For the quarterly period ended		Commission File
October 2, 2004		Number 0-20001
NATIONAL VISION, INC.
(Exact name of registrant as specified in its charter)
GEORGIA		58-1910859
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
296 Grayson Highway
Lawrenceville, Georgia		30045
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (770) 822-3600

 

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.

 

YES [X]    NO [_]

 

Indicate by check mark whether the registrant is an accelerated filer (as defined by Exchange Act Rule 12b-2).

 

YES [_]    NO [X]

 

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.

 

YES [X]    NO [_]

 

The number of shares of Common Stock of the registrant outstanding as of November 8, 2004 was 5,359,679.

 

 

	-2-

PART I

FINANCIAL INFORMATION

 

    

NATIONAL VISION, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

October 2, 2004 and January 3, 2004

(in thousands)

		October 2, 2004 (unaudited)			January 3, 2004
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	10,092		$	3,545
Accounts receivable (net of allowance: 2004 - $741; 2003 - $769)			3,067			3,078
Inventories			15,143			17,387
Other current assets			1,122			1,278
Deferred income tax asset			7,202			7,305
Total current assets			36,626			32,593
PROPERTY AND EQUIPMENT:
Equipment			22,506			20,383
Furniture and fixtures			7,837			7,785
Leasehold improvements			6,701			6,556
Construction in progress			564			1,750
			37,608			36,474
Less accumulated depreciation			(25,872	)		(22,855	)
Net property and equipment			11,736			13,619
INTANGIBLE VALUE OF CONTRACTUAL RIGHTS
(net of accumulated amortization:
2004 - $25,097; 2003 - $19,466)			87,648			93,279
OTHER ASSETS AND DEFERRED COSTS
(net of accumulated amortization:
2004 - $1,133; 2003 - $964)			684			806
		$	136,694		$	140,297

The accompanying notes are an integral part of these condensed consolidated financial statements.

	-3-

NATIONAL VISION, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

October 2, 2004 and January 3, 2004

(in thousands except share and par value information)

		October 2, 2004 (unaudited)			January 3, 2004
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable		$	5,253		$	3,506
Accrued expenses and other current liabilities			25,065			25,132
Senior Subordinated Notes - current portion						545
Total current liabilities			30,318			29,183
DEFERRED INCOME TAX LIABILITY			7,571			7,305
OTHER LONG TERM LIABILITIES			117
SENIOR SUBORDINATED NOTES			78,114			94,939
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Preferred stock, $1 par value; 5,000,000 shares authorized, none issued
Common stock, $0.01 par value; 10,000,000 shares authorized, 5,355,679 and 5,243,047 shares issued and outstanding at October 2, 2004 and January 3, 2004, respectively			54			52
Additional paid-in capital			25,378			25,129
Deferred stock compensation			(250	)		(108	)
Retained deficit			(4,289	)		(15,932	)
Accumulated other comprehensive loss			(319	)		(271	)
Total shareholders' equity			20,574			8,870
		$	136,694		$	140,297

The accompanying notes are an integral part of these condensed consolidated financial statements.

	-4-

	-5-

NATIONAL VISION, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

		Nine Months Ended
		October 2, 2004			September 27, 2003
OPERATING ACTIVITIES:
Net earnings (loss)		$	11,643		$	(4,413	)
Adjustments to reconcile net earnings (loss) to cash provided by operating activities:
Depreciation and amortization			10,105			11,993
Loss (gain) on disposal of equipment			114			(37	)
Gain on repurchase of Senior Subordinated Notes			(3,083	)
Deferred income tax provision			369
Cumulative effect of a change in accounting principle						564
Other			61			(54	)
Changes in operating assets & liabilities:
Accounts receivable			11			(547	)
Inventories			2,244			(1,180	)
Other current assets			156			252
Other assets			(37	)
Accounts payable			1,747			2,549
Accrued expenses and other current liabilities			(67	)		(2,996	)
Other long-term liabilities			117
Net cash provided by operating activities			23,380			6,131
INVESTING ACTIVITIES:
Proceeds from sale of equipment			205			184
Purchases of property & equipment			(2,742	)		(2,425	)
Net cash used in investing activities			(2,537	)		(2,241	)
FINANCING ACTIVITIES:
Purchase of Senior Subordinated Notes			(11,736	)
Repayments of Senior Subordinated Notes			(2,551	)		(8,160	)
Payments of deferred financing costs			(9	)
Advances on revolving credit facility						1,679
Payments on revolving credit facility						(1,679	)
Net cash used in financing activities			(14,296	)		(8,160	)
Net increase (decrease) in cash			6,547			(4,270	)
Cash, beginning of period			3,545			9,020
Cash, end of period		$	10,092		$	4,750

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

	-6-

NATIONAL VISION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

OCTOBER 2, 2004

(Unaudited)

(1) BASIS OF FINANCIAL STATEMENT PRESENTATION

We prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. Although we believe that the disclosures contained herein are adequate to make the information presented not misleading, we recommend that these interim condensed consolidated financial statements be read in conjunction with our most recent audited consolidated financial statements and the notes thereto. In our opinion, all adjustments necessary for a fair presentation of the financial position, results of operations, and cash flows for the interim periods presented have been made. Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for the year ending January 1, 2005.

(2) SIGNIFICANT ACCOUNTING POLICIES

The significant accounting policies that we follow are set forth in Note 2 in our Annual Report on Form 10-K for the fiscal year ended January 3, 2004. The following is a summary of the most significant accounting policies influencing the three and nine-month periods ended October 2, 2004.

Principles of Consolidation

The consolidated financial statements include our accounts as well as our subsidiaries’ accounts. All significant inter-company balances and transactions have been eliminated in consolidation.

Revenue Recognition

Our retail customers generally pay for their eyewear products at the time they place an order. We defer revenue recognition until delivery of the product by estimating the value of transactions for which final delivery to the customer has not occurred at the end of the period presented. These estimates are based on recent trends. Payments received prior to final delivery of the product are reflected as deposit liabilities within accrued liabilities.

In May 2003, we began to offer an extended warranty which provides for repair and replacement service during the first year after purchase. Revenues from the sale of these extended warranty contracts are deferred and amortized over the life of the contract on a straight-line basis.

A reconciliation of the changes in deferred revenue from the sale of warranty contracts described above is as follows (in thousands):

		Three Months Ended						Nine Months Ended
		October 2, 2004			September 27, 2003			October 2, 2004			September 27, 2003
Beginning balance		$	3,330		$	821		$	2,680		$	—
Warranty contracts sold			1,584			1,672			4,992			2,565
Amortization of deferred revenue:
Included in continuing operations			(1,474	)		(401	)		(3,950	)		(464	)
Included in discontinued operations			(121	)		(68	)		(403	)		(77	)
Ending balance		$	3,319		$	2,024		$	3,319		$	2,024

Premium revenue is earned from HMO memberships and services.  Revenue from premiums is recognized over the life of the policy as the related services are rendered.

	-7-

Cost of Goods Sold

We recognize the cost of product sold to retail customers when the sales transaction is complete and revenue is recognized. Periodically, we receive purchase discounts or reduced pricing on inventory purchases. These reductions in the normal purchase price are accounted for in the weighted average cost of inventory.

Income Taxes

We emerged from a Chapter 11 bankruptcy reorganization proceeding on May 31, 2001. Before, during and after the bankruptcy process, we incurred significant net operating losses (“NOL”) that result in tax loss carry-forwards.

Deferred income taxes are recorded using enacted tax rates in effect for the years in which temporary differences between financial statement and taxable operating results are expected to reverse. Deferred income taxes are provided for depreciation and amortization differences, inventory basis differences, certain accrued expenses and allowances that are not yet deductible and the expected future benefits of our NOL carry-forwards.

At October 2, 2004, our deferred tax liabilities exceed our deferred tax assets.  In previous periods our deferred tax assets exceeded our deferred tax liabilities and a valuation allowance was recorded against this net deferred tax asset because it was not considered "more likely than not" that we would be able to realize these excess NOL carryforwards to offset the future taxes.  During the first nine months of 2004, the Company generated taxable income sufficient to reverse the valuation allowance previously recorded against the net deferred tax asset resulting in a reduction of the effective tax rate to 5.8%.  In 2005, we expect our effective tax rate to more closely approximate the statutory tax rates.

Our ability to utilize our NOL carry-forwards to offset taxable income could be limited in the event of a greater than 50% change in our stock ownership, as defined by Section 382 of the Internal Revenue Code (the “Code”). As of October 2, 2004, we estimate that the cumulative change in ownership of our stock, as defined by Section 382 of the Code, is 27.2%. Any such limitation under Section 382 of the Code would be based on (1) our stock value and the Federal exempt tax rate on the date prior to the ownership change, (2) the amounts of any “built-in gains” (as defined in the Code) on the date of the ownership change, and (3) any gains subsequently realized upon repurchase of debt securities that were outstanding at the date of the ownership change. These limitations could create a cap on the amount of net operating loss carry-forwards that would be deductible for each year going forward until the amount is depleted or the time limitation on these net operating loss carry-forwards expires. A limitation in or loss of our ability to utilize the net operating loss carry-forwards could result in a significant non-cash charge to write down the deferred income tax asset recorded with respect to the NOL carry-forwards. Additionally, following such a change in control we would begin making income tax payments on our taxable income in excess of the net operating loss carry-forwards limitation amount.

After filing our U.S. Federal income tax return for 2003, we had U.S. regular tax net operating loss carry-forwards of  $81.3 million that can be used to reduce future federal income taxes. If not utilized, the carry-forwards will begin to expire in 2009.

Accounting for Stock Options

We apply the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”. Stock Option option awards continue to be accounted for in accordance with APB Opinion No. 25. The number of shares to be issued and the per share strike price are not subject to uncertainty; accordingly, our stock option grants qualify for fixed accounting treatment. As a result, we do not record compensation expense in connection with the granting of these stock options. (See Note 6 to the Condensed Consolidated Financial Statements.)

Use of Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires that we make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.

On an ongoing basis, we evaluate our estimates and judgments, and incorporate any changes in such estimates and judgments into the accounting records underlying our consolidated financial statements. We base our estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

	-8-

(3) DISCONTINUED OPERATIONS

During the third quarter of 2004, we closed 17 vision centers inside Wal-Mart stores located in the United States and 2 vision centers in Wal-Mart de Mexico stores. The 17 closings inside the Wal-Mart stores located in the United States were the result of lease expirations. One of these stores was moved to a freestanding location within the vicinity of the closed location and is therefore not considered as a discontinued operation.  The 2 locations inside Wal-Mart de Mexico stores were closed due to poor operating results and prospects. Condensed information for the 18 stores closed this quarter that are considered discontinued operations, the 33 stores closed during the first six  months of 2004 and the 54 stores closed in 2003 is presented below. The gain (loss) on disposal of these operations includes severance, closing costs and gains recorded from the sale of certain assets. Historical operating results for these closed vision centers have been reclassified as discontinued operations and shown separately for all periods presented in the Condensed Consolidated Statements of Operations.

		Three Months Ended						Nine Months Ended
		October 2, 2004			September 27, 2003			October 2, 2004			September 27, 2003
Total net sales		$	1,841		$	7,932		$	10,545		$	26,142
Operating income		$	384		$	593		$	1,749		$	1,393
Gain (loss) on disposal		$	9		$	17		$	(57	)	$	(149	)
Income tax expense		$	28					$	98

(4) SENIOR SUBORDINATED NOTES AND REVOLVING LINE OF CREDIT

Interest on our Senior Subordinated Notes accrues at the rate of 12% per annum and is payable twice a year at the end of March and September. Principal repayments are required semi-annually at the end of February and August based on excess cash flow (as defined) for the prior six-months periods ended June and December. The semi-annual principal repayments are limited to an amount that causes us to maintain a minimum pro forma cash balance of $3 million as of the measurement date. Our cash balance at the most recent measurement date was $5,006,000, limiting our August 2004 principal repayment to $2,006,000. The Senior Subordinated Notes mature on March 30, 2009.

Our revolving credit facility with Fleet Retail Group (the “Fleet Facility”) bears interest at the prime rate plus 0.75% per annum or at LIBOR plus 3.0%. Any borrowings made under this facility are secured by substantially all of our assets. The Fleet Facility contains various restrictive covenants and requires us to maintain minimum levels of EBITDA (as defined) and a minimum fixed charge coverage ratio (as defined) and limits the amount of our capital expenditures. We had no outstanding borrowings on the Fleet Facility at October 2, 2004. However, we had issued letters of credit under the facility aggregating $4.0 million. Our availability under the Fleet Facility at October 2, 2004, after reduction for the outstanding letters of credit, was approximately $3.3 million. On October 26, 2004, we amended the Fleet Facility to, among other things, increase our limit on capital expenditures for 2005 from $5,500,000 to $6,250,000 and exclude amounts we expend for the repurchase of Senior Subordinated Notes from the fixed charge coverage ratio for periods through January 1, 2005. The amendment also permits Fleet, at its discretion, to decline any request we may make for advances through February 28, 2005.

	-9-

(5) EARNINGS PER COMMON SHARE

Basic earnings per common share are computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per common share are computed as basic earnings per common share adjusted for the effect of all potential common stock equivalent shares. The computation of basic and diluted earnings per common share (“EPS”) is summarized as follows (amounts in thousands except per share information):

		Three Months Ended						Nine Months Ended
		October 2, 2004			September 27, 2003			October 2, 2004			September 27, 2003
Net earnings (loss) before discontinued operations and cumulative effect of a change in accounting principle		$	3,409		$	(254	)	$	10,049		$	(5,093	)
Earnings from discontinued operations			365			610			1,594			1,244
Earnings (loss) before cumulative effect of a change in accounting principle			3,774			356			11,643			(3,849	)
Cumulative effect of a change in accounting principle												(564	)
Net earnings (loss)		$	3,774		$	356		$	11,643		$	(4,413	)
Weighted average shares outstanding for basic EPS			5,137			5,042			5,087			5,028
Net effect of dilutive stock options and restricted stock awards			498			201			488
Weighted average shares outstanding for diluted EPS			5,635			5,243			5,575			5,028
Net earnings (loss) per basic share:
Earnings (loss) before discontinued operations and cumulative effect of a change in accounting principle		$	0.66		$	(0.05	)	$	1.98		$	(1.01	)
Earnings from discontinued operations			0.07			0.12			0.31			0.24
Earnings (loss) before cumulative effect
of a change in accounting principle			0.73			0.07			2.29			(0.77	)
Cumulative effect of a change in accounting principle												(0.11	)
Net earnings (loss) per basic share		$	0.73		$	0.07		$	2.29		$	(0.88	)
Net earnings (loss) per diluted share:
Earnings (loss) before discontinued operations and cumulative effect of a change in accounting principle		$	0.61		$	(0.05	)	$	1.80		$	(1.01	)
Earnings from discontinued operations			0.06			0.12			0.29			0.24
Earnings (loss) before cumulative effect of a change in accounting principle		$	0.67		$	0.07		$	2.09		$	(0.77	)
Cumulative effect of a change in accounting principle												(0.11	)
Net earnings (loss) per diluted share		$	0.67		$	0.07		$	2.09		$	(0.88	)

For the three and nine month periods ended September 27, 2003, approximately 286,000 and 467,000 stock options and unvested restricted shares were excluded from the computation of diluted earnings per share due to their antidilutive effect.

	-10-

 (6) ACCOUNTING FOR STOCK COMPENSATION / EQUITY TRANSACTIONS

We apply the disclosure provisions of SFAS No. 123, “Accounting for Stock Based Compensation”. Stock option awards continue to be accounted for in accordance with APB Opinion No. 25. The number of shares to be issued and the per share strike price are not subject to uncertainty; accordingly, our stock option grants qualify for fixed accounting treatment. As a result, we do not record compensation expense in connection with the granting of these stock options. Had compensation cost for the employee and non-employee director stock options been determined based on the fair value at the grant date consistent with the provisions of SFAS No. 123, our net earnings and earnings per share would have been reduced to the pro forma amounts indicated below (amounts in thousands except per share information):

		Three Months Ended						Nine Months Ended
		October 2, 2004			September 27, 2003			October 2, 2004			September 27, 2003
As reported:
Net earnings (loss)		$	3,774		$	356		$	11,643		$	(4,413	)
Pro forma compensation expense			(39	)		(17	)		(91	)		(52	)
Pro forma net earnings (loss)		$	3,735		$	339		$	11,552		$	(4,465	)
Basic net earnings (loss) per share as reported:
Net earnings (loss) per basic share		$	0.73		$	0.07		$	2.29		$	(0.88	)
Pro forma compensation expense per basic share			(0.01	)					(0.02	)		(0.01	)
Pro forma net earnings (loss) per basic share		$	0.72		$	0.07		$	2.27		$	(0.89	)
Diluted net earnings (loss) per share as reported:
Net earnings (loss) per diluted share		$	0.67		$	0.07		$	2.09		$	(0.88	)
Pro forma compensation expense per diluted share			(0.01	)					(0.02	)		(0.01	)
Pro forma net earnings (loss) per diluted share		$	0.66		$	0.07		$	2.07		$	(0.89	)

On June 29, 2004, our shareholders approved the National Vision, Inc., 2004 Equity Incentive Plan (the “2004 Equity Plan”). This Plan replaced the Company’s Restated Stock Option and Incentive Award Plan (the “Option Plan”) and the Restated Non-Employee Director Stock Option Plan (the “Directors Plan”). As a result, no additional awards may be granted under the Option Plan or the Directors Plan. As of June 29, 2004 there were 28,253 and 45,000 shares available for grant under the Option Plan and the Directors Plan, respectively. The total shares available for grant under the 2004 Equity Plan is 373,253, which represents an increase of 300,000 shares over the shares available under the Option Plan and the Directors Plan. In addition, any shares subject to outstanding grants under the Option Plan and the Directors Plan on June 29, 2004, which are forfeited or expire on or after June 29, 2004 will become available for grant under the 2004 Equity Plan.

On June 29, 2004 we issued 107,500 restricted shares and 50,000 options under the 2004 Equity Plan. The restricted shares were issued to management, and each of the five members of the Board of Directors received an option covering 10,000 shares. Of the restricted shares issued, 5,000 were cancelled during the third quarter of 2004, leaving 102,500 outstanding at October 2, 2004, of which, 51,250 vest on the third anniversary of the grant date. The remaining 51,250 vest on the fifth anniversary of the grant date with accelerated vesting if the Company achieves certain financial goals. The options were issued at an exercise price equal to the fair market value on the date of grant. The options vest at the rate of 50% on the first anniversary of the grant date, and 25% on each of the second and third anniversaries of the grant date. At October 2, 2004, a total of 599,275 options and 312,650 restricted shares were outstanding under the 2004 Equity Plan, the Option Plan and the Directors Plan. Also at October 2, 2004 there were 245,240 shares available for grant under the 2004 Equity Plan.

	-11-

 

(7) CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE

 

At the beginning of fiscal 2003, we adopted Emerging Issues Task Force Issue No. 02-16, “Accounting by a Customer for Certain Consideration Received from a Vendor”  (“EITF 02-16”).  This Issue addresses the method by which retailers account for vendor allowances.  As a result of the adoption of EITF 02-16, certain vendor allowances, which formerly were treated as a reduction in advertising costs, are presented as a reduction of inventory cost and subsequently as a component of cost of goods sold.  On the first day of fiscal 2003, we recorded additional expense of $564,000 as the cumulative effect for this change in accounting principle.  This amount reflects the portion of vendor allowances that would have reduced inventory costs had this new accounting pronouncement been in effect at the end of 2002.

(8) SUPPLEMENTAL DISCLOSURE INFORMATION

(i)	Supplemental cash flow information (amounts in thousands):

		Nine Months Ended
		October 2, 2004			September 27, 2003
Cash paid for:
Interest		$	11,061		$	13,055
Income taxes, net of refunds		$	415		$	8

(ii)	Inventory balances, by classification, are summarized as follows (amounts in thousands):

		Balance at October 2, 2004			Balance at January 3, 2004
Raw materials and work-in-process		$	8,009		$	9,941
Finished goods			6,698			6,961
Supplies			436			485
		$	15,143		$	17,387

(iii)

Accrued Expenses and Other Current Liabilities

Significant components of accrued expenses and other current liabilities are summarized as follows (amounts in thousands):

		Balance at			Balance at
		October 2, 2004			January 3, 2004
Accrued employee compensation and benefits		$	8,092		$	3,757
Provision for self-insured liabilities		$	3,410		$	3,785
Deferred revenue		$	3,657		$	2,965
Customer deposit liability		$	2,606		$	2,231
Accrued rent expense		$	4,065		$	5,612
Accrued interest expense		$	59		$	2,986

(iv)	Product Warranty Liability

The following table details the activity in our product warranty liabilities for the nine-month periods ended October 2, 2004 and September 27, 2003. This represents our liability for certain product warranty services provided free of charge (amounts in thousands):

		Nine Months Ended
		October 2, 2004			September 27, 2003
Beginning balance		$	716		$	1,120
Charged to expense			4,317			5,420
Claims paid			(4,545	)		(5,520	)
Ending balance		$	488		$	1,020

	-12-

 (9) COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss), which consists of net income and foreign currency translation adjustments, was $3.8 million and $257,000 for the three months ended October 2, 2004 and September 27, 2003, respectively. For the nine months ended October 2, 2004 and September 27, 2003, the comprehensive income (loss) was $11.6 million and $(4.5) million, respectively.

(10) RELATED PARTY TRANSACTIONS

On August 20, 2004, the Company and Dr. Marc Nelson, a member of the Board of Directors, entered into a consulting agreement under which Dr. Nelson will provide certain consulting services at the hourly rate of $150 with respect to the Company’s free-standing vision centers. The Audit Committee of the Board of Directors has approved this agreement.  The Company expects that Dr. Nelson will provide approximately four hundred hours of such services over the next 12 months.  Nelson Eye Associates, P.C., a professional corporation owned by Dr. Nelson, leases 10 vision centers from the Company including a freestanding vision center located in West Berlin, NJ. During the nine month periods ended October 2, 2004 and September 27, 2003, Nelson Eye Associates paid the Company approximately $231,000 and $226,000, respectively, in rent for these locations.

 

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        

 

OVERVIEW AND STRATEGIES

We were founded in 1990 to operate vision centers inside Wal-Mart stores located in the United States. We are still primarily an optical retailer and at October 2, 2004, 74% of our retail locations operated inside domestic Wal-Mart stores. These 311 domestic Wal-Mart stores contribute substantially more than 74% of consolidated revenues and income.

Under our Master License Agreement with Wal-Mart, we were granted the right to open 400 such vision centers. We opened our 400th location in 2001. We have a right to operate each vision center for a base term of nine years followed by a three-year renewal. Under certain circumstances, primarily when a Wal-Mart store closes because a new SuperCenter was built to replace it, the lease term for our vision center starts over, giving us an additional twelve years to operate in that location assuming exercise of the renewal option.

Since the end of 2001 and through October 2, 2004, we have closed 63 vision centers within domestic Wal-Mart stores because the twelve-year lease term expired. We have closed another 13 stores after the base term expired because the store economics did not warrant exercise of our renewal option. Additionally, we closed 13 stores prior to the expiration of the base term as a result of poor operating results and prospects.

We expect to close an additional 7 domestic Wal-Mart locations as their leases expire over the last three months of fiscal 2004. These seven stores are being returned to Wal-Mart at the expiration of the renewal term. During the first nine months of fiscal 2004, these stores generated $3.5 million in revenue.

We presently expect to close 34 domestic Wal-Mart stores as their leases expire in fiscal 2005. All of these are being returned to Wal-Mart at the expiration of the renewal term. During the first nine months of fiscal 2004, these stores generated $16.3 million in revenue.

The domestic Wal-Mart store closings present the Company’s management with a significant challenge. We are seeking to create and develop other business opportunities to improve our ability to pay or refinance our senior secured debt before its final maturity on March 30, 2009. To the extent that we do not create and develop these other opportunities, we increase the risk that we will be unable to repay or refinance this debt. In order to address these issues, we are:

1)	Seeking to optimize the profitability of our existing stores to reduce outstanding principle under our Notes and maximize the time available to develop new sustainable growth vehicles,

2)	Reviewing and testing growth opportunities within optics, and

3)	Testing non-optics opportunities inside Wal-Mart stores.

	-13-

Optimizing the Profitability of Existing Stores

 

From mid-2002 to the end of 2003, we implemented significant changes in our store-level businesses, resulting in a higher average sales transaction value and higher gross margins. Although we continue to make improvements, the bulk of these changes had been implemented by the beginning of the current fiscal year. As a result, our stores were able to operate on a more stable basis throughout the first nine months of fiscal 2004 and achieve significantly better results than in the first nine months of fiscal 2003 when they were dealing with rapid and substantive changes.

 

During the third quarter of 2004 we completed a rebidding process with all of our eyeglass lens vendors. As a result of this process, we reduced the number of our lens suppliers and obtained price reductions on future lens purchases.

 

We have also begun a program of importing frames direct from foreign vendors. This will enable us to expand our frame selection at various retail price points with frames that cost less than those we purchase domestically. By the end of 2005, we expect that we will be importing between 10% and 15% of all frame purchases.

 

See “RESULTS OF OPERATIONS” below for further information regarding our operating results for the three and nine-month periods ended October 2, 2004.

 

Growth Opportunities within Optics

We have reviewed several opportunities within optics and are presently beginning to implement two of them.

In the latter half of August, concurrent with the expiration of one of our current leases with Wal-Mart, we relocated an existing vision center to a new freestanding location in the same general vicinity. This was our first freestanding location since emerging from bankruptcy in 2001. All store personnel as well as the independent optometrist transferred from our vision center in Wal-Mart to the new freestanding location. On November 11, 2004 we similarly relocated another of our vision centers to a freestanding location. The operation of freestanding vision centers near our former Wal-Mart locations is a test, not a proven concept for us. Our historical strength has been in operating stores within host environments. Operating within a host such as Wal-Mart guarantees high traffic and visibility while allowing us to minimize advertising costs. We have not projected as high a level of revenue for the new locations as we are achieving at the locations that are closing. In addition, we expect higher advertising costs at these locations. We also may find it difficult to attract and retain independent optometrists, particularly those who may prefer to practice in Wal-Mart stores. We may need to offer attractive lease terms and other arrangements to these optometrists. Such arrangements may also increase our cost of doing business at these locations. If we learn that we can profitably operate freestanding stores near our closed locations, we could adopt this as a strategy that could at least partially offset lost revenues from such closed locations.

Our second opportunity is to open and operate vision centers subleased from Wal-Mart in Oklahoma. We have developed a business model for our proposed operations in that state. We have initiated litigation seeking a declaratory judgment confirming that our proposed business model complies with applicable legal requirements. See “Other Information - Legal Proceedings”. We believe that Wal-Mart operates approximately 100 locations in Oklahoma. If we obtain a favorable judgment, we may be able to expand our operations into that state. We are unable to predict whether we will prevail in the litigation and whether and on what terms we may be able to operate vision centers in Oklahoma. We also have no agreement with Wal-Mart as to whether we can operate multiple vision centers using this model.

Another opportunity for us is to operate vision centers on military bases in the United States. Since May 2001 we have opened 16 vision centers on military bases and closed 5 vision centers on military bases. We have been awarded contracts to open 3 additional vision centers on military bases in 2005. We intend to continue to bid for military optical locations as they are offered.

Other Growth Opportunities

In May 2004, we opened home medical equipment (“HME”) stores inside Wal-Mart locations in Hazleton, Pennsylvania and Murfreesboro, Tennessee. In these stores, we are selling items such as wheel chairs, scooters, lift chairs, diabetic shoes and hosiery, commode seat risers, bathtub rails and various orthopedic products.

Our research of the industry prior to opening these stores indicated that new medical equipment stores require a full three years to ramp up to stable sales volume. Accordingly, our operating projections assumed slow but growing sales, and net losses in the early months of operation. To date, we have fallen short of projected results but we started to see some improvement at the end of the third quarter.

	-14-

Presently, we are unable to predict whether our two HME test stores will achieve acceptable levels of profitability. If these stores do prove to be sufficiently profitable, we will likely find it very difficult to open new stores at a pace that supplants the vision centers that will close, first because of the long lead time involved in securing new locations and secondly because our Senior Subordinated Note Indenture may limit our investment in non-optical businesses to a cumulative total of $1.0 million from May 31, 2001 through March 30, 2009. As of October 2, 2004, we have utilized $475,000 of this amount. These limitations may affect our ability to open additional stores.

Additional New Business

Our HMO subsidiary has historically opened optometric examination offices in California Wal-Mart stores in which we have operated vision centers. During 2004, the HMO began operating optometric examination offices in certain California Wal-Mart and Sam’s Club stores in which the vision center is operated by Wal-Mart. As of October 2, 2004 we operated 16 such doctor’s offices. Most, but not all, of such practices in Wal-Mart stores are in locations where we previously operated a vision center.  We presently expect to open 13 additional optometric offices through the end of 2005 in Wal-Mart stores where the vision center will be operated by Wal-Mart.  Revenues generated by each optometric practice are significantly less than revenues generated by a retail vision center.

Retention of Financial Advisor

On May 17, 2004, the Company announced that its Board of Directors had retained TM Capital, Inc., an investment-banking firm, as its financial advisor to review the Company’s strategic alternatives. This review is ongoing. As a result, the Company may ultimately pursue strategies additional to or different from those described above.

RESULTS OF OPERATIONS

Our results of operations in any period are significantly affected by the number and mix of vision centers operating during such period. Vision centers in operation were as follows:

 

		As of			As of
		October 2, 2004			September 27, 2003
Wal-Mart
Domestic			311			373
Mexico			35			37
Fred Meyer			47			47
Military			27			24
Freestanding			1
Total			421			481
Vision centers currently reported in continuing operations			421			415

THREE MONTHS ENDED OCTOBER 2, 2004 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 27, 2003

CONTINUING OPERATIONS

Retail Sales, Net. In the current year three-month period, total domestic comparable store sales were down 1.5% compared to the prior year three-month period. The following reconciliation shows the components of the change in retail sales (amounts in thousands):

	-15-

		Three Months Ended
		October 2, 2004			September 27,2003			% Change
Domestic comparable stores sales		$	53,234		$	54,056			-1.5	%
Domestic - other (a)			1,076			304			253.9	%
Mexico			1,117			1,094			2.1	%
Total retail sales, net		$	55,427		$	55,454

a)	This category includes vision center stores that were not operating during the prior year quarter, the store that was relocated after its lease with Wal-Mart expired and two home medical equipment stores that opened in the current year.

We achieved flat retail sales in the current year third quarter despite the fact that the prior year quarter included sales of approximately $3.5 million from our semi-annual contact lens event, while the revenues from this event in 2004 were recognized in our second quarter when the products were delivered to our customers.  Excluding the contact lens event sales from the prior year, retail sales for the current year quarter increased $3.5 million over the prior year. Comparable store sales, excluding sales reported in the prior year for the contact lens event increased 5.1%.

The increase in sales excluding the contact lens event was attributable to increased sales of both eyeglasses and contact lenses and an increase in sales of our extended warranty plan as described in the following paragraph.

In May 2003, we began offering a twelve-month extended warranty plan in our Wal-Mart vision centers to provide for repair and replacement of eyeglasses during the first year after purchase. Revenue recognized during the current year quarter was approximately $1.5 million compared to $400,000 during the prior year quarter. Approximately 53% of our eyeglass transactions during the current year quarter included an extended warranty purchase. We expect the increases in revenue due to warranty sales to have a continued favorable impact on the remainder of 2004, but to a lesser extent than in the current year quarter. This revenue is reflected in “Retail sales, net” in our Condensed Consolidated Statements of Operations.

Premium Revenue. The increase in premium revenue for vision examination insurance can be largely attributed to increased enrollments in our California health maintenance organization. The HMO had approximately 168,000 members as of October 2, 2004 compared to approximately 112,000 members as of September 27, 2003.

Other Revenue. In 2003, we began manufacturing eyeglasses for a small retail optical company. Total revenue from this line of business for the three months ended October 2, 2004 was approximately $59,000 less than the prior year three-month period ended September 27, 2003. In January 2004 we began operating optometric examination offices in certain California Wal-Mart stores in which Wal-Mart operates a vision center. Revenue from patient co-payments was approximately $172,000 for the three months ended October 2, 2004.

Gross Profit. In the current year three-month period, gross profit dollars increased over gross profit dollars in the prior year three-month period. The components of sales and gross profit for these periods are detailed below (dollars in thousands):

	-16-

		Three Months Ended
		October 2, 2004						September 27, 2003
Retail sales, net		$	55,427			100.0%		$	55,454			100.0%
Retail cost of goods sold			23,290			42.0%			24,838			44.8%
Retail gross profit		$	32,137			58.0%		$	30,616			55.2%
Premium and other revenue		$	2,479			100.0%		$	2,092			100.0%
Other cost of sales			1,561			63.0%			1,698			81.2%
Other gross profit		$	918			37.0%		$	394			18.8%
Total net sales		$	57,906			100.0%		$	57,546			100.0%
Total cost of goods sold			24,851			42.9%			26,536			46.1%
Total gross profit		$	33,055			57.1%		$	31,010			53.9%

The improvement in the retail gross profit as a percent of sales in the current year quarter was in large part attributable to an increased ratio of eyeglass sales to retail net sales. In the current year quarter, eyeglass sales, which yield a higher margin than do contact lens sales, were 75.0% of retail net sales compared to 73.0% in the prior year quarter. Contact lens sales were 19.3% of retail net sales in the current year quarter compared to 23.3% in the prior year quarter, principally because of the timing of our contact lens event.

Other factors contributing to the improvement in the gross profit percent included an increase in revenue recognized from sales of extended warranties to $1,474,000 in the current year quarter from $401,000 in the prior year quarter, which improved margins as a percent of sales by approximately 0.8% in the current year quarter compared to the prior year quarter. Also, Fred Meyer locations experienced a decrease in rent (a component of Cost of Goods Sold) due to a revision in the lease agreement which became effective in January 2004. This resulted in savings of approximately $330,000 during the third quarter of 2004 compared to 2003 and favorably impacted the gross margin percentage by approximately 0.6%.

In addition, a change in our lens offering made in September 2003 and lower remake and warranty costs contributed to the improved gross profit percent.

Other gross profit represents 1) premium revenue less claims expenses for a managed care insurance product that we sell in California, 2) the gross profit on eyeglass manufacturing for a small independent optical chain and 3) revenue from eye exams in excess of the vision insurance premium from the California managed care insurance product (patient co-payment).

Selling, General, and Administrative Expense (“SG&A expense”). SG&A expense includes both store operating expenses and home office overhead and is shown below (dollars in thousands):

		Three Months Ended
		October 2, 2004						September 27, 2003
					% of						% of
		Amount			Total Revenue			Amount			Total Revenue
Store operating expenses		$	17,991			31.1%		$	18,227			31.7%
Store depreciation & amortization			843			1.5%			1,386			2.4%
Field supervision			1,338			2.3%			1,500			2.6%
Corporate support			4,754			8.2%			4,276			7.4%
Amortization of contractual rights			1,878			3.2%			1,848			3.2%
Other depreciation & amortization			431			0.7%			344			0.6%
Total SG&A expense		$	27,235			47.0%		$	27,581			47.9%

	-17-

The decline in store operating expenses in the current year quarter compared to the prior year quarter was primarily attributable to reduced workers compensation self-insurance provisions because of improved claims experience. Store depreciation and amortization costs declined in the current year quarter due to leasehold improvements and equipment at some stores becoming fully depreciated. We expect the year-over-year decline in depreciation expense to continue.

Field supervision expense declined in the current year quarter due to a reduction in the number of district managers.

The increase in corporate support in the current year quarter was primarily attributable to accruals made for incentive compensation expense. Because of improvement in our earnings year-over-year and an increase in our stock price, we accrued approximately $0.7 million in the current year quarter for payments expected to be made under various incentive plans. In the prior year quarter, there were no incentive plan accruals because we were not achieving our targeted operating results.  Declines in professional fees and retail support center payroll and benefits partially offset this increase.

Restructuring Expense.  During August 2003, as a result of the declining store base, the Company initiated and completed a restructuring of the retail field and home office retail support center.  The process resulted in a reduction in headcount approximating 30 employees of both the retail field management organization and the home office retail support center organization.  The total cost of the restructuring process was $484,000, which included separation and outplacement costs.

Interest Expense. The outstanding balance of our Senior Subordinated Notes is the primary driver of interest expense. Interest expense declined by approximately $0.8 million in the third quarter of 2004 compared to the third quarter of 2003 due to principal repayments and Note repurchases made during the second half of 2003 and the first nine months of 2004.

Gain on Repurchase of Notes. During the third quarter of 2004, we repurchased Notes with a par value of $0.7 million for total cash payments of $0.5 million, resulting in a gain of $0.2 million.

Income Tax Expense. The income tax expense in the current year three-month period consists of the amount we expect to pay under federal alternative minimum tax provisions and in states in which our taxable income cannot be offset by our net operating loss carry-forwards, plus deferred income tax provisions, offset by a reduction in the previously recorded valuation allowance.

Discontinued Operations. During the third quarter of 2004, we closed 17 vision centers inside Wal-Mart stores located in the United States and 2 vision centers in Wal-Mart de Mexico stores.  The 17 closings inside the Wal-Mart stores located in the United State were the result of lease expirations.  One of these stores was relocated to a freestanding location within the vicinity of the closed location and is therefore not considered a discontinued operation.  The 2 locations inside Wal-Mart de Mexico stores were closed due to poor operating results and prospects. In addition, during the first half of 2004 and fiscal year 2003, we closed 33 and 54 vision centers, respectively. The gain on disposal of these operations includes severance, closing costs and gains recorded from the sale of certain assets. Historical operating results for these closed vision centers, excluding the vision center relocated to a freestanding location, have been reclassified as discontinued operations and presented separately for all periods presented in the accompanying Condensed Consolidated Statements of Operations. Condensed information for these closed stores is presented below (dollars in thousands):

		Three Months Ended
		October 2, 2004			September 27, 2003
Total net sales		$	1,841		$	7,932
Operating income		$	384		$	593
Gain on disposal		$	9		$	17
Income tax expense		$	28

NINE MONTHS ENDED OCTOBER 2, 2004 COMPARED TO NINE MONTHS ENDED SEPTEMBER 27, 2003

CONTINUING OPERATIONS

Retail Sales, Net. In the current year nine-month period, total domestic comparable store sales were up 6.6% over the prior year nine-month period. The following reconciliation shows the components of the change in retail sales (amounts in thousands):

		Nine Months Ended
		October 2, 2004			September 27, 2003			% Change
Domestic comparable store sales		$	163,946		$	153,725			6.6	%
Domestic - other (a)			2,344			829			182.8	%
Mexico			3,313			3,408			-2.8	%
Total retail sales, net		$	169,603		$	157,962			7.4	%

	-18-

a)	This category includes vision center stores that were not operating during the prior year nine-month period, the store that was relocated after its lease with Wal-Mart expired and two home medical equipment stores that opened in the current year nine-month period.

In May 2003, we began offering a twelve-month extended warranty plan in our Wal-Mart vision centers to provide for repair and replacement of eyeglasses during the first year after purchase. Revenue recognized during the current year nine-month period was approximately $4.0 million compared to $464,000 during the prior year nine-month period. Approximately 51% of our eyeglass transactions during the current year nine-month period included an extended warranty purchase. We expect the increase in revenue due to warranty sales to have a continued favorable impact on the remainder of 2004, but to a lesser extent than in the current nine-month period. This revenue is reflected within “Retail sales, net” in our Condensed Consolidated Statements of Operations.

The remaining increase in retail net sales during the current year nine-month period was attributable to a variety of operational improvements in our stores. During the first nine months of 2004, we continued to benefit from changes made during the course of 2003 to help drive domestic sales. Although it is difficult to quantify the impact of each of these activities, we believe the following factors had the most significant impact on our retail domestic comparable store sales increase in the first nine months of 2004.

1.	In 2003, we implemented significant merchandising changes in every major category (frames, spectacle lenses and contact lenses) to modernize our collection and simplify the presentation for the customer. The most significant category changes affecting the current nine months are as follows:

a)

During the first quarter of 2003, we updated our frame collection to modernize and simplify our presentation. As part of this process, we substantially reduced the number of frame vendors, consolidated price points, and enhanced the presentation of frames to make them more brand focused for the customer, and easier to manage for our associates. We fully benefited from this change in the first nine months of 2004 compared with only a portion of the prior year nine-month period.

b)	During the first half of 2003, we aligned our contact lens selection with the products most frequently prescribed by our independent doctors. This favorably impacted our contact lens sales for the first nine months of 2004 which are up approximately 10.6% over the prior year nine-month period.

c)	During the first quarter of 2004, we refined the selection of single-vision lenses stocked in the stores to allow more eyeglasses to be manufactured in the store and to improve delivery times for most single vision eyeglass customers.

2.	In 2003, we restructured our personnel scheduling at the store-level to provide for consistent coverage based on operating needs by sales volume levels. We now review personnel scheduling on an ongoing basis to ensure that our stores are most efficiently staffed to meet customer needs.

3.	We amended our incentive programs to increase potential participation by, and therefore the productivity of, our associates.

Premium Revenue. The increase in premium revenue for vision examination insurance can be largely attributed to increased enrollments in our California health maintenance organization. The HMO had approximately 168,000 members as of October 2, 2004 compared to approximately 112,000 members as of September 27, 2003.

Other Revenue. In 2003, we began manufacturing eyeglasses for a small retail optical company. Total revenue from this line of business in the current year nine-month period was approximately $109,000 more than in the prior year nine-month period. In January 2004, we began operating optometric examination offices in certain California Wal-Mart stores in which Wal-Mart operates a vision center. Revenue from patient co-payments was approximately $287,000 for the nine-month period ended October 2, 2004.

Gross Profit. In the current year nine-month period, gross profit dollars increased over gross profit dollars in the prior year nine-month period. The components of sales and gross profit for these periods are detailed below (dollars in thousands):

	-19-

		Nine Months Ended
		October 2, 2004						September 27, 2003
Retail sales, net		$	169,603			100.0%		$	157,962			100.0%
Retail cost of goods sold			71,352			42.1%			69,009			43.7%
Retail gross profit		$	98,251			57.9%		$	88,953			56.3%
Premium revenue and other revenue		$	7,072			100.0%		$	5,695			100.0%
Other cost of sales			4,954			70.1%			4,721			82.9%
Other gross profit		$	2,118			29.9%		$	974			17.1%
Total net sales		$	176,675			100.0%		$	163,657			100.0%
Total cost of goods sold			76,306			43.2%			73,730			45.1%
Total gross profit		$	100,369			56.8%		$	89,927			54.9%

The improvement in retail gross margin to 57.9% in 2004 compared to 56.3% in 2003 was primarily the result of three factors:

-	An increase in revenue recognized from the sale of twelve-month extended warranties to $3,950,000 in the first nine months of 2004 from $464,000 in the first nine months of 2003, which improved margins as a percent of sales by approximately 0.9% in the current year.

-

Fred Meyer locations experienced a decrease in rent (a component of Cost of Goods Sold) due to a revision in the lease agreement which became effective in January 2004. This resulted in savings of approximately $930,000 during the first nine months of 2004 compared to the first nine months of 2003 and favorably impacted the gross margin percentage by approximately 0.6%.

-

Eyeglass margins improved during the first six months of 2004 compared to the prior year due to a change in lens offering and a reduction in remake and warranty claims. In the second half of 2003, we began testing different lens offerings to improve eyeglass profit margins and simplify customer presentation. We have substantially completed the first phase of our lens test, but expect this process to continue for the remainder of 2004.

Partially offsetting these improvements in the retail gross margin percentage was a shift in product mix to a higher percentage of contact lens sales and a lower percentage of eyeglass sales. Contact lens sales, which yield a lower margin than do eyeglass sales, increased by $3.3 million in the first nine months of 2004 to $34.2 million or 20.1% of retail net sales compared to $30.9 million or 19.6% of retail net sales in the first nine months of 2003. While our eyeglass sales increased $5.0 million in the first nine months of 2004 to $126.4 million from $121.4 million in the first nine months of 2003, as a percentage of retail net sales they declined to 74.5% from 76.8% in 2003.

Other gross profit represents 1) premium revenue less claims expenses for a managed care insurance product that we sell in California, 2) the gross profit on eyeglass manufacturing for a small independent optical chain and 3) revenue from eye exams in excess of the vision insurance premium from the California managed care insurance product (patient  co-payment).

Selling, General, and Administrative Expense (“SG&A Expense”). SG&A expense includes both store operating expenses and home office overhead and is shown below (dollars in thousands):

	-20-

		Nine Months Ended
		October 2, 2004						September 27, 2003
					% of						% of
		Amount			Total Revenue			Amount			Total Revenue
Store operating expenses		$	54,262			30.7%		$	54,965			33.6%
Store depreciation & amortization			2,653			1.5%			4,296			2.6%
Field supervision			4,039			2.3%			4,678			2.9%
Corporate support			17,269			9.8%			14,550			8.9%
Amortization of contractual rights			5,632			3.2%			5,542			3.4%
Other depreciation & amortization			925			0.5%			760			0.4%
Total SG&A expense		$	84,780			48.0%		$	84,791			51.8%

Store operating expenses declined in the current year nine-month period compared to the prior year primarily as a result of reductions in payroll and benefits, telephone, supplies, repairs and maintenance and managed care claims processing costs. Payroll and benefits savings were attributable to our new personnel scheduling and incentive plans implemented to control employee costs and lower health insurance claims. Negotiation of new contracts for telephone service and implementation of a new managed care claims system generated the savings in these areas. Supply costs were down compared to the prior year nine-month period because the prior year included large expenses necessitated by the many operational changes made in the stores during 2003 to improve sales and margins.

Store depreciation and amortization costs declined in the current year nine-month period due to leasehold improvements and equipment at some stores becoming fully depreciated. We expect the year-over-year decline in depreciation expense to continue.

Field supervision expense declined in the current year nine-month period due to a reduction in the number of regional and district managers.

The increase in corporate support in the current year nine-month period was primarily attributable to accruals made for incentive compensation expense. Because of improvement in our earnings year-over-year and an increase in our stock price, during the first nine months of the current year we have accrued approximately $4.3 million for payments expected to be made under various incentive plans. In the same period last year, there were no net incentive plan accruals because we were not achieving our targeted operating results. Declines in professional fees ($1.1 million) and retail support center payroll and benefits ($0.5 million) partially offset this increase. The reduction in professional fees was the result of operational consulting fees and unusually high audit and tax return preparation fees incurred in the prior year period. The decrease in payroll and benefits costs was attributable to corporate office staff reductions made in the second half of 2003.

Restructuring Expense.  During August 2003, as a result of the declining store base, the Company initiated and completed a restructuring of the retail field and home office retail support center.  The process resulted in a reduction in headcount approximating 30 employees of both the retail field management organization and the home office retail support center organization.  The total cost of the restructuring process was $484,000, which included separation and outplacement costs.

Interest Expense. The outstanding balance of our Senior Subordinated Notes is the primary driver of interest expense. Interest expense declined by approximately $1.6 million in the nine-month period ended October 2, 2004 compared to the nine-month period ended September 27, 2003 due to principal repayments and Note repurchases made during  2003 and the first nine months of 2004.

Gain on Repurchase of Notes. During 2004, we repurchased Notes with a par value of $14.8 million for total cash payments of $11.7 million, resulting in a gain of $3.1 million.