**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,DC  20549**

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** **

**FORM 10-Q**

**(Mark one)**

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

**For thequarterly period ended March 31, 2007**

**or**

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

**For thetransition period from                to                    .**

**Commissionfile number:        0-23633**

**1-800 CONTACTS, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

**(801) 316-5000**

(Registrant’stelephone number, including area code)

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

xYes                o No

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of theExchange Act).

Large acceleratedfiler   o     Accelerated filer  x              Non-accelerated filer   o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

oYes                xNo

As of May 3, 2007, the Registrant had 14,009,591shares 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  (unaudited)                                                                        |   |   |
|                                            |   | Condensed Consolidated  Balance Sheets as of December 30, 2006 and March 31, 2007                        |   |   |
|                                            |   | Condensed Consolidated  Statements of Operations for the Quarter Ended April 1, 2006 and  March 31, 2007 |   |   |
|                                            |   | Condensed Consolidated  Statements of Cash Flows for the Quarter Ended April 1, 2006 and  March 31, 2007 |   |   |
|                                            |   | Notes to  Condensed Consolidated Financial Statements                                                    |   |   |
| Item 2.                                         |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations              |   |   |
| Item 3.                                         |   | Quantitative  and Qualitative Disclosures About Market Risk                                              |   |   |
| Item 4.                                         |   | Controls and  Procedures                                                                                 |   |   |
|                                            |   |                                                                                                     |   |   |
| **PART II. OTHER  INFORMATION**                 |   |                                                                                                     |
| Item 1.                                         |   | Legal Proceedings                                                                                        |   |   |
| Item  1A.                                       |   | Risk  Factors                                                                                            |   |   |
| Item 2.                                         |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                        |   |   |
| Item 3.                                         |   | Defaults Upon  Senior Securities                                                                         |   |   |
| Item 4.                                         |   | Submission of  Matters to a Vote of Security Holders                                                     |   |   |
| Item 5.                                         |   | Other Information                                                                                        |   |   |
| Item  6.                                        |   | Exhibits                                                                                                 |   |   |

 

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**PART 1.  FINANCIALINFORMATION**

**Item 1.  Financial Statements**

**1-800 CONTACTS, INC**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(in thousands)**

**(unaudited)**
| ** **                                            | ** ** | **December 30,** | ** ** | **March 31,** | ** ** |
|-------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                            | ** ** | **2006**              | ** ** | **2007**           | ** ** |
| **ASSETS**                                            |       |                  |       |               |       |
| CURRENT ASSETS:                                       |       |                  |       |               |       |
| Cash                                                  |       | $                     | 2,737      |               | $          | 616 |   |
| Accounts receivable,  net                             |       | 3,577                 |       | 3,711              |       |
| Other  receivables                                    |       | 1,825                 |       | 1,885              |       |
| Inventories                                           |       | 24,325                |       | 23,738             |       |
| Deferred income  taxes                                |       | 1,886                 |       | 1,766              |       |
| Other current  assets                                 |       | 2,816                 |       | 1,465              |       |
| Total current  assets                                 |       | 37,166                |       | 33,181             |       |
| PROPERTY AND EQUIPMENT,  net                          |       | 27,555                |       | 26,425             |       |
| DEFERRED INCOME TAXES                                 |       | 898                   |       | 920                |       |
| GOODWILL                                              |       | 22,304                |       | 22,304             |       |
| DEFINITE-LIVED  INTANGIBLES, net                      |       | 11,500                |       | 10,969             |       |
| OTHER ASSETS                                          |       | 1,102                 |       | 912                |       |
| Total assets                                          |       | $                     | 100,525    |               | $          | 94,711 |   |
|                                                  |       |                  |       |               |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**        | ** ** | ** **            | ** ** | ** **         | ** ** |
| CURRENT LIABILITIES:                                  |       |                  |       |               |       |
| Current portion  of long-term debt                    |       | 2,633                 |       | 2,476              |       |
| Current portion  of capital lease obligations         |       | 57                    |       | 27                 |       |
| Income taxes  payable                                 |       | 722                   |       | 2,428              |       |
| Accounts payable                                      |       | 10,821                |       | 11,057             |       |
| Accrued  liabilities                                  |       | 10,013                |       | 8,770              |       |
| Unearned revenue                                      |       | 3,348                 |       | 2,167              |       |
| Total current liabilities                             |       | 27,594                |       | 26,925             |       |
| LONG-TERM LIABILITIES:                                |       |                  |       |               |       |
| Line of credit                                        |       | 29,970                |       | 26,144             |       |
| Long-term debt,  net of current portion               |       | 4,404                 |       | 3,934              |       |
| Capital lease  obligations, net of current portion    |       | 35                    |       | 29                 |       |
| Other long-term  liabilities                          |       | 844                   |       | 226                |       |
| Total long-term  liabilities                          |       | 35,253                |       | 30,333             |       |
| STOCKHOLDERS’ EQUITY:                            |       |                  |       |               |       |
| Common stock,  13,424 and 13,443 issued, respectively |       | 134                   |       | 135                |       |
| Additional  paid-in capital                           |       | 51,047                |       | 51,842             |       |
| Treasury stock  at cost, 8 and 9 shares, respectively |       | (133                  | )          | (137               | )          |
| Accumulated deficit                                   |       | (12,846               | )          | (13,798            | )          |
| Accumulated  other comprehensive loss                 |       | (524                  | )          | (589               | )          |
| Total  stockholders’ equity                      |       | 37,678                |       | 37,453             |       |
| Total liabilities and  stockholders’ equity      |       | $                     | 100,525    |               | $          | 94,711 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

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

**(unaudited)**
| ** **                                            | ** ** | **Quarter Ended** | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|
| ** **                                            | ** ** | **April 1,**      | ** ** | **March 31,** | ** ** |
| ** **                                            | ** ** | **2006**               | ** ** | **2007** | ** ** |
| NET SALES                                             |       | $                      | 63,491     |   | $ | 67,421 |   |
| COST OF GOODS  SOLD                                   |       | 39,013                 |       | 43,049 |   |
| Gross profit                                          |       | 24,478                 |       | 24,372 |   |
|                                                  |       |                   |       |   |   |
| SELLING, GENERAL  AND ADMINISTRATIVE EXPENSES:        |       |                   |       |   |   |
| Advertising                                           |       | 3,983                  |       | 4,421 |   |
| Legal and professional                                |       | 1,125                  |       | 1,630 |   |
| Research and development                              |       | 1,328                  |       | 1,251 |   |
| Restructuring charges                                 |       | —                 |       | 110 |   |
| Other selling, general and administrative             |       | 13,679                 |       | 14,963 |   |
| Total selling, general and administrative expenses    |       | 20,115                 |       | 22,375 |   |
|                                                  |       |                   |       |   |   |
| INCOME FROM  OPERATIONS                               |       | 4,363                  |       | 1,997 |   |
| OTHER INCOME  (EXPENSE), net                          |       | 313                    |       | (350 | ) |
|                                                  |       |                   |       |   |   |
| INCOME BEFORE  PROVISION FOR INCOME TAXES             |       | 4,676                  |       | 1,647 |   |
| PROVISION FOR  INCOME TAXES                           |       | (3,495                 | )          | (2,659 | ) |
| NET INCOME  (LOSS)                                    |       | $                      | 1,181      |   | $ | (1,012 | ) |
|                                                  |       |                   |       |   |   |
| PER SHARE  INFORMATION:                               |       |                   |       |   |   |
| Basic and  diluted net income (loss) per common share |       | $                      | 0.09       |   | $ | (0.08 | ) |

 

See accompanyingnotes to condensed consolidated financial statements.

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**1-800 CONTACTS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(in thousands)**

**(unaudited)**
| ** **                                                                                | ** ** | **Quarter Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                | ** ** | **April 1,**      | ** ** | **March 31,** | ** ** |
| ** **                                                                                | ** ** | **2006**               | ** ** | **2007** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                    |       |                   |       |   |   |
| Net income (loss)                                                                         |       | $                      | 1,181      |   | $ | (1,012 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                   |       |   |   |
| Depreciation and amortization                                                             |       | 2,298                  |       | 2,511 |   |
| Amortization of debt issuance costs and discounts                                         |       | 56                     |       | 52 |   |
| Foreign currency exchange gain                                                            |       | (732                   | )          | (212 | ) |
| Stock-based compensation                                                                  |       | 367                    |       | 723 |   |
| Tax benefits from share-based payment exercises                                           |       | (27                    | )          | (45 | ) |
| Loss on sale of property and equipment                                                    |       | 2                      |       | 22 |   |
| Deferred income taxes                                                                     |       | (216                   | )          | 98 |   |
| Changes in operating assets and liabilities:                                              |       |                   |       |   |   |
| Accounts receivable, net                                                                  |       | 623                    |       | 79 |   |
| Inventories, net                                                                          |       | 40                     |       | 666 |   |
| Other receivables                                                                         |       | 174                    |       | (60 | ) |
| Other current assets                                                                      |       | 1,619                  |       | 1,335 |   |
| Income taxes payable                                                                      |       | 3,551                  |       | 1,811 |   |
| Accounts payable                                                                          |       | 2,182                  |       | 23 |   |
| Accrued liabilities                                                                       |       | 1,528                  |       | (1,257 | ) |
| Unearned revenue                                                                          |       | 164                    |       | (1,199 | ) |
| Net cash provided by operating activities                                                 |       | 12,810                 |       | 3,535 |   |
|                                                                                      |       |                   |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |                   |       |   |   |
| Purchase of property and equipment                                                        |       | (2,658                 | )          | (1,067 | ) |
| Purchase of definite-lived intangible assets                                              |       | —                 |       | (64 | ) |
| Deposits and other                                                                        |       | (106                   | )          | 47 |   |
| Net cash used in  investing activities                                                    |       | $                      | (2,764     | ) | $ | (1,084 | ) |

 

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** **
| ** **                                              | ** ** | **Quarter Ended** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|
| ** **                                              | ** ** | **April 1,**      | ** ** | **March 31,** | ** ** |
| ** **                                              | ** ** | **2006**               | ** ** | **2007** | ** ** |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                  |       |                   |       |   |   |
| Proceeds from exercise of stock options                 |       | $                      | 97         |   | $ | 28 |   |
| Purchase of treasury stock                              |       | —                 |       | (4 | ) |
| Excess tax benefits from share-based payment  exercises |       | 27                     |       | 45 |   |
| Net repayments on line of credit                        |       | (10,684                | )          | (3,826 | ) |
| Principal payments on capital lease obligations         |       | (46                    | )          | (37 | ) |
| Principal payments on long-term debt                    |       | (464                   | )          | (711 | ) |
| Net cash used in financing activities                   |       | (11,070                | )          | (4,505 | ) |
| EFFECT OF  FOREIGN EXCHANGE RATES ON CASH               |       | (50                    | )          | (67 | ) |
|                                                    |       |                   |       |   |   |
| NET DECREASE IN  CASH                                   |       | (1,074                 | )          | (2,121 | ) |
| CASH AT  BEGINNING OF PERIOD                            |       | 1,481                  |       | 2,737 |   |
| CASH AT END OF  PERIOD                                  |       | $                      | 407        |   | $ | 616 |   |
|                                                    |       |                   |       |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                    |       |                   |       |   |   |
| Cash paid for interest                                  |       | $                      | 430        |   | $ | 537 |   |
| Cash paid for  income taxes                             |       | 150                    |       | 750 |   |

 

SUPPLEMENTAL DISCLOSURESOF NONCASH INVESTING AND FINANCING ACTIVITIES:

Effective December 31, 2006, we adopted the provisions of FinancialAccount Standards Board (FASB) issued Interpretation No. 48, “Accounting forUncertainty in Income Taxes.”  As aresult of the implementation of FIN 48, we recognized a $60 decrease to ourliability for income taxes payable, and a corresponding decrease to our fiscal2007 accumulated deficit beginning balance.

See accompanyingnotes to condensed consolidated financial statements.

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**1-800 CONTACTS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

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

We have preparedthe accompanying condensed consolidated financial statements, without audit,pursuant to the rules and regulations of the Securities and Exchange Commission(the “SEC”).  Certain information anddisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to such rules and regulations.  These condensed consolidated financialstatements reflect all adjustments (consisting only of normal recurringadjustments), which in the opinion of management, are necessary to presentfairly the results of our operations for the periods presented.  It is suggested that these condensedconsolidated financial statements be read in conjunction with the auditedfinancial statements and the notes thereto included in our Annual Report onForm 10-K for the year ended December 30, 2006.

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenue and expenses during the reporting period.  Actual results could differ from theseestimates.

# **NOTE 2. INVENTORIES**

Inventories are recorded at the lower of cost (usingthe first-in, first-out method) or market value.  Elements of cost in our manufacturedinventories generally include raw materials, direct labor, manufacturing overheadand freight-in.   Inventories consistedof the following (in thousands):

|                                           | ** ** | **December 30,** | ** ** | **March 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                | ** ** | **2006**              | ** ** | **2007**           | ** ** |
| Purchased contact  lenses and accessories |       | $                     | 12,689     |               | $          | 13,011 |   |
| Manufactured  inventories:                |       |                  |       |               |       |
| Raw materials                             |       | 801                   |       | 522                |       |
| Work in process                           |       | 985                   |       | 933                |       |
| Finished goods  contact lenses            |       | 9,850                 |       | 9,272              |       |
| Total                                     |       | $                     | 24,325     |               | $          | 23,738 |   |

 

Provision is madeto reduce excess and obsolete inventories to their estimated net realizablevalues.  As of December 30, 2006 andMarch 31, 2007, reserves for excess and obsolete inventories were approximately$1.2 million and $0.7 million, respectively.

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

Basic net income(loss) per common share (“Basic EPS”) excludes dilution and is computed bydividing 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 using the treasury stockmethod.  The computation of Diluted EPSdoes not assume exercise or conversion of securities that would have anantidilutive effect on net income (loss) per common share.  Additionally, we have not reflected performancebased unvested stock awards in Diluted EPS since the performance conditionswere not satisfied as of March 31, 2007.  For the quarters ended April 1,2006 and March 31, 2007, options to purchase 690,134 and 1,118,198 shares ofcommon 

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stock, respectively, aswell as 32,041 and 564,525 shares of unvested common stock, respectively, werenot included in the computation of Diluted EPS because the effect would beantidilutive.

The following is areconciliation of the numerator and denominator used to calculate Basic andDiluted EPS (in thousands, except per share amounts):
| ** **                       | ** ** | **Quarter Ended April 1, 2006** | ** ** | **Quarter Ended March 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                       | ** ** | **Net  Income**                                     | ** ** | **Shares**                                           | ** ** | **Per-Share  Amount** | ** ** | **Net  (Loss)** | ** ** | **Shares** | ** ** | **Per-Share  Amount** | ** ** |
| Basic  EPS                       |       | $                                                   | 1,181      |                                                 | 13,345     |   | $ | 0.09 |   | $ | (1,012 | ) | 13,420 |   | $ | (0.08 | ) |
| Effect  of stock options         |       |                                                |       | 96                                                   |       |   |   |   |   | —— |   |   |   |
| Effect  of unvested stock awards |       |                                                |       | ——                                         |       |   |   |   |   | —— |   |   |   |
| Diluted EPS                      |       | $                                                   | 1,181      |                                                 | 13,441     |   | $ | 0.09 |   | $ | (1,012 | ) | 13,420 |   | $ | (0.08 | ) |

 

**NOTE4.  COMPREHENSIVE INCOME (LOSS)**

Comprehensiveincome (loss) for the quarters ended April 1, 2006 and March 31, 2007 consistsof the following components (in thousands):

|                               | ** ** | **Quarter Ended**        | ** ** |
|-------------------------------|------------|-------------------------------|------------|
| ** **                    | ** ** | **April 1,   2006** | ** ** | **March 31,  2007** | ** ** |
| Net income (loss)             |       | $                             | 1,181      |   | $ | (1,012 | ) |
| Foreign currency  translation |       | (1                            | )          | (65 | ) |
| Comprehensive income (loss)   |       | $                             | 1,180      |   | $ | (1,077 | ) |

 

The foreigncurrency translation loss results primarily from changes in exchange ratesrelative to the U.S. dollar from the translation of our Singapore and UnitedKingdom subsidiaries’ financial statements.

**NOTE5.  STOCK-BASED COMPENSATION**

We account for share-based compensation in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised2004), “Share-Based Payment,” (“SFAS No. 123R”), which requires stock-basedcompensation to be measured based on the fair value of the award on the date ofgrant and recognized over the period during which service is required inexchange for the award.

SFAS No. 123R applies to all of ouroutstanding unvested share-based payment awards as of January 1, 2006 and allawards made thereafter.  All of ourstock-based awards, which are stock options and restricted stock awards, areclassified as equity instruments.  Compensationcost recognized in fiscal 2006 and in fiscal 2007 for unvested options as ofJanuary 1, 2006 was based on the grant-date fair value, using the Black-Scholesmodel, estimated in accordance with the original provisions of SFAS No. 123.

Stock-based expense for the first quarter of fiscal2006 and 2007 includes expense, recognized over the applicable vesting periods,for new restricted stock share-based awards and for restricted stock and stockoption share-based awards granted prior to, but not yet vested, as of January1, 2006.  Stock-based compensation expense for employees and non-employeedirectors for the first quarter of fiscal 2006 and 2007 totaled approximately$0.4 million and $0.7 million, respectively.  The excess income taxbenefit related to stock-based expense during the first quarter of fiscal 2006and 2007 was approximately $27,000 and $45,000, respectively.

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***Stock–BasedAward Plans***

***Stock Options.***We have established a stock optionplan that provides for the issuance of a maximum 1,940,000 shares of commonstock to officers, employees, directors and consultants. The plan allows forthe issuance of both incentive stock options, nonqualified stock options andrestricted stock. Incentive and nonqualified stock options are granted at notless than 100 percent of the fair market value of the underlying commonstock on the date of grant. As of March 31, 2007, 137,604 shares are availablefor future granting.

Prior to theestablishment of the stock option plan, we issued nonqualified stock options tovarious key employees, a consultant and a director of the Company.

All optionsgranted through January 1, 2000 vest equally over a three-year period andexpire ten years from the date of grant. The stock options issued as a portionof the consideration for the assignment of certain technologies andintellectual property in conjunction with the acquisition of ClearLabInternational in 2002 and other options issued to the chief technology officerof ClearLab International vest equally at the end of the third, fourth andfifth years and expire ten years from the date of grant.   All other options granted subsequent toJanuary 1, 2000, vest equally over a four-year period and expire betweenfive and ten years from the date of grant.

Stock optionsremained outstanding under various plans as of January 1, 2006. No stockoptions were granted from these plans during fiscal 2006 or the first quarterof fiscal 2007.  Our stock optionactivity during the first quarter of fiscal 2007 is as follows (in thousands, except option prices and years):
| ** **                                             | ** ** | ** **         | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|--------------------------------------------------------|------------|--------------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                                             | ** ** | ** **         | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                                             | ** ** | ** **         | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                                             | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| **Quarter Ended March 31, 2007**                       | ** ** | **Options**        | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Value**     | ** ** |
| Options  outstanding at December 30, 2006              |       | 1,125              |       | $            | 20.96      |                  |       |          |       |   |
| Exercised                                              |       | (5                 | )          | 5.32         |       |                  |       |          |       |
| Forfeited                                              |       | —             |       | —       |       |                  |       |          |       |
| Expired                                                |       | (2                 | )          | 32.95        |       |                  |       |          |       |
|                                                   |       |               |       |         |       |                  |       |          |       |
| Options  outstanding at March 31, 2007                 |       | 1,118              |       | $            | 20.97      |                  | 3.30       |          | $          | 2,707 |   |
|                                                   |       |               |       |         |       |                  |       |          |       |
| Options  vested and expected to vest at March 31, 2007 |       | 1,106              |       | $            | 20.89      |                  | 3.30       |          | $          | 2,707 |   |
|                                                   |       |               |       |         |       |                  |       |          |       |
| Options exercisable at March 31, 2007                  |       | 1,034              |       | $            | 20.38      |                  | 3.32       |          | $          | 2,707 |   |

 

Thetotal intrinsic value of options exercised total approximately $0.1 millionduring both quarters ended April 1, 2006 and March 31, 2007.

For the quarters ended April 1, 2006 and March 31,2007, stock option expense was recognized on a straight-line basis over thefour year vesting period.  Approximately$0.3 and $0.2 million was charged to expense in the first quarter of fiscal2006 and 2007, respectively. We have applied a weighted average forfeiture assumptionof approximately 15% in the calculation of such expense in the quarters endedApril 1, 2006 and March 31, 2007.

As of March 31, 2007, there was approximately $0.3million of unrecognized compensation cost related to non-vested stock options,which is expected to be recognized over a weighted-average period ofapproximately one year.

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Cash received from optionexercises during the first quarter of fiscal 2006 was approximately $0.1million, whereas the cash received from option exercises during the firstquarter of fiscal 2007 was approximately $28,000. The total tax benefitgenerated from options granted prior to January 1, 2006, which were exercisedduring the first quarter of fiscal 2007, was approximately $24,000 which wascredited to additional paid-in capital.

***Restricted Share Awards****.*Duringthe first quarter of fiscal 2006 and 2007 we granted 599,096 and 25,454 sharesof restricted common stock, respectively, to various employees and executivesof the Company.  The restricted sharegrants were valued at the closing stock price on the date of the grant, whichwas $13.14 for the 2006 grants and ranged from $16.28 to $17.10 for the 2007grants. The restricted share grants include both time-vesting andperformance-vesting restricted shares. The time-vesting shares for the 2006 grants vest 20% per year, beginningNovember 30, 2006 and ending November 30, 2010. All the 2007 grants were time-vesting shares and vest 20% per vesting period;10,500 of the 2007 grants included provisions that vested 20% of the shares onFebruary 25, 2007 and then the remaining unvested portion of the shares vest20% per year through February 25, 2011; 270 of the 2007 grants vest 20% peryear beginning January 25, 2008 and ending January 25, 2012; and the remaining14,684 grants made during 2007 vest 20% per year beginning February 25, 2008and ending February 25, 2012.  All firstquarter fiscal 2006 performance-vesting shares vest upon achievement of certainoperational milestones - such as obtaining sources for “doctors only” lenses oncompetitive terms, development of certain contact lens products and theachievement of an eight quarter cumulative financial target of at least $81million consolidated earnings before taxes by or before the end of fiscal2010.   Both the time-vesting andthe performance-vesting shares are subject to various change in controlprovisions involving us and our subsidiaries that may result in the acceleratedvesting of unvested shares as well as conversion of unvested shares  into a cash amount at the time of the changein control.

During the firstquarter of fiscal 2006 we also granted 50,000 shares of restricted common stockto our five non-employee directors. These grants vest equally over a three-year period; the vesting of theseawards will be accelerated upon a change in control of the Company.  The restricted share grants were also valuedat the closing stock price on the date of the grant which was $13.14.  An additional 2,500 shares of restrictedcommon stock were granted to one non-employee director during the first quarterof fiscal 2006.  This restricted sharegrant was valued at the closing stock price on the date of the grant, which was$13.28; and all shares vested on July 28, 2006.

Our activityrelating to restricted share awards during the first quarter of fiscal 2006 and2007 was as follows (in thousands, except fair values):
| ** **                       | ** ** | **Number of Restricted** | ** ** | **Weighted Average  Grant Date Fair** | ** ** |
|----------------------------------|------------|------------------------------------|------------|------------------------------------------------------|------------|
| **Quarter Ended March 31, 2007** | ** ** | **Share Awards**              | ** ** | **Value Per Award**                        | ** ** |
| Unvested at December  30, 2006   |       | 562                                |       | $                                                    | 14.20      |   |
| Granted                          |       | 26                                 |       | 17.09                                                |       |
| Vested                           |       | (23                                | )          | 15.18                                                |       |
| Forfeited and expired            |       | —                             |       | —                                               |       |
| Unvested at March 31, 2007       |       | 565                                |       | $                                                    | 14.29      |   |

 

For the first quarter of fiscal 2006 and 2007,approximately $0.1 million and $0.5 million, respectively, were charged toexpense relating to the amortization of the time-vested restricted shareawards.  At March 31, 2007, unrecognizedcompensation expense, including estimated forfeitures related to time-vestedrestricted share awards totaled approximately $3.9 million and will berecognized over a weighted average period of approximately 3.0 years,respectively.  The fair value of restrictedshare awards that vested during the quarters ended April 1, 2006 and March 31,2007 totaled approximately $0.1 million and $0.4 million, respectively.  Total tax benefit generated from vestedrestricted share awards for the quarter ended March 31, 2007 was approximately$21,000 which was credited to additional paid-in capital.

Expenserelated to performance-vesting shares will be recognized once it is determined “probable”that the operational milestones will be met. At the time the achievement of these operational milestones areconsidered “probable”, we will record a cumulative catch-up for the amount ofexpense that should have been recognized from the date of the grant to the dateit was determined achievement was probable and recognize the remaining expenseon 

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a straight-line basis throughthe estimated date of achievement.  Totalgross compensation expense, excluding any estimate of forfeitures related tothe outstanding performance-vesting shares, will be approximately $3.0 million.  As of March 31, 2007, we do not believe thatthe achievement of the operational milestones is probable.

**NOTE6.  DEBT OBLIGATIONS**

We have a loanagreement with a U.S. bank providing for a revolving credit facility thatmatures on June 1, 2009.  The loanagreement provides for borrowings of up to $40 million and for letters ofcredit up to a maximum of $15 million outstanding or payable at any time.The amount of any letters of credit outstanding is deducted from the amountavailable for borrowing.   There were outstandingletters of credit of $1.5 million as of March 31, 2007 that reduce the totalamount available under the loan agreement to $38.5 million.  We may reduce the maximum available advanceamount or terminate the loan at any time.

Outstandingborrowings on the revolving credit facility bear interest at a floating rateequal to the lender’s prime interest rate plus a margin or the lender’s LIBORrate plus a margin. The interest rate is adjusted quarterly and ranges betweenprime minus 0.75 percent and prime minus 1.25 percent or between theapplicable LIBOR rate plus 1.75 percent and the applicable LIBOR rate plus2.25 percent, depending on our maximum leverage ratio, as defined in theagreement. As of March 31, 2007, the prime rate margin is minus 1.00 percentand the LIBOR rate margin is 2.00 percent. Interest is payable monthly. Asof March 31, 2007, our outstanding borrowings on the credit facility, includingbank overdrafts, were $26.1 million and bore interest at the lender’sprime rate minus 1.00 percent (7.25% at March 31, 2007). The facilityrequires the quarterly payment of an unused credit fee which ranges from0.25 percent to 0.38 percent, depending on our maximum leverageratio.

Outstandingbalances on the credit facility are secured by substantially all of our U.S.assets, subsidiary debt instruments, 100 percent ownership interests inall domestic subsidiaries and 65 percent ownership interests in foreignsubsidiaries owned directly by us. The loan agreement includes variousfinancial covenants including a capital expenditure limit, a maximum leverageratio and a minimum fixed charge coverage ratio. The loan agreement does notpermit us or our subsidiaries to dissolve, sell, dispose or merge all of theirassets or acquire all of the assets of any entity without the written consentof the U.S. bank, unless the transaction meets the definition of a “PermittedAcquisition Basket,” as defined in the agreement. The loan agreement alsoplaces a limit on the amount we can loan to any entity, outside the normalcourse of business. Additionally, the loan agreement allows us to declare orpay cash dividends, to repurchase our stock or to perform other similar equitytransactions if such transactions would not exceed $15 million in any fiscalyear and subject to other terms. This agreement defines several customaryevents of default including any material adverse change or any event thatoccurs which may cause a material adverse change in our or our subsidiaries’condition.

As of March 31,2007, we had a term loan payable to a Singapore bank with a principal balanceof SGD$2,707,000 (USD$1,785,000) that bears interest at 6.75% and is secured bysubstantially all of the assets of ClearLab International.  Interest payments are due monthly.  Principal payments are due in monthlyinstallments through December 2007.  Thisnote also contains various financial covenants including minimums on net worthand shareholders’ funds.  1-800 CONTACTS,INC. has guaranteed this term loan.

As of March 31, 2007, we also had a note payable tothe former parent of ClearLab International with a principal balance ofSGD$6,771,000 (USD$4,463,000) that bears interest at 6% and has a subordinatedposition 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.

As of March 31,2007, we had an unsecured, non-interest bearing note to ClearLab International’schief technology officer with a principal balance of SGD$246,000 (USD$162,000).The note payable is discounted at 7%. Payments are due in equal monthly installments through July 2007.

Cross defaultclauses exist such that if we were in default on our U.S. debt, we would alsobe in default on our Singapore debt. If we were in default on our Singaporebank term loan, we would also be in default on our note payable to the formerparent of ClearLab International and our loan agreement with our U.S. bank.

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**NOTE 7.    STRATEGIC REVIEW AND RESTRUCTURINGS**

On July 26, 2006ClearLab introduced its AquaSoft Singles product.  We engaged an investment banking firm toevaluate a broad range of strategic alternatives in an effort to capitalize onthe value of ClearLab and this new product. Based on this review, we havecommitted to a separation of ClearLab from the U.S. Retail business and arecurrently assessing various strategic options. This separation will likely be accomplished in two separate transactions— one for the flat pack technology and intellectual property and one forClearLab’s Singapore operation.  As such,we announced on May 8, 2007 that we have entered into a Memorandum ofUnderstanding (“MOU”) to sell ClearLab’s Singapore operation to Mi GwangContact Lens Co., Ltd., a Korean based contact lens manufacturer.  The MOU includes a $1 million break-up feethat is applicable if either party does not execute a purchase agreement. Weexpect to execute the purchase agreement and close the transaction during thesecond quarter of fiscal 2007.  We arestill assessing various strategic options for the intellectual property andflat pack technology.

We have alsoundergone an extensive review of ClearLab’s manufacturing operations.  Based on this review, we made the decision toconsolidate ClearLab operations in Singapore and are proceeding with theclosure and consolidation.  Wesubstantially completed the UK site closure (except for ongoing leasecommitments and disposal of surplus equipment) in the first fiscal quarter of2007, and anticipate that all ongoing obligations relating to the UK operations(including lease commitments and disposal of surplus equipment) will cease nolater than the end of 2007. We anticipate that all manufacturing activity willbe consolidated in Singapore by the end of the third fiscal quarter of 2007.

***During fiscal 2006 and the first quarter of fiscal 2007, weexpensed $1,040,000 and $110,000, respectively, relating to these activities.***

***Of these expensed amounts, the following amounts wereaccrued as of December 30, 2006 and March 31, 2007:***

| Accrual at December 30, 2006 |   | $      | 1,020  |   |
|------------------------------|--------|--------|--------|--------|
| Additions                    |   | 110    |   |
| Payments                     |   | (1,095 | )      |
| Accrual at March 31, 2007    |   | $      | 35     |   |

 

We announced inthe first quarter of fiscal 2007 that our strategic review to determine how tomaximize value through a ClearLab separation has been broadened to include astrategic review of the U.S. Retail business and  we are currently progressing with thisreview.

**NOTE8.  COMMITMENTS AND CONTINGENCIES**

***Legaland Regulatory Matters***

The sale anddelivery of contact lenses are governed by both federal and state laws andregulations, including the federal Fairness to Contact Lens Consumers Act (“FCLCA”).The FCLCA requires a seller, prior to selling contact lenses to a consumer, toeither (i) obtain an actual copy of the consumer’s prescription or (ii) verifythe consumer’s prescription by direct communication with the customer’sprescriber. Consistent with this requirement, our current operating practice isto require all customers to provide either a valid copy of their prescriptionor the contact information for their prescriber so that we can verify theirprescription by direct communication with their prescriber. If we do not have avalid copy of the customer’s prescription, we directly communicate to thecustomer’s prescriber the precise prescription information received from thecustomer and, in accordance with the FCLCA, informs the prescriber that we willproceed with the sale based on this prescription information unless the prescriberadvises us within eight business hours that such prescription information isexpired or otherwise invalid. If the prescriber properly advises us within thistime period that the customer’s prescription is expired or otherwise invalid,our practice is to cancel the customer’s order. On the other hand, if theprescriber either advises us that the prescription is valid or fails to respondproperly within the required time period, our practice is to complete the salebased on the prescription information communicated to the prescriber, asexpressly permitted by the FCLCA. We 

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retain copies of thewritten prescriptions that we receive and maintain records of ourcommunications with the customer’s prescriber. The FCLCA provides for severalmeans of direct communication with eye care practitioners, and we may alter ourprescription verification procedures from time to time in keeping with theFCLCA and FTC guidelines.

We are involved inlegal proceedings generally incidental to our business. It is the opinion ofmanagement, after discussion with legal counsel, that the ultimate dispositionsof all of these matters will not have a material impact on our financialposition, liquidity, or results of operations.

***AdvertisingCommitments***

As of March 31,2007, we had entered into certain noncancelable commitments with variousadvertising companies that will require us to pay approximately $6.3 millionduring the remainder of 2007.

**NOTE 9.  SEGMENT INFORMATION**

We have two operating segments. These operating segments represent thecomponents of our Company for which separate financial information is availableand they are evaluated regularly by management in determination of resourceallocation and performance assessment. Our U.S. Retail segment includes theoperations of 1-800 CONTACTS, a direct marketer of replacement contact lenses.Our International segment includes the operations of ClearLab International andClearLab UK, developers, marketers, manufacturers and distributors of contactlenses and includes revenue from theJapanese license and royalty agreement.  Operating segment information for the first quarter ended April 1, 2006and March 31, 2007 is as follows (in thousands):
| **Quarter Ended April 1, 2006** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|-------------------|------------|------------------|------------|-----------|------------|
| Net  sales                                          |       | $                    | 59,173     |              | $          | 4,318            |       | $         | —     |   | $ | 63,491 |   |
| Gross  profit                                       |       | 23,624               |       | 638               |       | 216              |       | 24,478    |       |
| Research  and development                           |       | 10                   |       | 1,318             |       | —           |       | 1,328     |       |
| Other  selling, general and administrative expense  |       | 11,713               |       | 1,966             |       | —           |       | 13,679    |       |
| Income (loss) from operations                       |       | $                    | 7,006      |              | $          | (2,859           | )          | $         | 216        |   | $ | 4,363 |   |

 
| **Quarter Ended March 31, 2007** | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Eliminations** | ** ** | **Total** | ** ** |
|------------------------------------------------------|------------|----------------------|------------|-------------------|------------|------------------|------------|-----------|------------|
| Net  sales                                           |       | $                    | 61,829     |              | $          | 5,592            |       | $         | —     |   | $ | 67,421 |   |
| Gross  profit (loss)                                 |       | 24,829               |       | (457              | )          | —           |       | 24,372    |       |
| Research  and development                            |       | —               |       | 1,251             |       | —           |       | 1,251     |       |
| Restructuring  charges                               |       | —               |       | 110               |       | —           |       | 110       |       |
| Other  selling, general and administrative expense   |       | 12,710               |       | 2,253             |       | —           |       | 14,963    |       |
| Income (loss) from operations                        |       | $                    | 6,176      |              | $          | (4,179           | )          | —    |       | $ | 1,997 |   |
|                                                      |            |                      |            |                   |            |                  |            |           |            |  |  |  |  |

 

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The following reconciles total segment income from operations to incomebefore provision for income taxes for the quarters ended April 1, 2006 andMarch 31, 2007 as follows (in thousands):
| ** **                                       | ** ** | **Quarter Ended**      | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | **April 1, 2006** | ** ** | **March 31, 2007** | ** ** |
| Income  from operations                          |       | $                           | 4,363      |   | $ | 1,997 |   |
| Interest  expense                                |       | (412                        | )          | (558 | ) |
| Foreign  currency exchange transaction gain, net |       | 732                         |       | 212 |   |
| Other  expense, net                              |       | (7                          | )          | (4 | ) |
| Income before provision for income taxes         |       | $                           | 4,676      |   | $ | 1,647 |   |

 

Identifiablesegment assets are as follows (in thousands):

| Fiscal Year Ended December 30, 2006 | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|-----------|------------|
| Long-lived  assets, net                                      |       | $                    | 32,596     |              | $          | 28,763    |       | $ | 61,359 |   |
| Total assets                                                 |       | $                    | 50,933     |              | $          | 49,592    |       | $ | 100,525 |   |

 

| Quarter Ended March 31, 2007 | ** ** | **U.S. Retail** | ** ** | **International** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|----------------------|------------|-------------------|------------|-----------|------------|
| Long-lived  assets, net                          |       | $                    | 31,889     |              | $          | 27,809    |       | $ | 59,698 |   |
| Total assets                                     |       | $                    | 50,957     |              | $          | 43,754    |       | $ | 94,711 |   |

 

**NOTE 10.ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES**

On December 31,2006, we adopted the provisions of FASB Interpretation No. 48, Accounting forUncertainty in Income Taxes (“FIN 48”), which clarifies the accounting foruncertainty in income tax positions. This interpretation requires us torecognize in the consolidated financial statements only those tax positionsdetermined to be  more-likely-than-not ofbeing sustained upon examination, based on the technical merits of thepositions as of the reporting date.  If atax position is not considered more-likely-than-not to be sustained basedsolely on its technical merits, no benefits of the position are recognized.This is a different standard for recognition than was previously required. Themore-likely-than-not threshold must continue to be met in each reporting periodto support continued recognition of a benefit.  At adoption, companies must adjust their financial statements to reflectonly those tax positions that are more-likely-than-not to be sustained as ofthe adoption date. Any necessary adjustment is recorded directly to openingretained earnings in the period of adoption and reported as a change inaccounting principle.  As a result of theadoption of FIN-48, we recognized a decrease of $60,000 in the liabilityrecorded for unrecognized tax benefits, which was accounted for as a decreaseto the Fiscal 2007 beginning accumulated deficit balance. We do not have anyunrecognized tax benefits that, if recognized, would affect our effective taxrate. We recognize interest and potential penalties accrued related tounrecognized tax benefits in our provision for income taxes. We hadapproximately $54,000 accrued for the payment of interest as of March 31, 2007,which is classified as current income taxes payable on the balance sheet.

We have not beennotified of intent to audit, nor are we currently undergoing an income taxaudit in any jurisdiction. The tax years that remain subject to examination bysignificant jurisdiction are as follows:

| U.S. Federal   |   | 2003 through the current period |
|----------------|--------|---------------------------------|
| Utah           |   | 2003 through the current period |
| United Kingdom |   | 2004 through the current period |
| Singapore      |   | 2002 through the current period |

 

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**NOTE 11.RECENTLY ISSUED ACCOUNTING STANDARDS**

On February 15,2007, the Financial Accounting Standards Board issued SFAS No.159, “The FairValue Option for Financial Assets and Financial Liabilities” (“FAS 159”).  FAS 159 allows companies to elect to followfair value accounting for certain financial assets and liabilities in an effortto mitigate volatility in earnings without having to apply complex hedgeaccounting provisions.  FAS 159 isapplicable only to certain financial instruments and is effective for fiscalyears beginning after November 15, 2007, the fiscal year beginning December 30,2007 for the Company.  We have not yetcompleted our assessment of what impact, if any, the adoption of FAS 159 willhave on our financial statements.

In September2006, the FASB issued Statement of Financial Accounting Standard No. 157, “FairValue Measurements” (“FAS 157”). FAS 157 provides a definition of fair value,establishes acceptable methods of measuring fair value and expands disclosuresfor fair value measurements required under other accounting pronouncements, butdoes not change existing guidance as to whether or not an instrument is carriedat fair value. FAS 157 is effective for fiscal years beginning after November15, 2007, the fiscal year beginning December 30, 2007 for the Company.  We do not expect the adoption of FAS 157 tohave a material impact on our financial statements.

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

**Overview**

We are a direct marketer of replacement contact lensesand also a manufacturer, developer and distributor of our own branded andprivate label contact lenses through our operations in Singapore and the UnitedKingdom.  Our U.S. Retail operationssells all of the popular brands of contacts lenses, including thosemanufactured by Johnson & Johnson Vision Care, CIBA Vision, Bausch &Lomb and CooperVision.  ClearLab is ourinternational contact lens development, manufacturing and distributionbusiness.

On July 26, 2006 ClearLab introduced its AquaSoftSingles product.  We engaged aninvestment banking firm to evaluate a broad range of strategic alternatives in aneffort to capitalize on the value of ClearLab and this new product. Based onthis review, we have committed to a separation of ClearLab from the U.S. Retailbusiness and are currently assessing various strategic options.  This separation will likely be accomplishedin two separate transactions — one for the flat pack technology andintellectual property and one for ClearLab’s Singapore operation.  As such, we announced on May 8, 2007 that wehave entered into a Memorandum of Understanding (“MOU”) to sell ClearLab’sSingapore operation to Mi Gwang Contact Lens Co., Ltd., a Korean based contactlens manufacturer.  The MOU includes a $1million break-up fee that is applicable if either party does not execute apurchase agreement. We expect to execute the purchase agreement and close thetransaction during the second quarter of fiscal 2007.  We are still assessing various strategicoptions for the intellectual property and flat pack technology.

We have also undergone an extensive review of ClearLab’smanufacturing operations.  Based on thisreview, we made the decision to consolidate ClearLab operations in Singaporeand are proceeding with the closure and consolidation.  We substantially completed the UK siteclosure (except for ongoing lease commitments and disposal of surplusequipment) in the first fiscal quarter of 2007, and anticipate that all ongoingobligations relating to the UK operations (including lease commitments anddisposal of surplus equipment) will cease no later than the end of 2007. Weanticipate that all manufacturing activity will be consolidated in Singapore bythe end of the third fiscal quarter of 2007.

The following is an estimate of total costs we expectin conjunction with the closure of the U.K site described above:
| **Description of Costs**            | ** **   | **Estimated Amount** | ** **                 |
|-----------------------------------------------|--------------|---------------------------|----------------------------|
| ** **                                    | ** **   | **(in thousands)**   | ** **                 |
| Severance/retention  costs (a)                |         | $                         | 1,195                      |   |
| Termination of lease  commitments (b)         |         | 1,000 — 2,500        |                       |
| Asset impairment (c)                          |         | 3,605                     |                       |
| Costs to relocate  equipment to Singapore (b) |         | 125                       |                       |
| Other expenses (b)                            |         | 75                        |                       |
| ***Total  estimated costs***                  | *** *** | ***$***                   | ***6,000  — $7,500*** | *** *** |

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(a)      Approximately $1,040 and$110 of these charges were included in our financial results for the fourthquarter of fiscal 2006 and the first quarter of fiscal 2007, respectively.

(b)     We expect to incur thesecharges during the balance of fiscal 2007.

(c)      These charges were includedin our fiscal 2006 financial results. The asset impairment charge related to certain manufacturing and officeequipment that will not be relocated to Singapore, as well as leasehold improvements.

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As of March 31, 2007, we have incurred cashexpenditures associated with the closure and consolidation of ClearLab UK ofapproximately $1.1 million and anticipate future cash expenditures ofapproximately $1.9 million to $3.4 million. These estimated future cash expenditures include the repayment ofapproximately $0.6 million of a regional development grant that is not includedin the above table, as the repayment will not have an impact in our statementof operations.

We announced in the first quarter of fiscal 2007 thatour strategic review to determine how to maximize value through a ClearLabseparation has been broadened to include a strategic review of the U.S. Retailbusiness and we are currently progressing with this review.

***SupplierAgreements.******  ***OnJanuary 31, 2007, we announced that we had recently signed long-term supplyagreements with the three largest contact lens manufacturers/suppliers.  We have purchased directly from the fourthlargest manufacturer/supplier without a written agreement since 2001 and basedon our longstanding relationship and recent discussions with this supplier, wedo not expect this direct relationship to change.  During the latter part of fiscal 2004, wedecided to suspend sales of a specific brand of lens, as we were unable toobtain sufficient quantities of this lens from anyone other than themanufacturer, who refused to sell us this lens. With the signing of the long-term supply agreements, we recently beganto sell this lens again in 2007, as well as other lenses previously notavailable to us.

We also have agreements with certainmanufacturers/suppliers for improved pricing and marketing support. Thissupport has come and will continue to come in the form of cooperative marketingand rebate programs designed to promote the manufacturer’s products and buildsales. As part of our ongoing relationship with our suppliers, we periodicallyreview our specific marketing plan and negotiate our cooperative marketingprograms and product pricing.

***Japanese License and RoyaltyAgreement.***    In December 2004, we signed anagreement which grants Menicon Co., LTD (Menicon), Japan’s largest independentcontact lens manufacturer, exclusive rights to develop, manufacture and marketcertain disposable contact lenses and related intellectual property inJapan.  Under the terms of the agreement,Menicon licenses from us different types of intellectual property, includingcontact lens material, manufacturing technology and related knowledge.  As of March 31, 2007, we have received atotal of $12 million under the agreement to date, including $3 million inmilestone payments.

We recognize the guaranteed portion of the licensefees, and any milestone payments from this agreement on a straight-line basis,limited by the amount of cash received, over the period of our continuedinvolvement in meeting our obligations, which is estimated to be throughDecember 2007.  Approximately $1.5million in license fee revenue was recognized in the first fiscal quarter of2006, whereas approximately $1.0 million in license fee revenue was recognizedin the first fiscal quarter of 2007.

***Doctor ReferralNetwork.******  *** We are currently expanding our national doctorreferral network with select independent practitioners and optical retailchains and currently have nearly 1,000 locations. Under this referral program,when a current or potential customer needs a new contact lens prescription, weare able to facilitate the process of obtaining an eye examination through thisnetwork of providers. This process minimizes the interruptions in productconsumption for the consumer and improves our ability to capture new customersand retain current customers.

# **RegulatoryConsiderations**

***Fairness to Contact Lens ConsumerAct. *** In November 2003, Congress passed the Fairnessto Contact Lens Consumers Act (“FCLCA”), which establishes a national uniformstandard for both eye care practitioners and direct marketers with regard toreleasing and verifying consumer contact lens prescriptions as well as otherrequirements relating to the sale of contact lenses.  The FCLCA became effective February 4, 2004,and now requires all eye care practitioners to give patients a copy of theirprescription as soon as they have been fitted for contact lenses, whether thepatients ask for it or not.  It alsodirects contact lens sellers to contact eye care practitioners to requestverification of consumer prescriptions before shipping all orders (if theprescription is not already on file), and it provides that a practitioner’sfailure to respond within eight business hours shall result in the prescriptionbeing presumed valid, thereby eliminating the ability of eye care practitionersto impede sales by direct marketers simply 

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byignoring or refusing to respond to their requests to verify prescriptions.  The FCLCA also provides that prescriptionswill be valid for a minimum of at least one year (absent some special medicalreason justifying a shorter period).  Italso directed the Federal Trade Commission (“FTC”) to conduct a study examiningthe strength of competition in the market for contact lenses and to submit areport to Congress within twelve months of the FCLCA effective date. The FTCcompleted and published this study on February 15, 2005, with norecommendations for further changes in federal law.

To satisfy the prescription verification requirementof the FCLCA, a contact lens seller must either obtain a copy of theprescription or verify the prescription by direct communication with theprescriber. Consistent with this requirement, we require all customers toprovide either a valid copy of their prescription or the contact informationfor their prescriber so that we can verify their prescription.  If we do not have a valid copy of thecustomer’s prescription, we directly communicate to the customer’s prescriberthe precise prescription information received from the customer and informs theprescriber that we will proceed with the sale based on this prescriptioninformation unless the prescriber advises us within eight business hours thatsuch prescription information is expired or otherwise invalid.  If the prescriber properly advises us withinthis time period that the customer’s prescription is expired or otherwiseinvalid, we will cancel the customer’s order. On the other hand, if the prescriber either advises us that theprescription is valid or fails to respond properly within the required timeperiod, we will complete the sale based on the prescription informationcommunicated to the prescriber, as expressly permitted by the FCLCA.  We retain copies of the written prescriptionsthat we receive and maintain records of our communications with the customer’sprescriber.  The FCLCA provides forseveral means of direct communication with eye care practitioners, and we mayalter our prescription verification procedures from time to time in keepingwith the FCLCA and FTC guidelines.

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**Resultsof Operations**

Our fiscal year consists of a 52/53-week period endingon the Saturday nearest to December 31. Fiscal 2007 is a 52-week year and willend on December 29, 2007.

We have two operating segments referred to below.  Our domestic segment is represented by operationswithin the U.S. and we refer to it as “U.S. Retail,” whereas our internationalsegment is represented by operations in both Singapore and the U.K. and werefer to this segment as “ClearLab.”

The followingtable presents our results of operations expressed as a percentage of net salesfor the periods indicated:
| ** **                                           | ** ** | **Quarter Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **April 1,**      | ** ** | **March 31,** | ** ** |
| ** **                                           | ** ** | **2006**               | ** ** | **2007** | ** ** |
| NET SALES                                            |       | 100.0                  | %          | 100.0 | % |
| COST OF GOODS  SOLD                                  |       | 61.4                   |       | 63.9 |   |
| Gross profit                                         |       | 38.6                   |       | 36.1 |   |
|                                                 |       |                   |       |   |   |
| SELLING, GENERAL  & ADMINISTRATIVE EXPENSES:     |       |                   |       |   |   |
| Advertising                                          |       | 6.3                    |       | 6.6 |   |
| Legal and professional                               |       | 1.8                    |       | 2.4 |   |
| Research and development                             |       | 2.1                    |       | 1.9 |   |
| Restructuring charges                                |       | —                 |       | 0.2 |   |
| Other selling, general & administrative          |       | 21.5                   |       | 22.1 |   |
| Total selling, general & administrative expenses |       | 31.7                   |       | 33.2 |   |
| INCOME FROM  OPERATIONS                              |       | 6.9                    |       | 2.9 |   |
| OTHER INCOME  (EXPENSE), net                         |       | 0.5                    |       | (0.5 | ) |
|                                                 |       |                   |       |   |   |
| INCOME BEFORE  PROVISION FOR INCOME TAXES            |       | 7.4                    |       | 2.4 |   |
| PROVISION FOR  INCOME TAXES                          |       | (5.5                   | )          | (3.9 | ) |
| NET INCOME (LOSS)                                    |       | 1.9                    | %          | (1.5 | )% |

 

***Net sales***. Net sales for the quarter ended March 31, 2007 increased 6.2% to $67.4million from $63.5 million for the quarter ended April 1, 2006.  Net sales for our U.S. Retail operations forthe first quarter of fiscal 2007 were $61.8 million compared to $59.2 millionfor the first quarter of fiscal 2006. U.S. Retail net sales increased primarily due to an increase in averageorder size.

During the quarter endedMarch 31, 2007, we expensed approximately $4.4 million on advertising comparedto $4.0 million for the quarter ended April 1, 2006.  Our increase in advertising spending for thefirst quarter of fiscal 2007 from first quarter of fiscal 2006 is consistentwith our strategy to spend more on advertising in fiscal 2007.  During fiscal 2006 we focused on addressingthe threat of ‘doctors only’ lenses and as a result, we cut advertisingspending for the entire year.

We decided during thefourth quarter of fiscal 2004 to suspend sales of a specific brand of lens, aswe were unable to obtain sufficient quantities of this lens from anyone otherthan the manufacturer, who refused to sell us this lens.  Sales of this product representedapproximately 2.5% of our U.S. retail net sales prior to the supplyconstraints. During the first fiscal quarter of 2007, we signed long-termsupply agreements with the three largest contact lens suppliers.  As such, we no longer face supply constraintsrelated to the above mentioned lens and began selling this lens, as well asother lenses previously not available to us.

In January of fiscal 2007, one of our largestsuppliers announced manufacturing difficulties with one of our top sellinglenses, representing approximately 4% of our U.S. retail net sales in thesecond half of fiscal

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2006.  Net sales for the quarterended March 31, 2007 were negatively impacted by this supply constraint.  Subsequent to the end of the first quarter offiscal 2007, the supplier was able to begin providing some of these lenses tous at near normal levels; however, they continue to experience difficultiesproviding other lenses and cannot guarantee when these production issues willbe completely resolved.

Net sales for ClearLab for the quarter ended March 31,2007 increased 29.5% to $5.6 million from $4.3 million for the quarter endedApril 1, 2006.  ClearLab’s results forthe first quarter of fiscal 2007 include $1.0 million in license fees from ourJapanese license agreement compared to $1.5 million in the first quarter offiscal 2006.  ClearLab’s sales increasedprimarily from an increase in sales demand in Europe.

***Gross profit.*** Consolidated gross profit as a percentage of net sales decreased to36.1% for the quarter ended March 31, 2007 from 38.6% for the quarter endedApril 1, 2006.  Gross profit as apercentage of net sales for our U.S. Retail operations increased to 40.2% inthe first quarter of fiscal 2007 from 39.9% in the first quarter of fiscal2006.  We expect the U.S. Retail grossprofit margin to vary somewhat from quarter to quarter but to be approximately40% for fiscal 2007.  This improvement inU.S. Retail gross profit from the prior fiscal year was mainly the result ofhigher retail prices on certain products during the fourth quarter of fiscal2006, partially offset by increases in select product costs and shipping rates.

Gross profit (loss) as apercentage of net sales for ClearLab was (8.2)% for the first quarter of fiscal2007, including recognized license fee revenue from our Japanese licenseagreement, compared to 14.8% for the first quarter of fiscal 2006. Excludingapproximately $1.0 million of the license fee revenue in the first quarter offiscal 2007 and $1.5 million of the license fee revenue in the first quarter offiscal 2006, gross profit (loss) as a percentage of net sales for ClearLab was(31.7)% for the first quarter of fiscal 2007 compared to (30.6)% for the firstquarter of fiscal 2006.

***Advertisingexpense. ***Advertisingexpense for the quarter ended March 31, 2007 increased to $4.4 million from$4.0 million for the first quarter ended April 1, 2006.  As a percentage of net sales, advertisingexpense for the first quarter of fiscal 2007 increased to 6.6% from 6.3% forthe first quarter of fiscal 2006. We expect to increase advertising expense toan aggregate of approximately $18.0 million to $19.0 million for fiscal 2007from $13.6 million in fiscal 2006. Our experience has been that incrementalincreases in advertising expenditures have a direct impact on the growth of netsales not only in the current period but also in future periods.

We expense alladvertising costs when the advertising first takes 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 ofour printed advertisements. The volume of mailings and other advertising may varyin different quarters and from year to year depending on our assessment ofprevailing market opportunities.

***Legaland professional fees. ***Legaland professional fees for the quarter ended March 31, 2007 increased$0.5 million from the quarter ended April 1, 2006. As a percentage of netsales, legal and professional fees increased to 2.4% for the first quarter offiscal 2007 from 1.8% for the first quarter of fiscal 2006. A majority of theincrease during the first quarter of fiscal 2007 related to accounting andlegal fees associated with the strategic reviews of ClearLab and the U.S.Retail business.

***Researchand development expenses.*** Research and development expenses for the quarter ended March 31, 2007remained constant with expenses for the quarter ended April 1, 2006 atapproximately $1.3 million.  However, asa percentage of net sales, research and development expenses decreased to 1.9%of net sales for the quarter ended March 31, 2007 from 2.1% of net sales in thequarter ended April 1, 2006.  During thefirst quarter of fiscal 2007, we continued to fund research and developmentefforts for the continued development of our intellectual property in ClearLab.

***Restructuringcharges.***  ClearLabrecorded $0.1 million during the first quarter of fiscal 2007 for severance andretention costs related to the closure of our United Kingdom manufacturingoperations and consolidation of such operations into Singapore.

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***Otherselling, general and administrative expenses.***  Other selling, general and administrative expensesfor the quarter ended March 31, 2007 increased approximately $1.3 million, or9.4%, to $15.0 million from the quarter ended April 1, 2006.  As a percentage of net sales other selling,general and administrative expenses for the first quarter of fiscal 2007 alsoincreased to 22.1% from 21.5% for the first quarter of fiscal 2006. The firstquarter of fiscal 2007 results include approximately $0.2 million of expenserelated to stock options granted prior to fiscal 2006 and approximately $0.5million of expense related to restricted stock. The first quarter of fiscal 2006 results include approximately $0.3million of expense related to stock options granted prior to fiscal 2006 andapproximately $0.1 million of expense related to restricted stock grants.

Our U.S. Retail otherselling, general and administrative expenses increased by approximately $1.0million for the first quarter of fiscal 2007 from the first quarter of fiscal2006; additionally, such expenses also increased as a percentage of net sales to20.6% from 19.8%, respectively, for the same period.  The majority of the increase for U.S. Retailfrom the prior year related to planned increases in employee costs.  These increases include restricted stock andstock option expense, as discussed above, as well as employee costs to supportcurrent operations.  Additionally, theremaining portion of the increase in other selling, general and administrativeexpenses related to planned software and facilities maintenance/support costsand increased depreciation costs associated with equipment purchased tostrengthen our technology infrastructure.

ClearLab’s other selling,general and administrative expenses increased by approximately $0.3 million forthe first quarter of fiscal 2007 from the first quarter offiscal 2006.  A majority of ClearLab’sincrease is attributed to an increase in employee costs, specifically, theaccelerated vesting of restricted stock from revised stock agreements enteredinto during the fourth quarter of fiscal 2006.

***Other income (expense), net.***  For the quarter ended March 31, 2007, we hadother expense of $(0.4) million compared to other income for the quarter endedApril 1, 2006 of $0.3 million.  For thefirst quarter of fiscal 2006 and 2007, other income (expense) consisted mainlyof interest expense, resulting from use of the revolving credit facility andforeign exchange transaction gains. Interest expense for the first quarter offiscal 2007 increased to $0.6 million compared to $0.4 million in thefirst quarter of fiscal 2006. We recorded a foreign exchange transaction gainof approximately $0.2 million and a gain of approximately $0.7 millionduring the quarters ended March 31, 2007 and April 1, 2006, respectively.  These exchange gains relate primarily tointercompany loans to ClearLab.

***Income taxes.*** We are taxed in three separate jurisdictions -U.S., Singapore and the United Kingdom. Our effective U.S. income tax rate for the quarter ended March 31, 2007is approximately 41% as compared with the 45% reported for the quarter endedApril 1, 2006. The decrease in the effective U.S. income tax rate primarilyresults from the decrease in permanent nondeductible expenses, including thoserelating to our lobbying efforts.

In the first quarter  of fiscal2007, we recorded a valuation allowance for the full amount of losses fromoperations and other deferred income tax assets in excess of taxable temporarydifferences in Singapore and the U.K., as it is more likely than not that thesedeferred tax assets will not be realized.

We expect that our fiscal 2007 effective income tax rates willapproximate 41% for the U.S. operations. For the U.K. and Singapore operations,we expect that the effective tax rate will be 0% with the exception of theJapanese withholding tax on license payments made to ClearLab International.Our effective income tax rates may change as facts and circumstances change.

On December 31, 2006, we adopted the provisions of FASB InterpretationNo. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), which clarifiesthe accounting for uncertainty in income tax positions. This interpretationrequires us to recognize in the consolidated financial statements only thosetax positions determined to be more-likely-than-not of being sustained uponexamination, based on the technical merits of the positions as of the reportingdate.  If a tax position is notconsidered more-likely-than-not to be sustained based solely on its technicalmerits, no benefits of the position are recognized. This is a differentstandard for recognition than was previously required. The more-likely-than-notthreshold must continue to be met in each reporting period to support continuedrecognition of a benefit.   At adoption,companies must adjust their financial statements to reflect only those taxpositions that are more-likely-than-not to be sustained as of the adoptiondate. Any necessary adjustment is recorded directly to opening retainedearnings in the period of adoption and reported as a change in accountingprinciple.  As a result of the adoptionof FIN 48, we recognized a decrease of $60,000 in the liability recorded forunrecognized tax 

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benefits, whichwas accounted for as a decrease to the fiscal 2007 beginning accumulateddeficit balance.  We do not have anyunrecognized tax benefits that, if recognized, would affect our effective taxrate. We recognize interest and potential penalties accrued related tounrecognized tax benefits in our provision for income taxes. We hadapproximately $54,000 accrued for the payment of interest as of March 31, 2007,which is classified as current income taxes payable on the balance sheet.

We have not been notified of intent to audit, nor are we currentlyundergoing an income tax audit in any jurisdiction. The tax years that remainsubject to examination by significant jurisdiction are as follows:

| U.S. Federal   | 2003 through the current period |
|----------------|---------------------------------|
| Utah           | 2003 through the current period |
| United Kingdom | 2004 through the current period |
| Singapore      | 2002 through the current period |

 

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**Liquidity and Capital Resources**

Our principal sources ofliquidity have been cash provided by operating activities and proceeds fromdebt financings.  Our principal uses ofcash have been to meet debt service requirements, finance acquisitions, financecapital expenditures, fund working capital needs and repurchase commonstock.  We anticipate that these useswill continue to be the principal demands of cash in the future.  As of March 31, 2007, we had net workingcapital of approximately $6.3 million, compared to $9.6 million as of December30, 2006.

We believe thatour cash on hand, together with cash generated from operating activities andthe borrowings available through our credit facility, will be sufficient tosupport planned operations through the foreseeable future.  We announced on July 26, 2006 that we hadengaged an investment bank to assist in performing a strategic review ofClearLab.  In order to fullycommercialize our products, particularly the AquaSoft Singles product, weanticipate that ClearLab will require significant additional funding over theforeseeable future, which may not be available through our cash flows fromoperations, and will likely require us to secure alternative funding. Based onthis review, we have committed to a separation of ClearLab from the U.S. Retailbusiness and are currently assessing various strategic options.  This separation will likely be accomplishedin two separate transactions — one for the flat pack technology andintellectual property and one for ClearLab’s Singapore operation.  As such, we announced on May 8, 2007 that wehave entered into a Memorandum of Understanding (“MOU”) to sell ClearLab’sSingapore operation to Mi Gwang Contact Lens Co., Ltd., a Korean based contactlens manufacturer.  The MOU includes a $1million break-up fee that is applicable if either party does not execute apurchase agreement.

Wehave also undergone an extensive review of ClearLab’s manufacturingoperations.  Based on this review, wemade the decision to consolidate ClearLab operations in Singapore and areproceeding with the closure and consolidation. We substantially completed the UK site closure (except for ongoing leasecommitments and disposal of surplus equipment) in the first fiscal quarter of2007, and anticipate that all ongoing obligations relating to the UK operations(including lease commitments and disposal of surplus equipment) will cease nolater than the end of 2007. We anticipate that all manufacturing activity willbe consolidated in Singapore by the end of the third fiscal quarter of2007.  During the first quarter of fiscal2007, we used approximately $1.1 million in cash related to these consolidationefforts and anticipate the additional use of approximately $1.9 million to $3.4million in cash related to these closure and consolidation efforts during theremainder of fiscal 2007.  Should ourplans or expectations change, related to ClearLab or otherwise, we may berequired to seek additional sources of funds and there can be no assurance thatsuch funds will be available on satisfactory terms.  Failure to obtain such financing could delayor prevent our planned growth, and could adversely affect our business,financial condition, liquidity and results of operations.

As a result of regulatory requirements, our liquidity,capital resources and results of operations may be negatively impacted in thefuture if we incur increased costs (including legal fees) or fines, areprohibited from selling our products or experiences losses of a substantialportion of our customers for whom we are unable to obtain or verify aprescription due to the requirements of the FCLCA.

**Modified Loan Agreement**

We have a loan agreementwith a U.S. bank providing for a revolving credit facility that matures on June1, 2009.  The loan agreement provides forborrowings of up to $40 million and for letters of credit up to a maximum of$15 million outstanding or payable at any time. The amount of any lettersof credit outstanding is deducted from the amount available for borrowing.   There were outstanding letters of credit of$1.5 million as of March 31, 2007 that reduce the total amount available underthe loan agreement to $38.5 million.  Wemay reduce the maximum available advance amount or terminate the loan at anytime.

Outstanding borrowings onthe revolving credit facility bear interest at a floating rate equal to thelender’s prime interest rate plus a margin or the lender’s LIBOR rate plus amargin. The interest rate is adjusted quarterly and ranges between prime minus0.75 percent and prime minus 1.25 percent or between the applicableLIBOR rate plus 1.75 percent and the applicable LIBOR rate plus2.25 percent, depending on our maximum leverage ratio, as defined in theagreement. As of March 31, 2007, the prime rate margin is minus 1.00 percentand the LIBOR rate margin 

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is 2.00 percent. Interest is payable monthly. Asof March 31, 2007, our outstanding borrowings on the credit facility, includingbank overdrafts, were $26.1 million and bore interest at the lender’sprime rate minus 1.00 percent (7.25% at March 31, 2007). The facilityrequires the quarterly payment of an unused credit fee which ranges from0.25 percent to 0.38 percent, depending on our maximum leverageratio.

Outstanding balances onthe credit facility are secured by substantially all of our U.S. assets,subsidiary debt instruments, 100 percent ownership interests in alldomestic subsidiaries and 65 percent ownership interests in foreignsubsidiaries owned directly by us. The loan agreement includes variousfinancial covenants including a capital expenditure limit, a maximum leverageratio and a minimum fixed charge coverage ratio. The loan agreement does notpermit us or our subsidiaries to dissolve, sell, dispose or merge all of theirassets or acquire all of the assets of any entity without the written consentof the U.S. bank, unless the transaction meets the definition of a “PermittedAcquisition Basket,” as defined in the agreement. The loan agreement alsoplaces a limit on the amount we can loan to any entity, outside the normalcourse of business. Additionally, the loan agreement allows us to declare orpay cash dividends, to repurchase our stock or to perform other similar equitytransactions if such transactions would not exceed $15 million in any fiscalyear and subject to other terms. This agreement defines several customaryevents of default including any material adverse change or any event thatoccurs which may cause a material adverse change in our or our subsidiaries’condition.

**Other Debt**

As of March 31, 2007, we had a term loan payable to a Singapore bank with a principal balance of SGD$2,707,000 (USD$1,785,000) that bears interest at 6.75% and is secured by substantially all of the assets of ClearLab International.  Interest payments are due monthly.  Principal payments are due in monthly installments through December 2007.  This note also contains various financial covenants including minimums on net worth and shareholders’ funds.  1-800 CONTACTS, INC. has guaranteed this term loan.

As of March 31, 2007, we also had a note payable to the former parent of ClearLab International with a principal balance of SGD$6,771,000 (USD$4,463,000) 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 monthly installments from January 2008 through December 2009.  1-800 CONTACTS, INC. has guaranteed this note.

As of March 31, 2007, we had an unsecured, non-interest bearing note to ClearLab International’s chief technology officer with a principal balance of SGD$246,000 (USD$162,000). The note payable is discounted at 7%.  Payments are due in equal monthly installments through July 2007.

Cross default clauses exist such that if we were in default on our U.S. debt, we would also be in default on our Singapore debt. If we were in default on our Singapore bank term loan, we would also be in default on the note payable to the former parent of ClearLab International and the loan agreement with the U.S. bank.  As of March 31, 2007, we were in compliance with all of the restrictive covenants in the loan agreements.

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***Cash flows from operating activities.***  For the quarters ended March 31, 2007 andApril 1, 2006, net cash provided by operating activities was approximately $3.5million and $12.8 million, respectively. In the first quarter of fiscal 2007, cash provided by operatingactivities was primarily from operating income adjusted for non-cash items(such as depreciation, amortization and stock compensation), increases inincome tax payable as well as decreases in other current assets andinventories.  These increases to cashwere partially offset by a decrease in accrued liabilities and unearned revenue.  In the first quarter of fiscal 2006, cashprovided by operating activities was primarily from operating income adjustedfor non-cash items (such as depreciation, amortization and stock compensation),increases in income tax payable, accounts payable and accrued liabilities aswell as decreases in other current assets and accounts receivable.

***Cash flows frominvesting activities.*** We used approximately $1.1 million and $2.8 million for investingactivities in the quarters ended March 31, 2007 and April 1, 2006,respectively.  Capital expenditures forinfrastructure improvements for the quarters ended March 31, 2007 and April 1,2006 were approximately $1.1 million and $2.7 million, respectively.  Of these amounts, approximately $0.6 millionand $2.0 million relate to purchases made at ClearLab, respectively.  We anticipate additional capital expendituresin fiscal 2007 for infrastructure as we continue to expand and improveoperating facilities, telecommunications systems and management information systemsin order to handle future operations of our U.S. Retail operations.

***Cash flows from financingactivities.***  Duringthe quarters ended March 31, 2007 and April 1, 2006, net cash used in financingactivities was approximately $4.5 million and $11.1 million, respectively.  In the first quarter of 2007, we had netrepayments on our credit facility of approximately $3.8 million and madeprincipal payments on debt obligations and capital lease obligations ofapproximately $0.7 million.  In the firstquarter of 2006, we had net repayments on our credit facility of approximately$10.7 million and made principal payments on debt obligations and capital leaseobligations of approximately $0.5 million. In both the first quarter of fiscal 2007 and 2006, these amounts werepartially offset by proceeds from the exercise of common stock options.

We lease variousmanufacturing and other equipment from financing companies under capital leasearrangements.  All of the equipment ismaintained at the Singapore and United Kingdom facilities.  The majority of the leases were assumed inconnection with our acquisitions of ClearLab International and ClearLabUK.  As of March 31, 2007, the presentvalue of future minimum lease payments was approximately $0.1 million withpayments scheduled through fiscal 2009.

**Contractual Obligations andCommitments**

Subsequent to December 30, 2006, there have been nomaterial changes to our contractual obligations and commitments, outside thenormal course of business.

**Critical Accounting Policies**

Accountingpolices that require significant judgments and estimates include revenuerecognition (including sales returns and allowances and customer rebates);realizability of inventories; realizability of deferred income tax assets;assessment of realizability of long-lived assets; stock-based compensation; andlegal and regulatory contingencies.  Adescription of our significant accounting policies is included in the notes tothe consolidated financial statements included in our Form 10-K for the fiscalyear ended December 30, 2006.  Judgmentsand estimates are based on historical experience as well as relevant facts andcircumstances known at each reporting date. Actual results may differ from these estimates.

Sales are generally recognized when products areshipped and the customer takes ownership and assumes risk of loss, collectionof the related receivable is reasonably assured, the persuasive evidence of anarrangement exists and the sales price is fixed or determinable.  U.S. Retail net sales consist of productsales less a provision for sales returns and allowances and estimated customerrebates.  We accrue an estimated amountfor unclaimed customer rebates and sales returns and allowances based onhistorical information, adjusted for economic trends.  To the extent actual rebates, returns andallowances vary from historical experience revisions to the allowances may berequired.  ClearLab net sales consist ofproduct sales less a provision for sales returns and allowances. We provide ourcustomers with standard industry payment terms and perform ongoing creditevaluations of our customers and provide for doubtful accounts to the extentdetermined necessary based on historical data and current economic 

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trends.  ClearLab net sales also include license feesfrom our Japanese license agreement. Cash payments received from this license are recognized systematicallyover the periods that we earn the fees.

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

We havesignificant long-lived tangible and intangible assets consisting primarily ofproperty, plant and equipment, goodwill and definite-lived intangibles.  These assets are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountsof such assets may not be recoverable. In addition, we perform an impairment test related to goodwill at leastannually.  An impairment analysis relatedto long-lived tangible and definite-lived intangible assets requires theassessment of expected future undiscounted cash flows over the remaining usefullife of the asset.  An impairment analysisof goodwill requires the use of a fair-value based analysis.  All of the goodwill and a significant portionof the other long-lived assets were generated from our acquisitions of ClearLabInternational, ClearLab UK and Lens1st/Lens Express.  We recorded no impairment charges during thefirst quarter of fiscal 2007.

Deferred incometax assets are assessed for recoverability and valuation allowances areprovided as necessary to reduce deferred income tax assets to amounts expectedto be realized.  Should expectations oftaxable income change in future periods, it may become necessary to change thevaluation allowance, which could affect our results of operations in the periodsuch determination is made.  We record anincome tax provision or benefit at a rate that is based on expected results forthe fiscal year.  If future changes inmarket conditions cause actual results to be more or less favorable,adjustments to the effective income tax rate on a quarterly basis could berequired.

We recordliabilities for legal and regulatory matters when the contingency is bothprobable and reasonably estimable.  Weare involved in several legal and regulatory matters.  We believe, after consultation with legalcounsel, that the ultimate dispositions of these matters will not have amaterial impact on our financial position, liquidity or results ofoperations.  However, there can be noassurance that we will be successful in our efforts to satisfactorily resolvethese matters and the ultimate outcome could result in a material negativeimpact on our financial position, liquidity or results of operations.

We account forshare-based compensation in accordance with SFAS No. 123R, which requiresstock-based compensation to be measured based on the fair value of the award onthe date of grant and recognized over the period during which service isrequired in exchange for the award.  Under the fair value recognition provisions of SFAS No. 123R, werecognize stock-based compensation net of an estimated forfeiture rate and onlyrecognize compensation cost for those shares expected to vest over therequisite service period of the award. We generally recognized compensation expense for restricted stock awardsand, when we granted options with an exercise price below the market price onthe date of grant. We estimate the value of stock option awards on the date ofgrant using a Black-Scholes pricing model. Calculating the fair value ofshare-based payment awards requires the input of highly subjective assumptions,including the expected term of the share-based payment awards and expectedstock price volatility.  The expectedterm represents the average time that options that vest are expected to beoutstanding.  The expected volatilityrates are estimated based on a weighted average of the historical volatilitiesof our common stock.  The assumptionsused in calculating the fair value of share-based payment awards represent ourbest estimates, but these estimates involve inherent uncertainties and theapplication of our judgment. As a result, if factors change and we usedifferent assumptions, the stock-based compensation expense could be materiallydifferent in the future. In addition, we are required to estimate the expectedforfeiture rate and only recognize expense for those shares expected to vest.If our actual forfeiture rate is materially different from our estimate, thestock-based compensation expense could be significantly different from what wehave recorded in the current period.

Effective December31, 2006, we adopted the provisions of the SEC Staff Accounting BulletinNo. 108, “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements” (“SAB 108”).SAB 108 provides guidance on how prior year misstatements should be takeninto consideration when quantifying misstatements in current year financialstatements for purposes of determining whether the current year’s financialstatements are materially misstated. SAB 108 permits registrants to record thecumulative effect of initial adoption by recording the necessary “correcting”adjustments to the carrying values of 

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assets and liabilities asof the beginning of that year with the offsetting adjustment recorded to theopening balance of retained earnings only if material under the dualmethod.   Adoption of SAB 108 had noimpact on our consolidated financial statements in the current period.

Effective December31, 2006, we adopted the provisions of Financial Accounting Standards Board(FASB) issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes,” which defines the threshold for recognizing the benefits of tax returnpositions in the financial statements as more-likely-than-not to be sustainedby the taxing authority. A tax position that meets the more-likely-than-notcriterion shall be measured at the largest amount of benefit that is more than50% likely of being realized upon ultimate settlement. InterpretationNo. 48 applies to all tax positions accounted for under SFAS No. 109,“Accounting for Income Taxes.”  Uponadoption, we have adjusted the financial statements to reflect only those taxpositions that are more-likely-than-not to be sustained as of the adoptiondate. Any adjustment has been recorded directly to the beginning retainedearnings/accumulated deficit balance in the period of adoption and reported asa change in accounting principle.  As aresult of the implementation of FIN 48, we recognized a $60,000 decrease to ourliability for income taxes payable, and a corresponding decrease to our 2007beginning balance of accumulated deficit.

Effective December31, 2006, we adopted Emerging Issues Task Force (“EITF”) Issue No. 06-03 (“EITF06-03”), “How Taxes Collected from Customers and Remitted to GovernmentalAuthorities Should Be Presented in the Income Statement (That Is, Gross versusNet Presentation).”  EITF 06-03 providesthat the presentation of taxes assessed by a governmental authority that isdirectly imposed on a revenue-producing transaction between a seller and acustomer on either a gross basis (included in revenues and costs) or on a netbasis (excluded from revenues) is an accounting policy decision that should bedisclosed.  Adoption of EITF 06-03 didnot have a material impact on our consolidated financial statements in the currentperiod.

**CautionaryStatement Concerning Forward-Looking Statements**

This QuarterlyReport on Form 10-Q contains a number of statements about our future businessprospects which are forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995.  These forward-looking statements include allstatements which are not purely historical and include, but are not necessarilylimited to:

·                  Any statementsrelating in any way to the planned separation of ClearLab from the U.S. retailbusiness, including but not limited to the timing of such separation or theterms upon which such separation may be accomplished;

·                  Any statementsrelating in any way to our ongoing strategic review of the U.S. retailbusiness;

·                  Any statementsrelating to our perception of the contact lens market and anticipated trends inthat market in any of the countries in which we do business;

·                  Any statementsrelating to our relationships with our suppliers, our anticipated ability toprocure products, or the terms under which we may procure its products;

·                  Any statementsrelating to sales, usage, or trends in the contact lens industry and market;

·                  Any statementsrelating to our anticipated business operations, inventory levels, ability tohandle specific call volumes, ability to fill and timely ship orders, orsimilar statements;

·                  Any statementsrelating to our anticipated results of operations, including but not limited toanticipated sales, revenues, earnings, tax benefits, payments due pursuant toapplicable license agreements, or similar matters; and

·                  Any statementsrelating to expectations with respect to legal and legislative initiatives in2007 and beyond.

Without limitingthe foregoing, the words “believes,” “anticipates,” “plans,” “expects,” “intends,”“future,” “would,” “could,” “might,” “should,” “may”, and similar expressions,including any expressions of our plans, intentions, or goals, are intended toidentify forward-looking statements, although not all forward-lookingstatements contain these words.

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There are a number of important factors that could cause actual eventsor our actual results to differ materially from those indicated by suchforward-looking statements. These factors include, without limitation, thoseset forth under the captions “Application of Critical Accounting Policies,” “Liquidityand Capital Resources,” “Factors Affecting Future Operating Results” and “Quantitativeand Qualitative Disclosures about Market Risk” included this Quarterly Reporton Form 10-Q.  The factors discussedherein do not reflect the potential future impact of any mergers, acquisitionsor dispositions.  In addition, anyforward-looking statements represent our estimates only as of the day thisReport was first filed with the Securities and Exchange Commission and wespecifically disclaim any obligation to update forward looking statements, evenif our estimates change.

**Item 3.****          *****Quantitativeand Qualitative Disclosures about Market Risk***

***Interest Rate Risk.***** **As of March 31, 2007, we were exposed to changesin interest rates relating to our revolving credit facility and other debtobligations.  The revolving creditfacility bears interest at a variable rate based on the U.S. prime rate orLIBOR. Our outstanding borrowings on the credit facility, including bankoverdrafts, were approximately $26.1 million as of March 31, 2007. Theremainder of our interest bearing debt obligations, including capital leaseobligations, is denominated in Singapore dollars and British pounds and bearsinterest at a fixed rate.  As of March31, 2007, the face amounts of the outstanding borrowings on these fixed ratedebt obligations were approximately $6.4 million.  If interest rates were to change by a fullpercentage point, the net impact on interest expense would be approximately$0.3 million per year.

***Foreign CurrencyRisk.***  We faceforeign currency risks primarily as a result of our Singapore and UnitedKingdom operations and the intercompany balances, which are denominated in U.S.dollars, between the U.S. and these international operations.  The functional currency of our Singaporeoperations is the Singapore dollar.  Wehave debt and other long-term obligations of approximately $6.5 million that aredenominated in Singapore dollars and mature over the next three years.  If the U.S. dollar weakens relative to theSingapore dollar, additional funds may be required to meet these obligations ifthe debt cannot be adequately serviced from the Singapore operations.  Fluctuations in exchange rates between theU.S. dollar and the Singapore dollar could lead to additional currency exchangelosses or gains on the intercompany balances and transactions denominated incurrencies other than the functional currency. For the first quarter of fiscal 2007, we recorded approximately $0.3million of foreign currency transaction gains on the intercompany balancesbetween the U.S. and Singapore operations. A portion of the intercompany balances between the U.S. and Singaporeoperations is considered to be permanently invested and thus a correspondingportion of the first quarter of fiscal 2007 foreign currency transaction gains,not included in the amount shown above, are flowing through other comprehensiveincome in the equity section, rather than through other income in our statementof operations.  We recorded no foreigncurrency transaction gains or losses on sales with external parties.  From the date of the ClearLab Internationalacquisition, July 24, 2002, through May 3, 2007, the exchange rate hasfluctuated approximately 14.5 percent (weakening of the U.S. dollar).   If the Singapore dollar were to weakenagainst the U.S. dollar by 10 percent, we would record a $4.4 million dollarforeign currency loss on the intercompany balances that exist as of March 31,2007.

The functional currency of our United Kingdomoperations is the British pound. Fluctuations in exchange rates between the U.S. dollar and the Britishpound could lead to additional currency exchange losses or gains onintercompany balances and transactions denominated in currencies other than thefunctional currency.  For the firstquarter of fiscal 2007, we recorded an immaterial amount of foreign currencytransaction gains on the intercompany balances between the U.S. and UnitedKingdom operations; and recorded approximately $0.1 million of foreign currencytransactions losses on sales with external parties.  From the date of the ClearLab UK acquisition,February 24, 2004, through May 3, 2007, the exchange rate has fluctuatedapproximately 6.8 percent (weakening of the U.S. dollar).  If the British pound were to weaken againstthe U.S. dollar by 10 percent, we would record a $1.9 million dollar foreigncurrency loss on the intercompany balances that exist as of March 31, 2007.

We have not entered intoany foreign currency derivative financial instruments; however, we may chooseto do so in the future in an effort to manage or hedge our foreign currencyrisk.

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

Our ChiefExecutive Officer and Chief Financial Officer, after evaluating theeffectiveness of our disclosure controls and procedures (as defined in ExchangeAct Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by thisreport (the “Evaluation Date”), have concluded that, as of the Evaluation Date,our disclosure controls and procedures were adequate and effective to ensurethat material information relating to us and our consolidated subsidiarieswould be made known to them by others within those entities.

There were nosignificant changes in our internal controls over financial reporting or inother factors that have materially affected, or are reasonably likely tomaterially affect, our internal controls over financial reporting subsequent tothe Evaluation Date.  As a result, nocorrective actions were taken.

Our management,including the Chief Executive Officer and Chief Financial Officer, does notexpect that our disclosure controls and procedures or our internal controlsover financial reporting will prevent all error and all fraud.  A control system, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the control system are met.  Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs.  Because of inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, have been detected.

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**PART II.                OTHERINFORMATION**

**Item 1.                    *LegalProceedings***

From time to timewe are involved in legal matters generally incidental to our business. It isthe opinion of our management, after discussion with legal counsel, that exceptfor legal and professional fees that we incur from time to time, the ultimatedispositions of all of these matters will not have a material impact on ourfinancial position, liquidity or results of our operations. However, there canbe no assurance that we will be successful in our efforts to satisfactorilyresolve these matters, and the ultimate outcome could result in a materialnegative impact on our financial position, liquidity or results of operations.

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

Other than theadditional risk factor set forth below, there are no material changes from therisk factors previously disclosed in our Annual Report on Form 10-K for thefiscal year ended December 30, 2006.

**Ourefforts and progress towards selling our ClearLab operations and intellectualproperty may not result in transactions on favorable terms for us, or at all.**

While we haveexpended significant efforts, and made progress, toward the separation of ourClearLab operations from our U.S. Retail operations, including our announcementthat we have entered into a Memorandum of Understanding with Mi Gwang ContactLens Co., Ltd. for the sale of ClearLab’s Singapore manufacturing operations,our efforts and progress may not result in transactions that are on favorableterms to us, or at all.  We do not have adefinitive purchase agreement executed for any of ClearLab’s assets.  If we are unable to ultimately enter intotransactions that sell or otherwise separate ClearLab’s assets from our U.S.Retail operations on favorable terms, we will not realize benefits from thesignificant amounts of time, effort and funds that we have expended, we maycontinue to suffer losses from ClearLab’s operations that materially affect ouroverall financial results and condition, and we may be required to obtainunfavorable financing for ClearLab.

**Item 2.                    *UnregisteredSales of Equity Securities and Use of Proceeds***

None.

**Item 3.                    *DefaultsUpon Senior Securities***

None.

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

None.

**Item 5.                    *OtherInformation***

None.

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**Item 6.                    *Exhibits***

**(A) Exhibits**

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

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                     | **1-800 CONTACTS, INC.** |
|---------------------|--------------------------|
|                |                     |   |   |
|                |                     |   |   |
|                |                     |   |   |
|                |                     |   |   |
| Dated: May 10, 2007 | By:                      | /s/ Jonathan C. Coon |   |
|                |                     | Name: | Jonathan C. Coon |
|                |                     | Title: | Chief Executive Officer |
|                |                     |   |   |
|                | By:                      | /s/ Robert G. Hunter |   |
|                |                     | Name: | Robert G. Hunter |
|                |                     | Title: | Chief Financial Officer |
|                     |                          |  |  |  |  |

 

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