficient supply of products than wouldbe required if the Company were able to purchase directly from all contact lensmanufacturers.  The Company anticipatesfurther reductions in inventory in subsequent quarters as it continuesnegotiations with its suppliers.

 

***Investingactivities.*** The Company used approximately $9.5 million and $8.2 million forinvesting activities in the three quarters ended September 27, 2003 andSeptember 28, 2002, respectively. In the fiscal 2003 period, the Company paid approximately$7.0 million in cash (including $0.5 million in transaction costs) inconnection with the acquisition of Lens Express and Lens 1st.  The remaining consideration consisted of900,000 shares of restricted Common Stock of the Company and the assumption ofapproximately $4.1 million of current liabilities. In the fiscal 2002 period,the Company completed the acquisition of certain net assets and the majority ofthe business operations of IGEL.  Theconsideration paid by the Company consisted of approximately $6.6 million incash (which includes $1.2 million in transactions costs), $8.9 million inassumed building and business loans, $0.7 million in assumed capital leaseobligations, a non-interest bearing note payable of $2.1 million, 700,000shares of restricted common stock of the Company and 270,000 common stockoptions of the Company.

 

Capital expenditures for infrastructure improvements for the threequarters ended September 27, 2003 and September 28, 2002 wereapproximately $2.1 million and $1.2 million, respectively.  Of the fiscal 2003 amount, approximately$1.2 million related to the Singapore operations.  The Company anticipates additional capital expenditures in fiscal2003 for infrastructure as it continues to expand and improve operatingfacilities, telecommunications systems and management information systems inorder to handle future operations of both its U.S. and Singapore operations.

 

***Financingactivities.*** During the three quarters ended September 27, 2003 andSeptember 28, 2002, net cash (used in) provided by financing activitieswas approximately $(4.6) million and $5.0 million, respectively.  During the fiscal 2003 period, the Companyhad net repayments on its credit facility of approximately $3.2 million andmade principal payments on debt obligations and capital lease obligations ofapproximately $1.9 million, which were partially offset by proceeds of $0.8million from the exercise of common stock options.   During the fiscal 2002 period, the Company repurchased 200,000shares of its common stock for a total cost of approximately $2.2 million andmade net repayments on its credit facility of approximately $2.6 million.  The Company also obtained a $10 million termloan from its current lender to provide partial financing of its acquisition ofIGEL and made minor payments on the capital lease and debt obligations assumedin the acquisition.

 

The Company’sBoard of Directors has authorized the repurchase of up to 3,000,000 shares ofthe Company’s Common Stock.  A purchaseof the full 3,000,000 shares would equal approximately 23 percent of the

 

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total sharesissued as of September 27, 2003. The repurchase of common stock is subject to market conditions and isaccomplished through periodic purchases at prevailing prices on the openmarket, by block purchases or in privately negotiated transactions   From inception of its authorized repurchaseprograms through September 27, 2003, the Company had repurchased 1,706,500shares for a total cost of approximately $22.1 million.  No shares were repurchased by the Companyduring the three quarters ended September 27, 2003.  The repurchased shares were retained astreasury stock to be used for corporate purposes.  As of September 27, 2003, no shares remain in treasury giventhe use of such shares in connection with the ClearLab and Lens 1st/LensExpress acquisitions.

 

EffectiveJuly 22, 2002, the Company entered into a loan agreement with a U.S. bank,providing for both a $10 million term loan and a revolving credit facility forborrowings up to $20 million.  Theamounts outstanding on both the term loan and the revolving credit facility arelimited to a percentage of eligible inventory. As of the effective date, the percentage was 75% and is reduced by 1.25%each calendar quarter beginning September 30, 2002 until the percentage is50%.  The percentage as ofSeptember 27, 2003 was 70%.  Theoutstanding borrowings are secured by substantially all of the Company’s U.S.assets including a portion of the Company’s common stock ownership inClearLab.  The agreement containsvarious financial covenants including a capital expenditure limit, a minimumworking capital requirement, a leverage ratio and a minimum net incomerequirement. Also, if the Company were unable to cure a default on itsSingapore debt within 30 days of occurrence, the Company would be in default onthis debt.  As of December 28,2002, the Company was not in compliance with the minimum net income covenant orthe leverage ratio covenant.  However,the Company obtained waivers through October 3, 2004.  These waivers also established certain newfinancial covenants.  The Company was incompliance with these modified covenants and all other applicable covenants asof September 27, 2003.

 

The U.S. bank termloan bears interest at a floating rate equal to the bank’s prime interest rateplus 0.50 percent or 3.0 percent above the bank’s LIBOR for the applicableperiod.  As of September 27, 2003,the U.S. bank term loan interest rate was fixed at the 180-day LIBOR rate plus3% (4.14% at September 27, 2003) until December 3, 2003. Interest ispayable monthly.  Principal payments aredue quarterly until maturity on June 30, 2007.  As of September 27, 2003, the Company’s outstanding balanceon the term loan was approximately $8.2 million.

 

Outstandingborrowings on the revolving credit facility bear interest at a floating rateequal to the lender’s prime interest rate plus 0.25 percent (4.25 percent atSeptember 27, 2003) or 2.75 percent above the lender’s LIBOR for theapplicable period.  As ofSeptember 27, 2003, the interest rate on the outstanding borrowings wasbased on the lender’s prime interest rate plus 0.25 percent.  Interest is payable monthly. The creditfacility also includes an unused credit fee equal to one-eighth of one percent,payable quarterly.  As ofSeptember 27, 2003, the remaining availability on the credit facility was$8.2 million. The credit facility was scheduled to expire on April 30,2003, however the Company obtained an extension of the maturity date toJanuary 2, 2004.  The Company is inthe process of renewing the credit facility. The Company expects that the credit facility will be renewed prior tothe expiration of the extension; however, there can be no assurance that thefacility will be renewed with similar terms.

 

At September 27, 2003, the Company had an unsecured, non-interest bearing note to ClearLab’s president and chief technology officer with a principal balance of SGD$2,875,000 (USD$1,662,000). The note payable is discounted at 7%.  Payments are due in equal monthly installments through July 2007.

 

At September 27,2003, the Company had a term loan payable to a Singapore bank with a principalbalance of SGD$8,625,000 (USD$4,985,000) that bears interest at 6.75% and issecured by substantially all of the assets of ClearLab.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments from January 2003 through December 2007.  This note also contains various financialcovenants including minimums on net worth and shareholders’ funds.  As of September 27, 2003, the Companywas in compliance with all applicable covenants.  1-800 CONTACTS, INC. has guaranteed this term loan.

 

At September 27,2003, the Company also had a note payable to the parent of IGEL with aprincipal balance of SGD$6,892,000 (USD$3,984,000) that bears interest at 6%and has a subordinated 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.

 

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Cross default clausesexist such that if the Company were in default on its U.S. debt, the Companywould also be in default on its Singapore debt.  If the Company were in default on its Singapore bank term loan,the Company would also be in default on its note payable to the parent of IGEL.

 

The Company leasesvarious manufacturing and other equipment from financing companies undercapital lease arrangements.  All of theequipment is maintained at the Singapore facility.  The majority of the leases were assumed in connection with theCompany’s acquisition of IGEL.  As ofSeptember 27, 2003, the present value of future minimum lease payments wasapproximately SGD$566,000 (USD$328,000) with a majority of payments scheduledthrough fiscal 2004.

 

On March 13, 2003,the Company signed a letter of intent to pay a non-refundable sum equal to $1.5million to be used by an entity for research and development activitiesrelating to contact lenses.  Of theamount, $700,000 was paid on March 14, 2003 and the remaining $800,000 waspaid on June 13, 2003.  Inaddition, the Company was granted a six-month option to acquire this entity oracquire a worldwide license for $100,000. On September 12, 2003, theCompany exercised the option to acquire all of the shares of common stock ofthe entity.  The acquisition of theshares is expected to close within 120 days following September 12,2003.  As consideration for the shares,the Company will pay approximately $3.2 million in cash and $3,.2 million inshares of the Company’s common stock, but has the option to pay the entirepurchase price in cash.  In addition,the Company has agreed to pay, for ten years, a per unit royalty to theshareholders of the entity.  During theperiod between September 12, 2003 and the closing of the acquisition, theCompany will continue to pay certain fees and expenses of the entity related tothe entity’s research and development activities.  The Company paid $500,000 to the entity on September 15,2003 for such research and development activities.

 

In connection with theagreement, and the transactions discussed above, the Company has expensed atotal of approximately $2.3 million from March 13, 2003 throughSeptember 27, 2003 (inclusive of the $161,000 in costs) related to theseresearch and development initiatives. The Company funded these payments from its revolving credit facility andcash flow generated from operating activities. The Company expects to fund any future amounts payable under thisarrangement through borrowings under its revolving credit facility.

 

During thethird fiscal quarter, the Company entered into a five-year license and royaltyagreement requiring minimum payments aggregating to $400,000 over the term ofthe agreement.

 

The Company believes that its cash on hand, together with cash generatedfrom operations and the borrowings available through the credit facility willbe sufficient to support current operations through the next year. The Companymay be required to seek additional sources of funds for accelerated growth orcontinued growth beyond that point, and there can be no assurance that suchfunds will be available on satisfactory terms. Failure to obtain such financing could delay or prevent the Company’splanned growth, which could adversely affect the Company’s business, financialposition, liquidity, and results of operations.

 

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

 

**Contractual Obligations and Commitments**

 

Subsequent toDecember 28, 2002 there have been no material changes to the Company’scontractual obligations and commitments, outside the normal course of business,other than the letter of intent signed on March 13, 2003.  The letter of intent, as described above,committed the Company to pay a non-refundable sum equal to $1.5 million to beused by the entity for research and development activities relating to contactlenses.  The entire amount has been paidas of September 27, 2003.  TheCompany also reimbursed the entity and its shareholders $161,000 for legal andfinancial expenses incurred by the entity in connection with the transactionscontemplated by the letter of intent. On September 12, 2003 the Company exercised the option to acquireall of the shares of common

 

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stock of the entity.  The acquisition of the shares is expected toclose within 120 days following September 12, 2003.  As consideration for the shares, the Companywill pay approximately $3.2 million in cash and $3.2 million in shares of theCompany’s common stock, but has the option to pay the entire purchase price incash.  In addition, the Company hasagreed to pay, for ten years, a per unit royalty to the shareholders of theentity.  During the period betweenSeptember 12, 2003 and the closing of the acquisition, the Company willcontinue to pay certain fees and expenses of the entity related to the entity’sresearch and development activities.

 

**Recently Issued Accounting Standards**

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities andEquity.”  The new statement establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both debt and equity.  The provisions of SFAS No. 150 apply to theclassification and disclosure requirements for the following three types of financialinstruments:  Mandatorily RedeemableInstruments, Instruments with Repurchase Obligations, and Instruments withObligations to Issue a Variable Number of Securities.   The new reporting and disclosure requirements for SFAS No. 150become effective for the first interim period beginning after June 15,2003 or for any covered instruments entered into or modified subsequent toMay 31, 2003.  The Company adoptedthis statement during the third quarter of 2003.  There was no impact on the financial statements of the Company.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting forStock-Based Compensation – Transition and Disclosure – an amendment to FASBStatement No. 123, Accounting for Stock-Based Compensation.”  SFAS No. 148 provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 to require more prominent and morefrequent disclosures in financial statements about the effects of stock-basedcompensation. The Company has elected to continue using the intrinsic method ofaccounting for employee stock-based compensation and has adopted the interimdisclosure provisions.

 

In November 2002, the Financial Accounting Standards BoardEmerging Issues Task Force issued its consensus concerning Revenue Arrangementswith Multiple Deliverables (“EITF 00-21”). EITF 00-21 addresses how to determine whether a revenue arrangementinvolving multiple deliverables should be divided into separate units ofaccounting, and, if separation is appropriate, how the arrangementconsideration should be measured and allocated to the identified accountingunits.  The guidance in EITF 00-21 iseffective for revenue arrangements entered into in fiscal periods beginningafter June 15, 2003.  The adoptionof EITF 00-21 did not have a material impact on the Company’s financialstatements.

 

**Critical AccountingPolicies and Estimates**

 

Accounting polices that require significant judgments and estimatesinclude revenue recognition (including sales returns and allowances); excessand obsolete inventories; realizability of long-lived assets (includingintangible assets); realizability of deferred income tax assets; accounting forthe acquisitions of ClearLab and Lens Express and Lens 1st;stock-based compensation; and legal and regulatory contingencies.  Judgments and estimates are based onhistorical experience as well as relevant facts and circumstances known at eachreporting date.  Actual results maydiffer from these estimates.

 

Sales are generally recognized at the time of shipment to thecustomer.  Net sales consist of productsales less provisions for sales returns and allowances, which provisions aremade at the time of sale.  The Companyaccrues an estimated amount for sales returns and allowances based onhistorical information, adjusted for current economic trends. To the extentactual returns and allowances vary from historical experience, revisions to theallowances may be required.

 

In assessing the realizability of inventories, the Company makesjudgments as to future demand requirements and product expiration dates.  The inventory requirements change based onprojected customer demand, which changes due to market conditions and productlife cycle changes.

 

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The Company has significant long-lived tangible and intangible assetsconsisting of property, plant and equipment, goodwill and definite-livedintangibles.  These assets are reviewedfor impairment whenever events or changes in circumstances indicate that thecarrying amounts of such assets may not be recoverable.  An impairment analysis requires the use ofexpected future undiscounted cash flows over the remaining useful life of theasset.  As of September 27, 2003,the Company determined that no impairment existed.  All of the goodwill and a significant portion of the otherlong-lived assets were generated from the Company’s recent acquisitions ofClearLab and Lens Express and Lens 1st. If forecasts and assumptionsused to support the realizability of long-lived assets change in the future,significant impairment charges could result that would adversely affect theCompany’s results of operations and financial position.

 

Deferred income tax assets are assessed for recoverability andvaluation allowances are provided as necessary to reduce deferred income taxassets to amounts expected to be realized. Should expectations of taxable income change in future periods, it maybecome necessary to change the valuation allowance, which could affect theCompany’s results of operations in the period such determination is made.  The Company records an income tax provisionor benefit at a rate that is based on expected results for the fiscalyear.  If future changes in marketconditions cause actual results to be more or less favorable, adjustments tothe effective income tax rate on a quarterly basis could be required.

 

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

 

**Forward-Looking Statements**

 

Except for thehistorical information contained herein, the matters discussed in this Form10-Q are forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, and Section 27A of theSecurities Act of 1933, as amended. These forward-looking statements involve risks and uncertainties andoften depend on assumptions, data or methods that may be incorrect orimprecise.  The Company’s futureoperating results may differ materially from the results discussed in, orimplied by, forward-looking statements made by the Company.  Factors that may cause such differencesinclude, but are not limited to, those discussed below and the other risksdetailed in the Company’s other reports filed with the Securities and ExchangeCommission.  The words such as“believes,” “anticipates,” “expects,” “future,” “intends,” “would,” “may,” andsimilar expressions are intended to identify forward-looking statements.  The Company undertakes no obligation torevise any of these forward-looking statements to reflect events orcircumstances after the date hereof.

 

*Factors That May Affect Future Results*

 

•                                          The Company’ssales growth will not continue at historical rates and it may encounterunforeseen difficulties in managing its future growth;

 

•                                          A significantportion of the Company’s sales may be found not to comply with state laws andregulations concerning the delivery and sale of contact lenses;

 

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

 

•                                          It ispossible that the FDA could consider certain of the contact lenses the Companysells to be misbranded;

 

•                                          The Companycurrently purchases a portion of its products from unauthorized distributorsand is not an authorized distributor for some of the products that it sells;

 

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•                                          The Companyobtains a large percentage of its inventory from a limited number of suppliers,with a single distributor accounting for 35%, 46% and 35% of the Company’sinventory purchases in fiscal 2000, 2001 and 2002, respectively;

 

•                                          The Companymay continue to incur significant legal and professional fees related to itslegal matters and its increased efforts to proactively influence the industryon behalf of itself and consumers;

 

•                                          The Company’squarterly results are likely to vary based upon the level of sales andmarketing activity in any particular quarter;

 

•                                          The Companyis dependent on its telephone, Internet and management information systems forthe sale and distribution of contact lenses;

 

•                                          The retailsale of contact lenses is highly competitive; certain of the Company’scompetitors are large, national optical chains that have greater resources thanthe Company;

 

•                                          The demandfor contact lenses could be substantially reduced if alternative technologiesto permanently correct vision gain in popularity;

 

•                                          The Companydoes not have any property rights in the 1-800 CONTACTS telephone number or theInternet addresses that it uses;

 

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

 

•                                          The Company’sbusiness could be harmed if it is required to collect state sales tax on thesale of products;

 

•                                          The Companyfaces an inherent risk of exposure to product liability claims in the eventthat the use of the products it manufacturers or sells results in personalinjury;

 

•                                          The Companyconducts its retail operations through a single distribution facility;

 

•                                          The Company’ssuccess is dependent, in part, on continued use of the Internet;

 

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

 

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

 

•                                          The Companymay not be able to develop and manufacture a viable, high quality contact lensfor sale to consumers that meets all federal regulatory requirements;

 

•                                          The Companymay not be able to fully integrate the operations of its acquisitions into itsbusiness;

 

•                                          Consumer acceptanceof the Company’s manufactured products may not meet the Company’s expectations;

 

•                                          The Company’sintellectual property rights may be challenged;

 

•                                          The Companymay encounter legal, regulatory and government agency oversight risks withforeign operations;

 

•                                          The Companymay not be able to establish a sufficient network of eye care practitioners toprescribe the products manufactured by the Company;

 

•                                          The Companymay not be able to adequately manage its foreign currency risk;

 

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•                                          The Companymay incur unforeseen costs or not realize all of the anticipated benefits fromits new relationships with Johnson & Johnson Vision Care and Cole; and

 

•                                          The Companymay be required to reduce the carrying value of its intangible assets if eventsand circumstances indicate the remaining balance of intangible assets may notbe recoverable.

 

**Item3.****                                   *Quantitative and Qualitative Disclosures About MarketRisk***

 

***InterestRate Risk*. **As of September 27, 2003,****theCompany was exposed to changes in interest rates relating to its revolvingcredit facility and other debt obligations. The revolving credit facility and U.S. bank term loan bear interest at avariable rate based on the U.S. prime rate or LIBOR. The Company’s outstandingborrowings on the credit facility, including bank overdrafts, and U.S. bankterm loan were approximately $10.7 million as of September 27, 2003. Theremainder of the Company’s interest bearing debt obligations, including capitallease obligations, is denominated in Singapore dollars and bears interest at afixed rate.  As of September 27,2003, the face amounts of the outstanding borrowings on these fixed rate debtobligations were approximately $9.3 million. If interest rates were to change by one full percentage point, the netimpact on interest expense would be approximately $0.1 million per year.

 

***Foreign CurrencyRisk.***  The Companyfaces foreign currency risks primarily as a result of its Singapore operationsand the intercompany balances between its U.S. and Singapore operations.  The functional currency of the Company’sSingapore operations is the Singapore dollar, however, most of the sales of theSingapore operations and some of the expenses are denominated in U.S.dollars.  The Company has debt and otherlong-term obligations of approximately $11.0 million that are denominated inSingapore dollars and mature over the next seven years.  For the three quarters endedSeptember 27, 2003, the Company recorded a foreign currency transactiongain of approximately $46,000. Fluctuations in exchange rates between the U.S. dollar and the Singaporedollar could lead to additional currency exchange losses or gains on theintercompany balances and transactions denominated in currencies other than thefunctional currency.  If the U.S. dollarweakens relative to the Singapore dollar, additional funds may be required tomeet these obligations if the debt cannot be adequately serviced from theSingapore operations.  The exchange ratebetween the U.S. dollar and the Singapore dollar has fluctuated approximately0.4 percent (strengthening of the U.S. dollar) from December 29, 2002through November 3, 2003.  From thedate of acquisition, July 24, 2002, through November 3, 2003 theexchange rate has fluctuated approximately (0.4) percent (weakening of the U.S.dollar).  If the Singapore dollarweakens against the U.S. dollar by an additional 10 percent, the Company wouldrecord an additional $887,000 foreign currency loss on the intercompanybalances that exist as of September 27, 2003.  The Company has not entered into any foreign currency derivativefinancial instruments; however, it may choose to do so in the future in aneffort to manage or hedge its foreign currency risk.

 

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

 

***(a)**Evaluationof disclosure controls and procedures*.**  The Company’s Chief Executive Officer and Chief FinancialOfficer, after evaluating the effectiveness of the Company’s disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) asof the end of the period covered by this report (the “Evaluation Date”), haveconcluded that, as of the Evaluation Date, the Company’s disclosure controlsand procedures were adequate and effective to ensure that material informationrelating to the Company and its consolidated subsidiaries would be made knownto them by others within those entities.

 

***(b) Changes ininternal controls.***  There were no significant changes in the Company’s internalcontrols or in other factors that could significantly affect the Company’sdisclosure controls and procedures subsequent to the Evaluation Date, nor werethere any significant deficiencies or material weaknesses in such disclosurecontrols and procedures requiring corrective actions.  As a result, no corrective actions were taken.

 

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

 

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

 

See notes tocondensed consolidated financial statements.

** **

**Item 2.****                                  *****Changes in Securities and Use ofProceeds***

 

None.

 

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

 

None.

 

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

 

None.

 

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

 

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

 

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

 

**(A) Exhibits**

 
| **Exhibit No.** |   | **Description of Exhibit**                                                                                                                                              |
|-----------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1            |   | Employment Agreement between the Company and Brian W. Bethers.                                                                                                          |
| 10.2            |   | Eighth Amendment to Lease between the Company and Draper Land Limited  Partnership No. 2, dated January 17, 2001, with respect to the Company’s  call center. |
| 31.1            |   | Certification Required Pursuant to Section 302 of the  Sarbanes-Oxley Act of2002.                                                                                  |
| 31.2            |   | Certification Required Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                 |
| 32.1            |   | Certification Required Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                 |
| 32.2            |   | Certification Required Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                 |

 

**(B) Reports on Form8-K**

 
| Current Report on Form 8-K filed July 8, 2003, filing of Press  Release Announcing the Execution of an Agreement between Cole National  Corporation and the Company. |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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| Current Report on Form 8-K filed July 10, 2003, Temporary  Suspension of Trading Under Registrant’s Employee Benefit Plan.                                       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Current Report on Form 8-K filed July 29, 2003, filing of Press  Release Announcing Operating and Financial Results for the Second Quarter  Ended June 28, 2003. |
| Current Report on Form 8-K filed August 25, 2003, Temporary  Suspension of Trading Under Registrant’s Employee Benefit Plan.                                     |

 

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**SIGNATURES**

 

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

 

 
|                                | **1-800 CONTACTS,  INC.** |
|-------------------------------------|---------------------------|
|                                |                      |   |
|                                |                      |   |
| Dated:  November 10, 2003 | By:                       | /s/ Jonathan C. Coon |   |
|                                | Name:                     | Jonathan C. Coon |
|                                | Title:                    | President and Chief Executive Officer |
|                                |                      |   |
|                                | By:                       | /s/ Brian W. Bethers |   |
|                                | Name:                     | Brian W. Bethers |
|                                | Title:                    | Chief Financial Officer |

 

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