UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark one)
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended April 1, 2006
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
Commission file number: 0-23633
1-800 CONTACTS, INC.
(Exact name of registrant as specified in its charter)
Delaware |
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87-0571643 |
(State or other jurisdiction of |
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(I.R.S. Employer Identification No.) |
incorporation or organization) |
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66 E. Wadsworth Park Drive, |
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Draper, UT |
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84020 |
(Address of principal executive offices) |
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(Zip Code) |
(801) 316-5000 |
(Registrants telephone number, including area code) |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
ý Yes No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer o |
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Accelerated filer ý |
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Non-accelerated filer o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
o Yes ý No
As of May 4, 2006, the Registrant had 14,009,689 shares of Common Stock, par value $0.01 per share, outstanding.
1-800 CONTACTS, INC.
INDEX
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Condensed Consolidated Balance Sheets as of December 31, 2005 and April 1, 2006 |
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Managements Discussion and Analysis of Financial Condition and Results of Operations |
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1-800 CONTACTS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
ASSETS
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December 31, |
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April 1, |
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2005 |
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2006 |
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CURRENT ASSETS: |
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Cash |
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$ |
1,481 |
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$ |
407 |
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Accounts receivable, net |
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3,451 |
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3,027 |
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Other receivables |
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1,738 |
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1,564 |
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Inventories, net |
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21,458 |
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21,596 |
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Deferred income taxes |
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1,624 |
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1,872 |
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Other current assets |
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3,792 |
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2,202 |
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Total current assets |
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33,544 |
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30,668 |
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PROPERTY AND EQUIPMENT, net |
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29,705 |
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31,389 |
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DEFERRED INCOME TAXES |
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1,087 |
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1,054 |
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GOODWILL |
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35,405 |
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35,773 |
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DEFINITE-LIVED INTANGIBLES, net |
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13,847 |
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13,268 |
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OTHER ASSETS |
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1,357 |
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1,365 |
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Total assets |
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$ |
114,945 |
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$ |
113,517 |
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LIABILITIES AND STOCKHOLDERS EQUITY |
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CURRENT LIABILITIES: |
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Line of credit |
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$ |
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$ |
13,061 |
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Current portion of long-term debt |
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1,633 |
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1,686 |
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Current portion of capital lease obligations |
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58 |
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28 |
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Income taxes payable |
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567 |
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4,104 |
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Accounts payable |
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12,063 |
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14,533 |
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Accrued liabilities |
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8,197 |
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9,784 |
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Unearned revenue |
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3,299 |
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4,024 |
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Total current liabilities |
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25,817 |
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47,220 |
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LONG-TERM LIABILITIES: |
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Line of credit |
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23,746 |
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Long-term debt, net of current portion |
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6,440 |
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6,211 |
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Capital lease obligations, net of current portion |
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83 |
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70 |
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Unearned revenue, net of current portion |
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973 |
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498 |
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Other long-term liabilities |
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669 |
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645 |
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Total long-term liabilities |
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31,911 |
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7,424 |
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STOCKHOLDERS EQUITY: |
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Common stock, 13,340 and 13,358 issued and outstanding, respectively |
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133 |
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134 |
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Additional paid-in capital |
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47,876 |
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48,351 |
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Retained earnings |
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9,613 |
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10,794 |
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Accumulated other comprehensive loss |
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(405 |
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(406 |
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Total stockholders equity |
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57,217 |
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58,873 |
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Total liabilities and stockholders equity |
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$ |
114,945 |
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$ |
113,517 |
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See accompanying notes to condensed consolidated financial statements.
3
1-800 CONTACTS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
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Quarter Ended |
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April 2, |
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April 1, |
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2005 |
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2006 |
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NET SALES |
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$ |
60,283 |
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$ |
63,491 |
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COST OF GOODS SOLD |
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37,775 |
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39,013 |
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Gross profit |
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22,508 |
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24,478 |
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SELLING, GENERAL AND ADMINISTRATIVE EXPENSES: |
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Advertising |
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6,538 |
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3,983 |
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Legal and professional |
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1,284 |
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1,125 |
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Research and development |
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1,055 |
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1,328 |
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Other selling, general and administrative |
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11,517 |
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13,679 |
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Total selling, general and administrative expenses |
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20,394 |
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20,115 |
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INCOME FROM OPERATIONS |
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2,114 |
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4,363 |
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OTHER INCOME (EXPENSE), net |
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(641 |
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313 |
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INCOME BEFORE PROVISION FOR INCOME TAXES |
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1,473 |
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4,676 |
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PROVISION FOR INCOME TAXES |
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(1,290 |
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(3,495 |
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NET INCOME |
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$ |
183 |
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$ |
1,181 |
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PER SHARE INFORMATION: |
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Basic and diluted net income per common share |
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$ |
0.01 |
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$ |
0.09 |
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See accompanying notes to condensed consolidated financial statements.
4
1-800 CONTACTS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
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Quarter Ended |
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April 2, |
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April 1, |
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2005 |
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2006 |
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CASH FLOWS FROM OPERATING ACTIVITIES: |
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Net income |
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$ |
183 |
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$ |
1,181 |
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Adjustments to reconcile net income to net cash provided by operating activities: |
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Depreciation and amortization |
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2,126 |
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2,298 |
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Amortization of debt issuance costs and discounts |
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48 |
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56 |
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Foreign currency exchange loss (gain) |
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312 |
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(732 |
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Stock-based compensation |
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5 |
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367 |
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Tax benefits from share-based payment exercises |
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(14 |
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Loss on sale of property and equipment |
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107 |
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2 |
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Deferred income taxes |
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(626 |
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(216 |
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Changes in operating assets and liabilities: |
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Accounts receivable, net |
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(321 |
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623 |
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Inventories, net |
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489 |
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40 |
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Other receivables |
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447 |
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174 |
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Other current assets |
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72 |
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1,619 |
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Income taxes payable |
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1,190 |
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3,538 |
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Accounts payable |
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1,938 |
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2,182 |
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Accrued liabilities |
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1,276 |
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1,528 |
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Unearned revenue |
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(1,070 |
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164 |
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Net cash provided by operating activities |
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6,176 |
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12,810 |
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CASH FLOWS FROM INVESTING ACTIVITIES: |
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Purchase of property and equipment |
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(1,282 |
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(2,658 |
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Proceeds from sale of property and equipment |
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27 |
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Deposits and other |
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(598 |
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(106 |
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Net cash used in investing activities |
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$ |
(1,853 |
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$ |
(2,764 |
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5
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Quarter Ended |
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April 2, |
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April 1, |
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2005 |
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2006 |
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CASH FLOWS FROM FINANCING ACTIVITIES: |
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Proceeds from exercise of stock options |
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$ |
78 |
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$ |
97 |
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Excess tax benefits from share-based payment exercises |
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27 |
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Net repayments on line of credit |
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(5,988 |
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(10,684 |
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Principal payments on capital lease obligations |
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(13 |
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(46 |
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Principal payments on long-term debt |
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(421 |
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(464 |
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Net cash used in financing activities |
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(6,344 |
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(11,070 |
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EFFECT OF FOREIGN EXCHANGE RATES ON CASH |
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36 |
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(50 |
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NET DECREASE IN CASH |
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(1,985 |
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(1,074 |
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CASH AT BEGINNING OF PERIOD |
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3,105 |
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1,481 |
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CASH AT END OF PERIOD |
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$ |
1,120 |
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$ |
407 |
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SUPPLEMENTAL CASH FLOW INFORMATION: |
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Cash paid for interest |
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$ |
262 |
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$ |
430 |
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Cash paid for income taxes |
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725 |
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150 |
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See accompanying notes to condensed consolidated financial statements.
6
1-800 CONTACTS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The accompanying condensed consolidated financial statements have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments), which in the opinion of management, are necessary to present fairly the results of operations of the Company for the periods presented. It is suggested that these condensed consolidated financial statements be read in conjunction with the audited financial statements and the notes thereto included in the Companys Annual Report on Form 10-K for the year ended December 31, 2005.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates.
Inventories are recorded at the lower of cost (using the first-in, first-out method) or market value. Elements of cost in the Companys manufactured inventories generally include raw materials, direct labor, manufacturing overhead and freight-in. Inventories consisted of the following (in thousands):
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December 31, |
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April 1, |
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2005 |
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2006 |
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Purchased contact lenses and accessories |
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$ |
13,554 |
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$ |
11,723 |
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Manufactured inventories: |
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Raw materials |
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1,322 |
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1,288 |
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Work in process |
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1,894 |
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1,747 |
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Finished goods contact lenses |
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4,688 |
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6,838 |
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Total |
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$ |
21,458 |
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$ |
21,596 |
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Provision is made to reduce excess and obsolete inventories to their estimated net realizable values. As of December 31, 2005 and April 1, 2006, reserves for excess and obsolete inventories were approximately $2.2 million and $2.4 million, respectively.
NOTE 3. NET INCOME PER COMMON SHARE
Basic net income per common share (Basic EPS) excludes dilution and is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted net income per common share (Diluted EPS) reflects the potential dilution that could occur if stock options or other common stock equivalents were exercised or converted into common stock using the treasury stock method. The computation of Diluted EPS does not assume exercise or conversion of securities that would have an antidilutive effect on net income per common share. Additionally, the Company has not reflected performance awards in Diluted EPS since the performance conditions have not been satisfied as of April 1, 2006. For the quarter ended April 2, 2005, options to purchase 830,124 shares of common stock were not included in the computation of Diluted EPS because the effect would be antidilutive. For the quarter ended April 1, 2006, options to purchase 690,134 shares of common stock and 32,041 shares of unvested common stock were not included in the computation of Diluted EPS because the effect would be antidiultive.
7
The following is a reconciliation of the numerator and denominator used to calculate Basic and Diluted EPS (in thousands, except per share amounts):
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Quarter Ended April 2, 2005 |
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Quarter Ended April 1, 2006 |
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Net |
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Shares |
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Per-Share |
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Net |
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Shares |
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Per-Share |
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Basic EPS |
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$ |
183 |
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13,302 |
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$ |
0.01 |
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$ |
1,181 |
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13,345 |
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$ |
0.09 |
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Effect of stock options |
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191 |
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96 |
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Effect of unvested stock awards |
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Diluted EPS |
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$ |
183 |
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13,493 |
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$ |
0.01 |
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$ |
1,181 |
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13,441 |
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$ |
0.09 |
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NOTE 4. COMPREHENSIVE INCOME
Comprehensive income for the quarters ended April 2, 2005 and April 1, 2006 consists of the following components (in thousands):
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Quarter Ended |
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April 2, |
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April 1, |
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Net income |
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$ |
183 |
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$ |
1,181 |
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Foreign currency translation |
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(117 |
) |
(1 |
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Comprehensive income |
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$ |
66 |
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$ |
1,180 |
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The foreign currency translation loss results primarily from changes in exchange rates relative to the U.S. dollar from the translation of the Companys Singapore and United Kingdom subsidiaries financial statements.
NOTE 5. STOCK-BASED COMPENSATION
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), Share-Based Payment, (SFAS No. 123R), which requires stock-based compensation to be measured based on the fair value of the award on the date of grant and recognized over the period during which service is required in exchange for the award. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB No. 107) relating to SFAS No. 123R. The Company has applied the provisions of SAB No. 107 in its adoption of SFAS No. 123R.
Prior to January 1, 2006, the Company applied Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations (APB 25), and adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123 (SFAS No. 123), Accounting for Stock-Based Compensation. Under APB 25, no compensation expense was recognized in net income for grants of employee stock options prior to 2006.
SFAS No. 123R applies to all of the Companys outstanding unvested share-based payment awards as of January 1, 2006 and all prospective awards. All of the Companys stock-based awards, which are stock options and restricted stock awards, are classified as equity instruments. In accordance with SFAS No. 123R, the Company elected to use the modified prospective transition method and therefore, financial statements prior to adoption remain unchanged. Under this transition method, compensation cost for the quarter ended April 1, 2006, includes amounts associated with (i) unvested stock options granted prior
8
to January 1, 2006, (ii) restricted stock awards granted prior to January 1, 2006 and (iii) restricted stock awards granted during the quarter. Compensation cost recognized in the first quarter of fiscal 2006 for unvested options as of January 1, 2006 was based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123. The following discusses certain other elections and assumptions the Company made as a result of adopting SFAS No. 123R:
Black-Scholes Model. For the Companys pro forma disclosures under SFAS No. 123, it used the Black-Scholes option pricing model. Upon the adoption of SFAS No. 123R, the Company has elected to continue to use the Black-Scholes option pricing model to compute the fair value of options granted on or after January 1, 2006.
Forfeitures. Forfeitures under SFAS No. 123 were recognized when they occurred. SFAS No. 123R, however, requires forfeitures to be estimated at the grant date. Accordingly, compensation cost is recognized based on the number of awards expected to vest. There may be adjustments in future periods if actual forfeitures differ from the Companys estimates. The Companys forfeiture rates are based upon historical experience.
Short-cut Method. The Company has elected to use the short-cut method in accordance with FSP 123R-3 in measuring its APIC pool available to absorb tax deficiencies recognized in subsequent periods from the exercise of unqualified stock options and vesting of restricted stock awards. Under the short-cut method, the Company has determined that it has no APIC pool as of January 1, 2006. Accordingly, realized tax deficiencies in excess of tax benefits related to fully vested awards as of January 1, 2006, will be recorded as additional income tax expense in the period determined.
Prior to the adoption of SFAS No. 123R, the Company presented tax benefits resulting from share-based compensation as operating cash flows in the consolidated statements of cash flows. SFAS 123R requires that cash flows resulting from tax deductions in excess of compensation cost recognized in the financial statements be classified as financing cash flows. However, under the short-cut method, for all vested awards as of January 1, 2006, any realized tax benefits are recorded as financing cash flows and an increase to additional paid in capital. For the first quarter of fiscal 2006, approximately $27,000 of excess tax benefits were generated.
Stock-based expense for the first quarter of fiscal 2006 includes expense, recognized over the applicable vesting periods, for new restricted stock share-based awards and for restricted stock and stock option share-based awards granted prior to, but not yet vested, as of January 1, 2006. As a result of adopting SFAS No. 123R, the stock-based compensation expense for employees and non-employee directors for the first quarter of fiscal 2006 totaled approximately $0.4 million. The total income tax benefit related to stock-based expense during the first quarter of fiscal 2006 was approximately $0.1 million. The impact on basic and diluted earnings per share for the first quarter of fiscal 2006 was a decrease of approximately $0.02 per share. In addition, prior to the adoption of SFAS No. 123R, the Company presented the tax benefit from the exercise of common stock option exercises as, a component of cash flows from operating activities. Upon the adoption of SFAS No. 123R, tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are classified as a component of cash flows from financing activities. This resulted in a decrease of $27,000 in cash flows from operating activities and an increase of $27,000 in cash flows from financing activities compared to cash flows from stock-based compensation presented under APB 25.
Stock Based Award Plans
Stock Options. The Company has established a stock option plan that provides for the issuance of a maximum 1,940,000 shares of common stock to officers, employees, directors and consultants. The plan allows for the issuance of both incentive stock options, nonqualified stock options and restricted stock. Incentive and nonqualified stock options are granted at not less than 100 percent of the fair market value of the underlying common stock on the date of grant. As of April 1, 2006, 17,398 shares are available for future granting.
Prior to the establishment of the stock option plan, the Company issued nonqualified stock options to various key employees, a consultant and a director of the Company.
9
All options granted through January 1, 2000 vest equally over a three-year period and expire in ten years. The stock options issued as a portion of the consideration for the assignment of certain technologies and intellectual property in conjunction with the acquisition of ClearLab International and other options issued to the chief technology officer of ClearLab International vest equally at the end of the third, fourth and fifth years and expire in ten years. All other options granted subsequent to January 1, 2000, vest equally over a four-year period and expire in five to ten years.
Stock options remain outstanding under these various plans as of January 1, 2006. There were no options granted from these plans during the first quarter of fiscal 2006, and the Company does not currently plan to grant any stock options in fiscal 2006. Under SFAS No. 123, pro-forma expense for stock options was calculated using a straight-line vesting schedule over the vesting period of approximately four years. Had the Company used the fair value based accounting method for stock option expense prescribed by SFAS No. 123, the Companys net income and earnings per share for the first quarter of fiscal 2005 would have been reduced to the pro-forma amounts illustrated as follows (in thousands, except per share amounts):
|
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Quarter Ended |
|
|
|
|
April 2, 2005 |
|
|
Net income (loss): |
|
|
|
|
As reported |
|
$ |
183 |
|
Add: Stock based compensation expense included in reported net income, net of tax |
|
5 |
|
|
Deduct: Fair-value based compensation, net of tax |
|
(314 |
) |
|
Pro forma |
|
$ |
(126 |
) |
|
|
|
|
|
Basic and diluted net income(loss) per common share: |
|
|
|
|
As reported |
|
$ |
0.01 |
|
Pro forma |
|
$ |
(0.01 |
) |
The Companys stock option activity during the first quarter of fiscal 2006 is as follows (in thousands, except option prices and years):
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|
|
|
|
Weighted |
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|
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Weighted |
|
Average |
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|
|
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Average |
|
Remaining |
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Aggregate |
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|
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Number of |
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Exercise |
|
Contractual |
|
Intrinsic |
|
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|
|
Options |
|
Price |
|
Life (Years) |
|
Value |
|
||
|
|
|
|
|
|
|
|
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|
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Options outstanding at December 31, 2005 |
|
1,243 |
|
$ |
20.90 |
|
|
|
|
|
|
Exercised |
|
(14 |
) |
7.14 |
|
|
|
|
|
||
Forfeited |
|
(14 |
) |
22.19 |
|
|
|
|
|
||
Expired |
|
(2 |
) |
23.94 |
|
|
|
|
|
||
Options outstanding at April 1, 2006 |
|
1,213 |
|
$ |
21.03 |
|
4.17 |
|
$ |
1,421 |
|
Options vested and expected to vest at April 1, 2006 |
|
1,152 |
|
20.67 |
|
4.13 |
|
1,420 |
|
||
|
|
|
|
|
|
|
|
|
|
||
Options exercisable at April 1, 2006 |
|
808 |
|
$ |
17.56 |
|
3.76 |
|
$ |
1,416 |
|
The total intrinsic value of options exercised during the first quarters of fiscal 2006 and 2005 totaled approximately $0.1 million for both respective periods. The weighted average fair value of stock option grants was $11.30 for the first quarter of fiscal 2005. No stock options were granted in the first quarter of fiscal 2006.
10
The fair value of options granted in the first quarter of fiscal 2005 was estimated using the Black-Scholes option valuation model that used the assumptions noted in the table below. Expected volatility and expected dividend yield are based on actual historical experience of the Companys stock. The expected life represents the period of time that options granted are expected to be outstanding. The risk-free rate is based on the U.S. Treasury security with terms equal to the expected time of exercise as of the grant date.
|
|
Quarter Ended |
|
|
|
|
April 2, 2005 |
|
|
Risk-free interest rate |
|
3.7 |
% |
|
Expected dividend yield |
|
0.0 |
% |
|
Volatility |
|
66 |
% |
|
Expected life |
|
5 years |
|
For the first quarter of fiscal 2006, stock option expense is recognized on a straight-line basis over the four year vesting period. Approximately $0.3 million was charged to expense in the first quarter of fiscal 2006. The Company has applied a weighted average forfeiture assumption of 15.03% in the calculation of such expense.
As of April 1, 2006, there was approximately $1.4 million of unrecognized compensation cost related to non-vested stock options, which is expected to be recognized over a weighted-average period of approximately one year.
Cash received from option exercises during the first quarter of fiscal 2006 was approximately $0.1 million. The total tax benefit generated from options granted prior to December 31, 2005, which were exercised during the first quarter of fiscal 2006, was approximately $27,000 which was credited to additional paid-in capital.
Restricted Share Awards. During the fiscal quarter ended April 1, 2006, the Companys Board of Directors approved a grant of 599,096 shares of restricted common stock to various employees and executives of the Company. The restricted share grants were valued at the closing stock price on the date of the grant, March 27, 2006, which was $13.14. The restricted share grants include both time-vesting and performance-vesting restricted shares. The time-vesting shares (273,451 awards) vest 20% per year beginning November 30, 2006 and ending November 30, 2010. The performance-vesting shares (325,645 awards) vest upon achievement of certain operational milestones - such as obtaining sources for doctors only lenses on competitive terms, development of certain contact lens products and the achievement of an eight quarter cumulative financial target of at least $81 million consolidated earnings before taxes by or before the end of fiscal 2010. Both the time-vesting and the performance-vesting shares are subject to various change in control provisions involving the Company and its subsidiaries that may result in the accelerated vesting of unvested shares as well as conversion of unvested shares into a cash amount at the time of the change in control.
The Company also granted 50,000 shares of restricted common stock to its five non-employee Directors. These grants vest equally over a three-year period ended March 27, 2009, the vesting of these awards will be accelerated upon a change in control of the Company. The restricted share grants were also valued at the closing stock price on the date of the grant, March 27, 2006, which was $13.14. An additional 2,500 shares of restricted common stock were granted to one non-employee Director. This restricted share grant was valued at the closing stock price on the date of the grant, March 29, 2006, which was $13.28 and vests on July 28, 2006.
11
The Companys activity relating to restricted share awards during the first quarter of fiscal 2006 was as follows (in thousands, except fair values):
|
|
Number of Restricted |
|
Weighted Average |
|
|
|
|
Share Awards |
|
Value Per Award |
|
|
Unvested at December 31, 2005 |
|
36 |
|
$ |
17.82 |
|
Granted |
|
652 |
|
13.14 |
|
|
Vested |
|
(4 |
) |
22.69 |
|
|
Forfeited and expired |
|
|
|
|
|
|
Unvested at April 1, 2006 |
|
684 |
|
$ |
13.33 |
|
For the first quarter of fiscal 2006, approximately $0.1 million was charged to expense relating to the amortization of the time-vested restricted share awards. At April 1, 2006 unrecognized compensation expense related to time-vested restricted share awards totaled approximately $4.5 million and will be recognized over a weighted average period of approximately four years. The fair value of restricted share awards that vested during the quarter ended April 2, 2005 and the quarter ended April 1, 2006 totaled $0 and approximately $0.1 million, respectively.
Expense related 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 are considered probable, the Company will record a cumulative catch-up for the amount of expense that should have been recognized from the date of the grant to the date it was determined achievement was probable and recognize the remaining expense on a straight-line basis through the estimated date of achievement. Total gross compensation expense, excluding any estimate of forfeitures related to the performance-vesting shares, is approximately $4.3 million.
NOTE 6. DEBT OBLIGATIONS
The Company has a loan agreement with a U.S. bank providing for a revolving credit facility. On January 13, 2006, the Company entered into a modified agreement which modified this loan agreement effective as of December 30, 2005. The modified loan agreement provides for borrowings of up to $30 million, $35 million, or $40 million, depending on the Companys minimum fixed coverage ratio assessed on a quarterly basis, as defined in the agreement. As of April 1, 2006, the Company could borrow up to $30 million. Subsequent to the first quarter of fiscal 2006, the Company could borrow up to $40 million. Additionally, the agreement provides for letters of credit 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 amount available for borrowing. The maturity date of the loan agreement remains February 27, 2007, as such, the amounts due under the line of credit are reported as current liabilities in the condensed consolidated balance sheet as of April 1, 2005. Outstanding borrowings on the revolving credit facility bear interest at a floating rate equal to the lenders prime interest rate plus a margin or the lenders LIBOR rate plus a margin. The interest rate is adjusted quarterly and ranges between prime minus 0.25 percent and prime plus 0.25 percent or between the applicable LIBOR rate plus 1.75 percent and the applicable LIBOR rate plus 2.25 percent, depending on the Companys maximum leverage ratio, as defined in the agreement. As of April 1, 2006, the prime rate margin is 0.25 percent and the LIBOR rate margin is 2.25 percent. Interest is payable monthly. As of April 1, 2006, the Companys outstanding borrowings on the credit facility, including bank overdrafts, were $13.1 million. Of this amount, $9.0 million bore interest at the lenders LIBOR rate plus 2.25 percent (7.06% at April 1, 2006) and the remaining $4.1 million bore interest at the lenders prime rate plus 0.25 percent (8.00% at April 1, 2006). The facility requires the quarterly payment of an unused credit fee which ranges from 0.25 percent to 0.38 percent, depending on the Companys maximum leverage ratio.
Outstanding balances on the credit facility are secured by substantially all of the Companys U.S. assets, subsidiary debt instruments, 100 percent ownership interests in all domestic subsidiaries and 65 percent ownership interests in foreign subsidiaries directly owned by the Company. The modified loan agreement includes various financial covenants including a capital expenditure limit, a maximum leverage ratio and a minimum fixed charge coverage ratio. The modified loan agreement does not permit the Company or its subsidiaries to dissolve, sell, dispose or merge all of their assets or acquire all of the assets of any entity without the written consent of the U.S.
12
bank, unless the transaction meets the definition of a Permitted Acquisition Basket, as defined in the agreement. The modified loan agreement also places a limit on the amount the Company can loan to any entity, outside the normal course of business. Additionally, the modified agreement allows the Company to declare or pay cash dividends, to repurchase its stock or to perform other similar equity transactions if such transactions would not exceed $15 million in any fiscal year and subject to other terms. This agreement defines several customary events of default including any material adverse change or any event that occurs which may cause a material adverse change in the Companys or its subsidiaries condition.
The Companys Singapore bank term loan contains various financial covenants including minimums on net worth and shareholders funds of the Singapore operations. 1-800 CONTACTS, INC. has guaranteed this term loan.
Cross default clauses exist such that if the Company were in default on its U.S. debt, the Company would also be in default on its Singapore debt. If the Company were in default on its Singapore bank term loan, the Company would also be in default on its note payable to the former parent of ClearLab International and its loan agreement with its U.S. bank.
NOTE 7. COMMITMENTS AND CONTINGENCIES
Legal and Regulatory Matters
The sale and delivery of contact lenses are governed by both federal and state laws and regulations, including the federal Fairness to Contact Lens Consumer Act (FCLCA). The FCLCA requires that contact lenses only be sold to customers based on the seller obtaining a copy of the prescription itself or verifying the prescription by direct communication with the customers prescriber. Consistent with this requirement, the Companys current operating practice is to require all customers to provide either a valid copy of their prescription or the contact information for their prescriber so that the Company can verify their prescription by direct communication with their prescriber. If the Company does not have a valid copy of the customers prescription, the Company directly communicates to the customers prescriber the precise prescription information received from the customer and, in accordance with the FCLCA, informs the prescriber that it will proceed with the sale based on this prescription information unless the prescriber advises it within eight business hours that such prescription information is expired or otherwise invalid. If the prescriber properly advises the Company within this time period that the customers prescription is expired or otherwise invalid, the Companys practice is to cancel the customers order. On the other hand, if the prescriber either advises the Company that the prescription is valid or fails to respond properly within the required time period, the Companys practice is to complete the sale based on the prescription information communicated to the prescriber, as expressly permitted by the FCLCA. The Company retains copies of the written prescriptions that it receives and maintains records of its communications with the customers prescriber. The FCLCA provides for several means of direct communication with eye care practitioners, and the Company may alter its prescription verification procedures from time to time in keeping with the FCLCA and FTC guidelines.
From time to time the Company is involved in legal matters generally incidental to its business. It is the opinion of management, after discussion with legal counsel that, except for legal and professional fees that the Company incurs from time to time, the ultimate dispositions of all of these matters will not have a material impact on the financial position, liquidity or results of operations of the Company. However, there can be no assurance that the Company will be successful in its efforts to satisfactorily resolve these matters, and the ultimate outcome could result in a material negative impact on the Companys financial position, liquidity or results of operations.
Advertising Commitments
As of April 1, 2006, the Company had entered into certain noncancelable commitments with various advertising companies that will require the Company to pay approximately $5.9 million during the remainder of 2006.
13
NOTE 8. SEGMENT INFORMATION
The Company has two operating segments. These operating segments represent components of the Company for which separate financial information is available and are evaluated regularly by management in determination of resource allocation and performance assessment. The Companys U.S. Retail segment includes the operations of 1-800 CONTACTS, a direct marketer of replacement contact lenses. The Companys International segment includes the operations of ClearLab International and ClearLab UK, developers, marketers, manufacturers and distributors of contact lenses. The U.S. Retail segment includes revenue from the optical retail store agreement and the International segment includes revenue from the Japanese license and royalty agreement. Operating segment information for the first quarter ended April 2, 2005 and April 1, 2006 is as follows (in thousands):
Quarter Ended April 2, 2005 |
|
U.S. Retail |
|
International |
|
Eliminations |
|
Total |
|
||||
|
|
|
|
|
|
|
|
|
|
||||
Net sales (International segment includes intersegment sales of $371) |
|
$ |
56,366 |
|
$ |
4,288 |
|
$ |
(371 |
) |
$ |
60,283 |
|
Gross profit |
|
22,187 |
|
603 |
|
(282 |
) |
22,508 |
|
||||
Research and development |
|
|
|
1,055 |
|
|
|
1,055 |
|
||||
Other selling, general and administrative expense |
|
10,078 |
|
1,439 |
|
|
|
11,517 |
|
||||
Income (loss) from operations |
|
$ |
4,403 |
|
$ |
(2,007 |
) |
$ |
(282 |
) |
$ |
2,114 |
|
Quarter Ended April 1, 2006 |
|
U.S. Retail |
|
International |
|
Eliminations |
|
Total |
|
||||
|
|
|
|
|
|
|
|
|
|
||||
Net sales |
|
$ |
59,173 |
|
$ |
4,318 |
|
$ |
|
|
$ |
63,491 |
|
Gross profit |
|
23,624 |
|
638 |
|
216 |
|
24,478 |
|
||||
Research and development |
|
10 |
|
1,318 |
|
|
|
1,328 |
|
||||
Other selling, general and administrative expense |
|
11,713 |
|
1,966 |
|
|
|
13,679 |
|
||||
Income (loss) from operations |
|
$ |
7,006 |
|
$ |
(2,859 |
) |
$ |
216 |
|
$ |
4,363 |
|
14
The following reconciles total segment income from operations to income before provision for income taxes for the quarters ended April 2, 2005 and April 1, 2006 as follows (in thousands):
|
|
Quarter Ended |
|
||||
|
|
April 2, 2005 |
|
April 1, 2006 |
|
||
Income from operations |
|
$ |
2,114 |
|
$ |
4,363 |
|
Interest expense, net |
|
(301 |
) |
(412 |
) |
||
Foreign currency exchange transaction gain (loss), net |
|
(312 |
) |
732 |
|
||
Other, net |
|
(28 |
) |
(7 |
) |
||
Income before provision for income taxes |
|
$ |
1,473 |
|
$ |
4,676 |
|
Identifiable segment assets are as follows (in thousands):
Fiscal Year Ended December 31, 2005 |
|
U.S. Retail |
|
International |
|
Total |
|
|||
|
|
|
|
|
|
|
|
|||
Long-lived assets, net |
|
$ |
35,130 |
|
$ |
43,828 |
|
$ |
78,958 |
|
Total assets |
|
54,758 |
|
60,187 |
|
114,945 |
|
|||
Quarter Ended April 1, 2006 |
|
U.S. Retail |
|
International |
|
Total |
|
|||
|
|
|
|
|
|
|
|
|||
Long-lived assets, net |
|
$ |
34,627 |
|
$ |
45,803 |
|
$ |
80,430 |
|
Total assets |
|
52,947 |
|
60,570 |
|
113,517 |
|
|||
15
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
Overview
The Company is a direct marketer of replacement contact lenses and is also a manufacturer, developer and distributor of its own branded and private label contact lenses through its operations in Singapore and the United Kingdom. The Companys U.S. Retail operations sell almost all of the popular brands of contacts lenses, including those manufactured by Johnson & Johnson Vision Care, CIBA Vision, Bausch & Lomb and CooperVision. ClearLab is the Companys international contact lens development, manufacturing and distribution business.
Japanese License and Royalty Agreement. In December 2004, the Company signed an agreement which grants Menicon Co., LTD (Menicon), Japans largest independent contact lens manufacturer, exclusive rights to develop, manufacture and market certain disposable contact lenses and related intellectual property in Japan. Under the terms of the agreement, Menicon licenses from the Company different types of intellectual property, including contact lens material, manufacturing technology and related knowledge. During the first quarter of fiscal 2006, the Company received a payment of $2 million and has received a total of $10 million under the agreement to date.
Optical Retail Store Agreement. During the latter part of 2004, the Company entered into an agreement with a regional optical retail chain in Utah. Under the terms of the agreement, the companies effectively combined their contact lens business in Utah and began jointly serving these customers in December 2004. The objective of this agreement is to partner with an optical retailer to create a seamless experience for consumers that will include exams as well as in-store, phone and online service.
Under the agreement, the Company fulfills substantially all orders taken at the retail optical chain for contact lenses and both parties share in the operating results of the combined contact lens business based on a certain allocation percentage. However, during the term of the agreement, the Company guaranteed that the retail chain would receive at least $0.5 million of annual earnings under the arrangement. Additionally, the Company committed to purchase approximately $0.3 million per year in inventory from the retail chains source of supply. Under the arrangement, the Company records gross revenues for all orders fulfilled and records selling, general and administrative expense for the retail chains share of the net operating results.
This agreement expired in January 2006; however, both parties continue to operate their contact lens businesses jointly as they work towards confirming the terms of a new arrangement. The Company is deferring any decision to launch a national network with optical retail stores until a resolution can be found to industry practices relating to doctors only lenses and after a review of the Companys progress with the doctor referral network.
Doctor Referral Network. The Company is currently expanding its national doctor referral network with select optical retail chains and independent practitioners and plans to have 1,000 locations by the end of 2006. Under this referral program, when a current or potential customer needs a new contact lens prescription, the Company can facilitate the process of obtaining an eye examination through this network of providers. This process minimizes the interruptions in product consumption for the consumer and improves the Companys ability to capture new customers and retain its current customers.
The Company is developing this referral program under the brand name ProNet. ProNet will serve as the division of the Company dedicated to the national doctor referral network. The Company launched a website in support of the ProNet brand during March 2006. This website will serves as a tool to assist ProNet in recruiting providers and communicating with its current providers
Supplier Agreements. The Company has agreements with its top two vendors for improved pricing and marketing support. This support comes in the form of cooperative marketing and rebate programs designed to promote the manufacturers products and build sales. As part of its ongoing relationship with its suppliers, the Company periodically reviews its specific marketing plans and negotiates cooperative marketing programs and product pricing.
16
Fairness to Contact Lens Consumer Act. In November 2003, Congress passed the Fairness to Contact Lens Consumer Act (FCLCA), which establishes a national uniform standard for both eye care practitioners and direct marketers with regard to releasing and verifying consumer contact lens prescriptions as well as other requirements relating to the sale of contact lenses. The FCLCA became effective February 4, 2004, and now requires all eye care practitioners to give patients a copy of their prescription as soon as they have been fitted for contact lenses, whether the patients ask for it or not. It also directs contact lens sellers to contact eye care practitioners to request verification of consumer prescriptions before shipping all orders (if the prescription is not already on file), and it provides that failure to respond within eight business hours shall result in the prescription being presumed valid, thereby eliminating the ability of eye care practitioners to impede sales by direct marketers simply by ignoring or refusing to respond to their requests to verify prescriptions. The FCLCA also provides that prescriptions will be valid for a minimum of at least one year (absent some special medical reason justifying a shorter period). It also directed the Federal Trade Commission (FTC) to conduct a study examining the strength of competition in the market for contact lenses and to submit a report to Congress within twelve months of the FCLCA effective date. This FTC completed and published this study on February 15, 2005, with no recommendations for further changes in federal law.
Satisfying the prescription verification requirement of the FCLCA obligates a contact lens seller either to obtain a copy of the prescription itself or to verify the prescription by direct communication with the customers prescriber. Consistent with this requirement, the Companys current operating practice is to require all customers to provide either a valid copy of their prescription or the contact information for their prescriber so that the Company can verify their prescription by direct communication with their prescriber. If the Company does not have a valid copy of the customers prescription, the Company directly communicates to the customers prescriber the precise prescription information received from the customer and informs the prescriber that it will proceed with the sale based on this prescription information unless the prescriber advises it within eight business hours that such prescription information is expired or otherwise invalid. If the prescriber properly advises the Company within this time period that the customers prescription is expired or otherwise invalid, the Companys practice is to cancel the customers order. On the other hand, if the prescriber either advises the Company that the prescription is valid or fails to respond properly within the required time period, the Companys practice is to complete the sale based on the prescription information communicated to the prescriber, as expressly permitted by the FCLCA. The Company retains copies of the written prescriptions that it receives and maintains records of its communications with the customers prescriber. The FCLCA provides for several means of direct communication with eye care practitioners, and the Company may alter its prescription verification procedures from time to time in keeping with the FCLCA and FTC guidelines.
17
Results of Operations
The Companys fiscal year consists of a 52/53-week period ending on the Saturday nearest to December 31. Fiscal 2006 is a 52-week year and will end on December 30, 2006.
The Company has two operating segments referred to below. The Companys domestic segment is represented by operations within the U.S. and is referred to as U.S. Retail by the Company, whereas the Companys international segment is represented by operations in both Singapore and the U.K. and is referred to as ClearLab by the Company.
The following table presents the Companys results of operations expressed as a percentage of net sales for the periods indicated:
|
|
Quarter Ended |
|
||
|
|
April 2, |
|
April 1, |
|
|
|
2005 |
|
2006 |
|
NET SALES |
|
100.0 |
% |
100.0 |
% |
COST OF GOODS SOLD |
|
62.7 |
|
61.4 |
|
Gross profit |
|
37.3 |
|
38.6 |
|
|
|
|
|
|
|
SELLING, GENERAL & ADMINISTRATIVE EXPENSES: |
|
|
|
|
|
Advertising |
|
10.8 |
|
6.3 |
|
Legal and professional |
|
2.1 |
|
1.8 |
|
Research and development |
|
1.8 |
|
2.1 |
|
Other selling, general & administrative |
|
19.1 |
|
21.5 |
|
Total selling, general & administrative expenses |
|
33.8 |
|
31.7 |
|
INCOME FROM OPERATIONS |
|
3.5 |
|
6.9 |
|
OTHER INCOME (EXPENSE), net |
|
(1.1 |
) |
0.5 |
|
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES |
|
2.4 |
|
7.4 |
|
PROVISION FOR INCOME TAXES |
|
(2.1 |
) |
(5.5 |
) |
NET INCOME |
|
0.3 |
% |
1.9 |
% |
Net sales. Net sales for the quarter ended April 1, 2006 increased 5.3% to $63.5 million from $60.3 million for the quarter ended April 2, 2005. Net sales for the Companys U.S. Retail operations for the first quarter of fiscal 2006 were $59.2 million compared to $56.4 million for the first quarter of fiscal 2005. U.S. Retail net sales increased primarily from an increase in sales on the internet due mainly to upgrades the Company made to its website during fiscal 2005 and from targeted online marketing programs.
During the quarter ended April 1, 2006 the Company spent approximately $4.0 million on advertising spending compared to $6.5 million for the quarter ended April 2, 2005. The Companys reduction in advertising spending during the quarter from the first quarter of fiscal 2005 is consistent with the Companys plans to spend less on advertising in fiscal 2006 as the Company focuses on addressing the threat of doctors only lenses. Although the Company saw an increase in sales during the first quarter of 2006 compared to the first quarter of 2005, the Company expects that U.S. Retail net sales will be impacted by the decrease in advertising spending later this year. Additionally, U.S. Retail net sales growth continues to be constrained by lost sales related to certain doctors only contact lenses that the Company cannot obtain in order to fill orders for customers who wish to purchase the product.
Net sales for ClearLab for the first quarter of fiscal 2006 were consistent with net sales for the first quarter of fiscal 2005 at $4.3 million. ClearLabs results for the first quarter of fiscal 2006 include $1.5 million in license fees from the Companys Japanese license agreement compared to $1.0 million in the first quarter of fiscal 2005.
18
The increase in license fees was largely offset by a decrease of $0.4 million in intercompany sales to the Companys U.S. Retail business, as ClearLab recorded no sales to the U.S. Retail business in the first quarter of fiscal 2006.
Gross profit. Consolidated gross profit as a percentage of net sales increased to 38.6% for the quarter ended April 1, 2006 from 37.3% for the quarter ended April 2, 2005. Gross profit as a percentage of net sales for the Companys U.S. Retail operations increased to 39.9% in the first quarter of fiscal 2006 from 39.4% in the first quarter of fiscal 2005. The Company expects the U.S. Retail gross profit margin to remain at approximately 40% throughout the remainder of fiscal 2006, although the margin may vary somewhat from quarter to quarter.
Gross profit as a percentage of net sales for ClearLab was 14.8% for the first quarter of fiscal 2006, compared to 14.1% for the first quarter of fiscal 2005. The Company expects to see improvement in gross margins from ClearLab in fiscal 2006 as production and sales volumes increase.
Advertising expense. Advertising expense for the quarter ended April 1, 2006 decreased to $4.0 million from $6.5 million for the first quarter ended April 2, 2005. As a percentage of net sales, advertising expense for the first quarter of fiscal 2006 decreased to 6.3% from 10.8% for the first quarter of fiscal 2005. The Company expects to decrease fiscal 2006 advertising expenses by approximately $10 to $12 million from fiscal 2005 as it focuses its resources towards legislative and public relations initiatives. However, if opportunities present themselves, the Company may increase advertising spending above currently planned levels. The Companys experience has been that increases in advertising expenditures have a direct impact on the growth of net sales not only in the current period but also in future periods.
The Company expenses all advertising costs when the advertising first takes place. As a result, quarter-to-quarter comparisons are impacted within and between quarters by the timing of television, radio and Internet advertisements and by the mailing of the Companys printed advertisements. The volume of mailings and other advertising may vary in different quarters and from year to year depending on the Companys assessment of prevailing market opportunities.
Legal and professional fees. Legal and professional fees for the quarter ended April 1, 2006 decreased $0.2 million, or 12%, from the first quarter ended April 2, 2005. As a percentage of net sales, legal and professional fees decreased to 1.8% for the first quarter of fiscal 2006 from 2.1% for the first quarter of fiscal 2005.
During the first quarter of fiscal 2006, the Company continued to incur professional fees for Sarbanes-Oxley compliance, and other internal control initiatives, as well as ongoing legal, lobbying and regulatory initiatives. The Company will continue to focus its efforts on compliance with federal rules and regulations as well as continue to support legal and legislative initiatives that it believes will benefit contact lens wearers and the industry. As such, the Company expects to increase its fiscal 2006 legal and professional fees to support these legislative initiatives.
Research and development expenses. Research and development expenses for the quarter ended April 1, 2006 increased to $1.3 million, or 2.1% of net sales, from $1.1 million, or 1.8% of net sales, from the quarter ended April 2, 2005. During the first quarter of fiscal 2006, the Company continued to fund research and development efforts for ClearLabs operations.
Total fiscal 2006 research and development costs will be dependent on progress with research and development efforts relating to expanding ClearLabs product offering and developing its intellectual property.
Other selling, general and administrative expenses. Other selling, general and administrative expenses for the quarter ended April 1, 2006 increased approximately $2.2 million, or 18.8%, to $13.7 million from the quarter ended April 2, 2005. As a percentage of net sales other selling, general and administrative expenses for the first quarter of fiscal 2006 also increased to 21.5% from 19.1% for the first quarter of fiscal 2005. The first quarter of fiscal 2006 results include approximately $0.3 million of expense related to stock options granted prior to fiscal 2006 and approximately $0.1 million of expense related to restricted stock grants compared to approximately $5,000 of expense related to restricted stock grants in the first quarter of fiscal 2005.
19
The majority of the increase in the consolidated other selling, general and administrative expenses in the first quarter of 2006 relates to the Companys U.S. Retail business which had a $1.6 million increase from the same quarter in the prior year. Additionally, such expenses also increased as a percentage of net sales to 19.8% for the first quarter of fiscal 2006 from 17.9% for the first quarter of fiscal 2005. The majority of the increase for U.S. Retail from the first quarter of fiscal 2005 relates to planned increases in employee costs to support a retail network, an initiative which is currently focused on expanding our doctor referral network, and to strengthen and build the Companys Information Technology organization and technology infrastructure. The Company also had increases in other selling, general and administrative expenses related to the Companys legislative efforts.
ClearLabs other selling, general and administrative expenses increased by approximately $0.6 million for the quarter ended April 1, 2006 from the quarter ended April 2, 2005. A majority of ClearLabs increase related to increases in employee costs to support the enhancement and scale up of its operations.
Other income (expense), net. For the quarter ended April 1, 2006, the Company had other income of $0.3 million compared to other expense for the quarter ended April 2, 2005 of $(0.6) million. For the first quarters of fiscal 2005 and 2006, other income (expense) consisted mainly of interest expense, resulting from use of the revolving credit facility and foreign exchange transaction gains or losses. Interest expense for the first quarter of fiscal 2006 increased $0.1 million to $0.4 million compared to $0.3 million in the first quarter fiscal 2005. The Company recorded a foreign exchange transaction gain of approximately $0.7 million and a loss of approximately $(0.3) million during the quarters ended April 1, 2006 and April 2, 2005, respectively. These exchange gains and losses relate primarily to intercompany loans to ClearLab.
Income taxes. The Company is taxed in three separate jurisdictions-U.S., Singapore and the United Kingdom. The Companys effective U.S. income tax rate for the quarter ended April 1, 2006 is approximately 45% as compared with the 39% reported for the quarter ended April 2, 2005. The increase in the effective U.S. income tax rate primarily results from the increase in permanent nondeductible expenses, including those relating to the Companys lobbying efforts.
During 2005, the Companys Singapore operations met the requirements for the pioneer tax certificate in Singapore. This pioneer tax certificate allows for a seven-year tax holiday in Singapore beginning with fiscal 2003, with an extension for an additional three years if certain conditions are met. The tax holiday has clawback provisions if the Company does not continually meet certain research and development, capital investment and employment requirements. The tax holiday reduces the Singapore statutory tax rate to 0% on qualified income for 2003 and future periods through the end of the tax holiday. The Company expects to continue to meet the requirements for this pioneer tax certificate. During the first quarter of fiscal 2006, the Company did not record a tax benefit for the loss from the operations of ClearLab International due to the pioneer tax certificate and the uncertainty with respect to the realization of a tax benefit in Singapore relating to losses prior to 2003. However, the Company recorded a current tax provision in Singapore due to Japanese withholding tax on payments received from the Japanese license agreement. The foreign tax credit for this Japanese withholding tax is not eligible for carryforward in the Singapore tax jurisdiction.
In the first quarter of fiscal 2006, the Company recorded a valuation allowance for deferred tax assets in excess of taxable temporary differences in the U.K. as it is more likely than not that these deferred tax assets will not be realized.
The Company expects that its fiscal 2006 effective income tax rates will approximate 45% for the U.S. operations. For the U.K. and Singapore operations, the Company expects that the effective tax rate will be 0% with the exception of the Japanese withholding tax on license payments made to ClearLab International. The Companys effective income tax rates may change as facts and circumstances change.
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Liquidity and Capital Resources
The Companys principal sources of liquidity have been cash provided by operating activities and proceeds from debt financings. The Companys principal uses of cash have been to meet debt service requirements, finance acquisitions, finance capital expenditures, fund working capital needs and repurchase common stock. The Company anticipates that these uses will continue to be the principal demands on its cash in the future. As of April 1, 2006, the Company had net working capital (deficit) of approximately $(16.6) million, compared to $7.7 million as of December 31, 2005. This large decrease in net working capital during the first quarter of fiscal 2006 relates to the Companys line of credit that is now classified as current on the Condensed Consolidated Balance Sheet as the maturity date is February 27, 2007. The Company intends to renew or refinance this line of credit prior to the maturity date.
The Company believes that its cash on hand, together with cash generated from operating activities and the borrowings available through the credit facility, will be sufficient to support planned operations through the foreseeable future. Should the Companys plans or expectations change, the Company may be required to seek additional sources of funds and there can be no assurance that such funds will be available on satisfactory terms. Failure to obtain such financing could delay or prevent the Companys planned growth, which could adversely affect the Companys business, financial condition, liquidity and results of operations.
As a result of regulatory requirements, the Companys liquidity, capital resources and results of operations may be negatively impacted in the future if the Company incurs increased costs (including legal fees) or fines, is prohibited from selling its products or experiences losses of a substantial portion of the Companys customers for whom the Company is unable to obtain or verify a prescription due to the requirements of the FCLCA.
The Company has a loan agreement with a U.S. bank providing for a revolving credit facility. On January 13, 2006, the Company entered into a modified agreement which modified this loan agreement effective as of December 30, 2005. The modified loan agreement provides for borrowings of up to $30 million, $35 million or $40 million, depending on the Companys minimum fixed coverage ratio assessed on a quarterly basis, as defined in the agreement. As of April 1, 2006, the Company could borrow up to $30 million. Subsequent to the first quarter of fiscal 2006, the Company could borrow up to $40 million. Additionally, the agreement provides for letters of credit 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 amount available for borrowing. The maturity date of the loan agreement remains February 27, 2007, as such, the amounts due under the line of credit are reported as current liabilities in the condensed consolidated balance sheet as of April 1, 2005. Outstanding borrowings on the revolving credit facility bear interest at a floating rate equal to the lenders prime interest rate plus a margin or the lenders LIBOR rate plus a margin. The interest rate is adjusted quarterly and ranges between prime minus 0.25 percent and prime plus 0.25 percent or between the applicable LIBOR rate plus 1.75 percent and the applicable LIBOR rate plus 2.25 percent, depending on the Companys maximum leverage ratio, as defined in the agreement. As of April 1, 2006, the prime rate margin is 0.25 percent and the LIBOR rate margin is 2.25 percent. Interest is payable monthly. As of April 1, 2006, the Companys outstanding borrowings on the credit facility, including bank overdrafts, were $13.1 million. Of this amount, $9.0 million bore interest at the lenders LIBOR rate plus 2.25 percent (7.06% at April 1, 2006) and the remaining $4.1 million bore interest at the lenders prime rate plus 0.25 percent (8.00% at April 1, 2006). The facility requires the quarterly payment of an unused credit fee which ranges from 0.25 percent to 0.38 percent, depending on the Companys maximum leverage ratio.
Outstanding balances on the credit facility are secured by substantially all of the Companys U.S. assets, subsidiary debt instruments, 100 percent ownership interests in all domestic subsidiaries and 65 percent ownership interests in foreign subsidiaries directly owned by the Company. The modified loan agreement includes various financial covenants including a capital expenditure limit, a maximum leverage ratio and a minimum fixed charge coverage ratio. The modified loan agreement does not permit the Company or its subsidiaries to dissolve, sell, dispose or merge all of their assets or acquire all of the assets of any entity without the written consent of the U.S. bank, unless the transaction meets the definition of a Permitted Acquisition Basket, as defined in the agreement. The modified loan agreement also places a limit on the amount the Company can loan to any entity, outside the normal course of business. Additionally, the modified agreement allows the Company to declare or pay cash dividends, to repurchase its stock or to perform other similar equity transactions if such transactions would not exceed $15 million in any fiscal year and subject to other terms. This agreement defines several customary events of
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default including any material adverse change or any event that occurs which may cause a material adverse change in the Companys or its subsidiaries condition.
As of April 1, 2006, the Company had an unsecured, non-interest bearing note to ClearLab Internationals chief technology officer with a principal balance of SGD$1,000,000 (USD$617,000). The note payable is discounted at 7%. Payments are due in equal monthly installments through July 2007.
As of April 1, 2006, the Company had a term loan payable to a Singapore bank with a principal balance of SGD$5,110,000 (USD$3,155,000) that bears interest at 6.75% and is secured by 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 April 1, 2006, the Company also had a note payable to the former parent of ClearLab International with a principal balance of SGD$6,892,000 (USD$4,255,000) 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.
Cross default clauses exist such that if the Company were in default on its U.S. debt, the Company would also be in default on its Singapore debt. If the Company were in default on its Singapore bank term loan, the Company would also be in default on its note payable to the former parent of ClearLab International and its restated loan agreement with its U.S. bank. As of April 1, 2006, the Company was in compliance with all of the restrictive covenants in its loan documents.
Cash flows from operating activities. For the quarters ended April 1, 2006 and April 2, 2005, net cash provided by operating activities was approximately $12.8 million and $6.2 million, respectively. In the first quarter of fiscal 2006, cash provided by operating activities was primarily from net income adjusted for non-cash items such as depreciation, amortization and stock compensation, increases in the income tax payable, accounts payable and accrued liabilities as well as decreases in other current assets and accounts receivable. In the first quarter of fiscal 2005, cash provided by operating activities was primarily from net income adjusted for non-cash items such as depreciation and amortization expense, increases in accounts payable, accrued liabilities and income taxes payable and decreases in other current assets and inventories. This increase was partially offset by decreases in unearned revenues and increases in net accounts receivable.
Cash flows from investing activities. The Company used approximately $2.8 million and $1.9 million for investing activities in the quarters ended April 1, 2006 and April 2, 2005, respectively. In the first quarter of fiscal 2006, the Companys deposits, associated mainly with the expansion and improvements in the Companys infrastructure at ClearLab, increased by approximately $0.1 million. In the first quarter of fiscal 2005, the Company paid approximately $0.6 million in deposits associated mainly with the expansion of and improvements in the Companys infrastructure at ClearLab.
Capital expenditures for infrastructure improvements for the quarters ended April 1, 2006 and April 2, 2005 were approximately $2.7 million and $1.3 million, respectively. Of these amounts, approximately $2.0 million and $0.7 million relate purchases made at ClearLab, respectively. The Company anticipates additional capital expenditures in fiscal 2006 for infrastructure as it continues to expand and improve operating facilities, telecommunications systems and management information systems in order to handle future operations of both its U.S. and international operations.
Financing activities. During the quarters ended April 1, 2006 and April 2, 2005, net cash used in financing activities was approximately $11.1 million and $6.3 million, respectively. In the first quarter of 2006, the Company had net repayments on its credit facility of approximately $10.7 million and made principal payments on debt obligations and capital lease obligations of approximately $0.5 million. In the first quarter of 2005, the Company paid down its credit facility by approximately $6.0 million and made principal payments on debt obligations and
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capital lease obligations of approximately $0.4 million. In both the first quarters of fiscal 2006 and 2005, these amounts were partially offset by proceeds from the exercise of common stock options.
The Company leases various manufacturing and other equipment from financing companies under capital lease arrangements. All of the equipment is maintained at the Singapore and United Kingdom facilities. The majority of the leases were assumed in connection with the Companys acquisitions of ClearLab International and ClearLab UK. As of April 1, 2006, the present value of future minimum lease payments was approximately $0.1 million with payments scheduled through fiscal 2009.
Contractual Obligations and Commitments
Subsequent to December 31, 2005, there have been no material changes to the Companys contractual obligations and commitments, outside the normal course of business.
Critical Accounting Policies
Accounting polices that require significant judgments and estimates include revenue recognition (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; and legal and regulatory contingencies. A description of the Companys significant accounting policies is included in the notes to the consolidated financial statements included in the Companys Form 10-K for the fiscal year ended December 31, 2005. Judgments and estimates are based on historical experience as well as relevant facts and circumstances known at each reporting date. Actual results may differ from these estimates.
Sales are generally recognized when products are shipped and the customer takes ownership and assumes risk of loss, collection of the related receivable is reasonably assured, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. U.S. Retail net sales consist of product sales less a provision for sales returns and allowances and estimated customer rebates. The Company accrues an estimated amount for unclaimed customer rebates and sales returns and allowances based on historical information, adjusted for economic trends. To the extent actual rebates, returns and allowances vary from historical experience revisions to the allowances may be required. ClearLab net sales consist of product sales less a provision for sales returns and allowances. The Company provides its customers with standard industry payment terms and performs ongoing credit evaluations of its customers and provides for doubtful accounts to the extent determined necessary based on historical data and current economic trends. ClearLab net sales also include license fees from the Companys Japanese license agreement. Cash payments received from this license are recognized systematically over the periods that the fees are earned by the Company.
In assessing the realizability of inventories, the Company makes judgments as to future demand requirements and product expiration dates. The inventory requirements change based on projected customer demand, which changes due to fluctuations in market conditions and product life cycles.
The Company has significant long-lived tangible and intangible assets consisting of property, plant and equipment, goodwill and definite-lived intangibles. These assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amounts of such assets may not be recoverable. In addition, the Company performs an impairment test related to goodwill at least annually. An impairment analysis related to long-lived tangible and definite-lived intangible assets requires the assessment of expected future undiscounted cash flows over the remaining useful life of the asset. An impairment analysis of goodwill requires the use of a fair-value based analysis. All of the goodwill and a significant portion of the other long-lived assets were generated from the Companys acquisitions of ClearLab International, ClearLab UK and Lens1st/Lens Express. If forecasts and assumptions used to support the realizability of long-lived assets change in the future, significant impairment charges could result that would adversely affect the Companys results of operations and financial position.
Deferred income tax assets are assessed for recoverability and valuation allowances are provided as necessary to reduce deferred income tax assets to amounts expected to be realized. Should expectations of taxable
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income change in future periods, it may become necessary to change the valuation allowance, which could affect the Companys results of operations in the period such determination is made. The Company records an income tax provision or benefit at a rate that is based on expected results for the fiscal year. If future changes in market conditions cause actual results to be more or less favorable, adjustments to the effective income tax rate on a quarterly basis could be required.
The Company records liabilities for legal and regulatory matters when the contingency is both probable and reasonably estimable. The Company is involved in several legal and regulatory matters. The Company, after consultation with legal counsel, believes that the ultimate dispositions of these matters will not have a material impact on its financial position, liquidity or results of operations. However, there can be no assurance that the Company will be successful in its efforts to satisfactorily resolve these matters and the ultimate outcome could result in a material negative impact on the Companys financial position, liquidity or results of operations.
Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123R, using the modified prospective transition method, and therefore has not restated prior periods results. Under this method the Company recognizes compensation expense for all share-based payments granted after January 1, 2006 and prior to but not yet vested as of January 1, 2006, in accordance with SFAS No. 123R. Under the fair value recognition provisions of SFAS No. 123R, the Company recognizes stock-based compensation net of an estimated forfeiture rate and only recognizes compensation cost for those shares expected to vest over the requisite service period of the award. Prior to SFAS No. 123R adoption, the Company accounted for share-based payments under APB No. 25. Therefore, the Company generally recognized compensation expense for restricted stock awards and, when it granted options with an exercise price below the market price on the date of grant. The Company estimates the value of stock option awards on the date of grant using a Black-Scholes pricing model. Calculating the fair value of share-based payment awards requires the input of highly subjective assumptions, including the expected term of the share-based payment awards and expected stock price volatility. The expected term represents the average time that options that vest are expected to be outstanding. The expected volatility rates are estimated based on a weighted average of the historical volatilities of the Companys common stock. The assumptions used in calculating the fair value of share-based payment awards represent managements best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and the Company uses different assumptions, its stock-based compensation expense could be materially different in the future. In addition, the Company is required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If the Companys actual forfeiture rate is materially different from its estimate, the stock-based compensation expense could be significantly different from what the Company has recorded in the current period.
Forward-Looking Statements
Except for historical information contained herein, the matters discussed in this form 10-Q are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 7A of the Securities Act of 1933, as amended. These forward-looking statements involve risks and uncertainties and often depend on assumptions, data or methods that may be incorrect or imprecise. The Companys future operating results may differ materially from the results discussed in, or implied by, forward-looking statements made by the Company. Factors that may cause such differences include, but are not limited to, those discussed below and the other risks detailed in the Companys other reports filed with the Securities and Exchange Commission. Words such as believes, anticipates, expects, future, intends, would, may and similar expressions are intended to identify forward-looking statements. The Company undertakes no obligation to revise any of these forward-looking statements to reflect events or circumstances after the date hereof.
Factors that may affect future results may include, but are not limited to, those factors set forth under Item 1A. of Part II of this Form 10-Q.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk. As of April 1, 2006, the Company was exposed to changes in interest rates relating to its revolving credit facility and other debt obligations. The revolving credit facility bears interest at a variable rate based on the U.S. prime rate or LIBOR. The Companys outstanding borrowings on the credit facility, including bank overdrafts, were approximately $13.1 million as of April 1, 2006. The remainder of the Companys interest bearing debt obligations, including capital lease obligations, is denominated in Singapore dollars and British pounds and bears interest at a fixed rate. As of April 1, 2006, the face amounts of the outstanding borrowings on these fixed rate debt obligations were approximately $7.5 million. If interest rates were to change by a full percentage point, the net impact on interest expense would be approximately $0.1 million per year.
Foreign Currency Risk. The Company faces foreign currency risks primarily as a result of its acquired Singapore and United Kingdom operations and the intercompany balances between its U.S. and these international operations which are denominated in U.S. dollars. The functional currency of the Companys Singapore operations is the Singapore dollar. The Company has debt and other long-term obligations of approximately $8.0 million that are denominated in Singapore dollars and mature over the next four years. If the U.S. dollar weakens relative to the Singapore dollar, additional funds may be required to meet these obligations if the debt cannot be adequately serviced from the Singapore operations. Fluctuations in exchange rates between the U.S. dollar and the Singapore dollar could lead to additional currency exchange losses or gains on the intercompany balances and transactions denominated in currencies other than the functional currency. For the first quarter of fiscal 2006, the Company recorded a foreign currency transaction gain of approximately $0.6 million on the intercompany balances between the U.S. and Singapore operations. From the date of the ClearLab International acquisition, July 24, 2002, through May 4, 2006 the exchange rate has fluctuated approximately 10.9 percent (weakening of the U.S. dollar). If the Singapore dollar were to weaken against the U.S. dollar by 10 percent, the Company would record a $2.6 million dollar foreign currency loss on the intercompany balances that exist as of April 1, 2006.
The functional currency of the Companys United Kingdom operations is the British pound. Fluctuations in exchange rates between the U.S. dollar and the British pound could lead to additional currency exchange losses or gains on intercompany balances and transactions denominated in currencies other than the functional currency. For the first quarter of fiscal 2006, the Company recorded a foreign currency transaction gain of approximately $0.1 million on the intercompany balances between the U.S. and United Kingdom operations. From the date of the ClearLab UK acquisition, February 24, 2004, through May 4, 2006 the exchange rate has fluctuated approximately 1.4 percent (strengthening of the U.S. dollar). If the British pound were to weaken against the U.S. dollar by 10 percent, the Company would record a $1.4 million dollar foreign currency loss on the intercompany balances that exist as of April 1, 2006.
The Company has not entered into any foreign currency derivative financial instruments; however, it may choose to do so in the future in an effort to manage or hedge its foreign currency risk.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures. The Companys Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of the Companys disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report (the Evaluation Date), have concluded that, as of the Evaluation Date, the Companys disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities.
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(b) Changes in internal controls over financial reporting. There were no significant changes in the Companys internal controls over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, the Companys disclosure controls and procedures subsequent to the Evaluation Date. As a result, no corrective actions were taken.
The Companys management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Companys disclosure controls and procedures or its internal controls over financial reporting will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.
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From time to time the Company is involved in legal matters generally incidental to its business. It is the opinion of management, after discussion with legal counsel that, except for legal and professional fees that the Company incurs from time to time, the ultimate dispositions of all of these matters will not have a material impact on the financial position, liquidity or results of operations of the Company. However, there can be no assurance that the Company will be successful in its efforts to satisfactorily resolve these matters, and the ultimate outcome could result in a material negative impact on the Companys financial position, liquidity or results of operations.
There are no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
None.
(A) Exhibits
Exhibit No. |
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Description of Exhibit |
3.1 (i) |
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Restated Certificate of Incorporation of the Company. (1) |
3.1 (ii) |
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Restated By-Laws of the Company. (1) |
4.1 |
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Form of certificate representing shares of Common Stock, $0.1 par value per share. (2) |
31.1 |
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Certification Required Pursuant to Section 302 of the Sarbanes-Oxley Act of2002. |
31.2 |
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Certification Required Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
32.1 |
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Certification Required Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
32.2 |
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Certification Required Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
(1) Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the quarterly period ended April 4, 1998 (Commission File No. 0-23633).
(2) Incorporated by reference to the same numbered exhibit to the Companys Registration Statement on Form S-1 (Registration No. 333-41055).
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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1-800 CONTACTS, INC. |
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Dated: May 11, 2006 |
By: |
/s/ Jonathan C. Coon |
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Name: |
Jonathan C. Coon |
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Title: |
Chief Executive Officer |
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By: |
/s/ Robert G. Hunter |
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Name: |
Robert G. Hunter |
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Title: |
Chief Financial Officer |
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