UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x                      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JULY 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:

001-31829

CARTER’S, INC.

(Exact name of Registrant as specified in its charter)

 

The Proscenium
1170 Peachtree Street NE, Suite 900
Atlanta, Georgia  30309
(Address of principal executive offices, including zip code)

(404) 745-2700
(Registrant’s 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.   Yes x    No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one)

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

 

CARTER’S, INC.
INDEX

 

				Page
Part I.   Financial Information
Item 1.		Financial Statements
		Unaudited Condensed Consolidated Balance Sheets as of July 1, 2006 and December 31, 2005		3
		Unaudited Condensed Consolidated Statements of Operations for the three and six-month periods ended July 1, 2006 and July 2, 2005		4
		Unaudited Condensed Consolidated Statements of Cash Flows for the six-month periods ended July 1, 2006 and July 2, 2005		5
		Unaudited Condensed Consolidated Statement of Changes in Stockholders’ Equity for the six-month period ended July 1, 2006		6
		Notes to the Unaudited Condensed Consolidated Financial Statements		7
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		23
Item 3.		Quantitative and Qualitative Disclosures about Market Risk		36
Item 4.		Controls and Procedures		37
Part II.   Other Information
Item 1.		Legal Proceedings		38
Item 1A.		Risk Factors		38
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		38
Item 3.		Defaults upon Senior Securities		38
Item 4.		Submission of Matters to a Vote of Security Holders		38
Item 5.		Other Information		38
Item 6.		Exhibits		39
Signatures				40
Certifications

2

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PART I.   FINANCIAL INFORMATION

ITEM 1.   FINANCIAL STATEMENTS

CARTER’S, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except for share data)
(unaudited)

		July 1, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents		$	41,624		$	84,276
Accounts receivable, net		103,151			96,144
Inventories, net		190,524			188,454
Prepaid expenses and other current assets		8,413			6,262
Deferred income taxes		18,795			23,909
Total current assets		362,507			399,045
Property, plant, and equipment, net		76,192			79,458
Tradenames		322,233			322,233
Cost in excess of fair value of net assets acquired		283,122			284,172
Deferred debt issuance costs, net		7,118			8,257
Licensing agreements, net		15,022			17,150
Leasehold interests, net		1,385			1,619
Other assets		7,779			4,793
Total assets		$	1,075,358		$	1,116,727
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term debt		$	3,979		$	3,241
Accounts payable		57,074			63,735
Other current liabilities		55,490			89,627
Total current liabilities		116,543			156,603
Long-term debt		389,915			426,791
Deferred income taxes		127,613			124,439
Other long-term liabilities		21,528			22,250
Total liabilities		655,599			730,083
Commitments and contingencies
Stockholders’ equity:
Preferred stock; par value $.01 per share; 100,000 shares authorized; none issued or outstanding at July 1, 2006 and December 31, 2005		—			—
Common stock, voting; par value $.01 per share; 150,000,000 shares authorized; 58,153,110 shares issued and outstanding at July 1, 2006; 40,000,000 shares authorized, 28,909,729 shares issued and outstanding at December 31, 2005		582			289
Additional paid-in capital		263,822			260,414
Deferred compensation		—			(2,749		)
Accumulated other comprehensive income		3,215			1,354
Retained earnings		152,140			127,336
Total stockholders’ equity		419,759			386,644
Total liabilities and stockholders’ equity		$	1,075,358		$	1,116,727

See accompanying notes to the unaudited condensed consolidated financial statements

3

 

CARTER’S, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except for share data)
 (unaudited)

		For the  three-month periods ended						For the six-month periods ended
		July 1, 2006			July 2, 2005			July 1, 2006			July 2, 2005
Net sales		$	277,577		$	192,500		$	574,024		$	398,707
Cost of goods sold		180,342			126,435			368,625			256,877
Gross profit		97,235			66,065			205,399			141,830
Selling, general, and administrative expenses		82,466			51,243			165,448			103,239
Closure costs		10			4,569			91			4,569
Royalty income		(6,654		)	(2,813		)	(13,828		)	(6,336		)
Operating income		21,413			13,066			53,688			40,358
Interest expense, net		6,929			4,055			13,813			8,457
Income before income taxes		14,484			9,011			39,875			31,901
Provision for income taxes		5,466			3,561			15,071			12,602
Net income		$	9,018		$	5,450		$	24,804		$	19,299
Basic net income per common share		$	0.16		$	0.10		$	0.43		$	0.34
Diluted net income per common share		$	0.15		$	0.09		$	0.41		$	0.32
Basic weighted-average number of shares outstanding		57,877,753			57,159,886			57,793,393			57,046,684
Diluted weighted-average number of shares outstanding		61,183,491			60,643,410			61,160,185			60,514,664

 

See accompanying notes to the unaudited condensed consolidated financial statements

4

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CARTER’S, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(unaudited)

		For the six-month periods ended
		July 1, 2006			July 2, 2005
Cash flows from operating activities:
Net income		$	24,804		$	19,299
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization		12,735			9,378
Amortization of debt issuance costs		1,139			1,066
Accretion of debt discount		—			38
Income tax benefit from exercised stock options		(2,378		)	2,958
Non-cash stock-based compensation expense		2,858			753
Non-cash closure costs		—			106
Loss on sale of property, plant, and equipment		108			28
Deferred income taxes		7,236			(264		)
Effect of changes in operating assets and liabilities:
Accounts receivable		(7,007		)	(1,565		)
Inventories		(2,070		)	(18,852		)
Prepaid expenses and other assets		(1,823		)	(925		)
Accounts payable and other liabilities		(38,311		)	10,616
Net cash (used in) provided by operating activities		(2,709		)	22,636
Cash flows from investing activities:
Capital expenditures		(7,541		)	(5,933		)
Proceeds from sale of property, plant, and equipment		344			9
Transaction costs		—			(782		)
Collections on loan		—			600
Net cash used in investing activities		(7,197		)	(6,106		)
Cash flows from financing activities:
Payments on term loan		(36,138		)	(35,261		)
Income tax benefit from exercised stock options		2,378			—
Proceeds from exercise of stock options		1,014			842
Net cash used in financing activities		(32,746		)	(34,419		)
Net decrease in cash and cash equivalents		(42,652		)	(17,889		)
Cash and cash equivalents, beginning of period		84,276			33,265
Cash and cash equivalents, end of period		$	41,624		$	15,376

 

See accompanying notes to the unaudited condensed consolidated financial statements

5

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CARTER’S, INC.
 CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
(dollars in thousands, except for share data)
(unaudited)

		Common stock			Additional paid-in capital			Deferred compensation			Accumulated other comprehensive income			Retained earnings			Total stockholders’ equity
Balance at December 31, 2005		$	289		$	260,414		$	(2,749	)	$	1,354		$	127,336		$	386,644
Tax benefit from exercise of stock options		—			2,378			—			—			—			2,378
Exercise of stock options (236,280 shares)		2			1,012			—			—			—			1,014
Stock-based compensation expense		—			2,518			—			—			—			2,518
Issuance of common stock (17,172 shares)		—			540			—			—			—			540
Reversal of deferred compensation (see Note 9)		—			(2,749		)	2,749			—			—			—
Two-for-one common stock split (see Note 8)		291			(291		)	—			—			—			—
Comprehensive income:
Net income		—			—			—			—			24,804			24,804
Unrealized gain on interest rate swap, net of taxes of $991		—			—			—			1,756			—			1,756
Unrealized gain on interest rate collar, net of taxes of $61		—			—			—			105			—			105
Total comprehensive income		—			—			—			1,861			24,804			26,665
Balance at July 1, 2006		$	582		$	263,822		$	—		$	3,215		$	152,140		$	419,759

 

See accompanying notes to the unaudited condensed consolidated financial statements

 

6

CARTER’S, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

NOTE 1 — THE COMPANY:

Carter’s, Inc., and its wholly-owned subsidiaries (collectively, the “Company,” “we,” “us,” “its,” and “our”) design, source, and market branded newborn and childrenswear under the Carter’s, Child of Mine, Just One Year, OshKosh B’Gosh, and related labels.  Our products are sourced through contractual arrangements with manufacturers worldwide.  Products are sourced for wholesale distribution to major domestic retailers, including the mass channel, and for our 200 Carter’s brand and 143 OshKosh brand retail stores that market our brand name merchandise and other licensed products manufactured by other companies.

On July 14, 2005, Carter’s, Inc., through its wholly-owned subsidiary, The William Carter Company (“TWCC”), acquired all of the outstanding common stock of OshKosh B’Gosh, Inc. for a purchase price of $312.1 million, which included payment for vested stock options (the “Acquisition”).  Established in 1895, OshKosh designs, sources, and markets apparel for children sizes newborn to 16.  The accompanying unaudited condensed consolidated financial statements include the operations of OshKosh for the three and six-month periods ended July 1, 2006.  Financial results for the three and six-month periods ended July 2, 2005 do not include the operations of OshKosh.

NOTE 2 — BASIS OF PREPARATION:

The accompanying unaudited condensed consolidated financial statements comprise the consolidated financial statements of Carter’s, Inc. and its subsidiaries.  All intercompany accounts and transactions have been eliminated in consolidation.

In our opinion, the Company’s accompanying unaudited condensed consolidated financial statements contain all adjustments necessary for a fair statement of our financial position as of July 1, 2006, the results of our operations for the three and six-month periods ended July 1, 2006 and July 2, 2005, cash flows for the six-month periods ended July 1, 2006 and July 2, 2005 and changes in stockholders’ equity for the six-month period ended July 1, 2006.  Operating results for the six-month period ended July 1, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending December 30, 2006.  Our accompanying condensed consolidated balance sheet as of December 31, 2005 is from our audited consolidated financial statements included in our most recently filed Annual Report on Form 10-K, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

Certain information and footnote disclosure normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission and the instructions to Form 10-Q.  The accounting policies we follow are set forth in our most recently filed Annual Report on Form 10-K in the notes to our consolidated financial statements for the fiscal year ended December 31, 2005.

Our fiscal year ends on the Saturday in December or January nearest to the last day of December.  The accompanying unaudited condensed consolidated financial statements for the second quarter and first half of fiscal 2006 reflect our financial position as of July 1, 2006.  The second quarter and first half of fiscal 2005 ended on July 2, 2005.

Certain prior year amounts have been reclassified for comparative purposes.

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NOTE 3 — BUSINESS COMBINATION AND REFINANCING:

As noted above, on July 14, 2005, we acquired all of the outstanding common stock of OshKosh.  The Acquisition was accounted for under the purchase method of accounting.  The purchase price for the Acquisition, including related fees and expenses, was allocated to the fair value of tangible and identifiable intangible assets and liabilities acquired with the remainder allocated to cost in excess of fair value of net assets acquired.  As part of financing the Acquisition, the Company refinanced its existing debt (the “Refinancing”), including its senior credit facility (“former senior credit facility”) and repurchased its $113.8 million 10.875% Senior Subordinated Notes due 2011 (the “Notes”).  The repurchase of the Notes together with the Refinancing and Acquisition is referred to as the “Transaction.”

Financing for the Transaction was provided by a new $500 million Term Loan 1 (see Note 6) and a $125 million revolving credit facility (including a sub-limit for letters of credit of $80 million, the “Revolver”) entered into by TWCC with Bank of America, N.A., as administrative agent, Credit Suisse, and certain other financial institutions (the “Senior Credit Facility”).  The term of the Revolver extends to July 14, 2011 and the term of the Term Loan 1 extends to July 14, 2012.

The proceeds of the Refinancing were used to purchase the outstanding common stock and vested stock options of OshKosh ($312.1 million), pay transaction expenses ($6.2 million), refinance the Company’s former senior credit facility ($36.2 million), repurchase the Notes ($113.8 million), pay a redemption premium on the Company’s Notes ($14.0 million), along with accrued and unpaid interest ($5.1 million), and pay debt issuance costs ($10.6 million).  Other Transaction expenses paid prior and subsequent to the closing of the Transaction totaled $1.4 million, including $0.2 million in debt issuance costs.

As a result of the Refinancing, we expensed $4.5 million in unamortized debt issuance costs related to the former senior credit facility and Notes and expensed $0.5 million related to the debt discount on the Notes.  Additionally, we expensed approximately $1.1 million of debt issuance costs associated with the Senior Credit Facility in accordance with Emerging Issues Task Force (“EITF”) No. 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments.”

The Senior Credit Facility requires us to hedge at least 25% of our variable rate debt under the term loan.  On September 22, 2005, we entered into a swap agreement to receive floating interest and pay fixed interest.  This swap agreement is designated as a cash flow hedge of the variable interest payments on a portion of our variable rate Term Loan 1 debt.  The swap agreement matures on July 30, 2010.  The unrealized gain, net of taxes, related to the interest rate swap was $0.8 million and $1.8 million, respectively, for the three and six-month periods ended July 1, 2006 and is included within accumulated other comprehensive income on the accompanying unaudited condensed consolidated balance sheet.  During the three and six-month periods ended July 1, 2006, we reclassified approximately $0.2 million and $0.4 million, respectively, related to the swap agreement into earnings.

On May 25, 2006, we entered into an interest rate collar agreement (the “collar”) with a floor of 4.3% and a ceiling of 5.5%.  The collar covers $100 million of our variable rate Term Loan 1 debt and is designated as a cash flow hedge of the variable interest payments on such debt.  The collar matures on January 31, 2009.  The unrealized gain, net of taxes, related to the collar was $0.1 million for the three-month period ended July 1, 2006 and is included within accumulated other comprehensive income on the accompanying unaudited condensed consolidated balance sheet.

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A summary of the Acquisition purchase price allocation is as follows:

 

During the six-month period ended July 1, 2006, the following adjustments were made to the purchase price allocation:

 

The following unaudited pro forma summary presents information as if the Transaction occurred on the first day of fiscal 2005 and assumes that there were no other changes in our operations.  This pro forma information does not necessarily reflect the actual results that would have occurred had the Transaction occurred on that date, nor is it necessarily indicative of the future results of operations of the combined Company.

The results reflect the combined Company for the three and six-month periods ended July 2, 2005, adjusted to reflect increased interest expense, amortization of the capitalized value of OshKosh licensing agreements and leasehold interests, and incremental depreciation expense.

 

9

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NOTE 4 — COST IN EXCESS OF FAIR VALUE OF NET ASSETS ACQUIRED AND OTHER INTANGIBLE ASSETS:

In connection with the Acquisition, the Company recorded the cost in excess of fair value of net assets acquired and other intangible assets in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations.”

As of July 1, 2006, cost in excess of fair value of net assets acquired and other intangible assets resulting from the Acquisition were as follows:

 

Amortization expense for intangible assets subject to amortization was approximately $1.2 million and $2.4 million for the three and six-month periods ended July 1, 2006.  Annual amortization expenses for the OshKosh licensing agreements and leasehold interests are expected to be as follows:

 

As described in Note 2 to our consolidated financial statements in our most recently filed Annual Report on Form 10-K, our existing Carter’s tradename and cost in excess of fair value of net assets acquired have been deemed to have indefinite lives and are not being amortized.

NOTE 5 — INVENTORIES:

Inventories consisted of the following:

 

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NOTE 6 — CREDIT FACILITY AMENDMENT:

On April 28, 2006, the Company entered into Amendment No. 1 (“Amendment No. 1”) to the Senior Credit Facility.  Amendment No. 1 reduced the Company’s interest rate by refinancing the existing Term Loan B (initially priced at LIBOR + 1.75% with a leverage-based pricing grid ranging from LIBOR + 1.50% to LIBOR + 1.75%) with a new Term Loan 1 having an applicable rate of LIBOR + 1.50% with no leverage-based pricing grid.  If the Company makes any optional prepayments of its Term 1 Loans prior to the one-year anniversary of Amendment No. 1 in connection with any repricing transaction, the Company will be required to pay a prepayment premium of 1% of the amount of such Term 1 Loans being prepaid.

Amendment No. 1 also lowered the threshold for permitting restricted payments by raising the required leverage ratio (as defined) from 1.5 times to 2.5 times provided the Company has revolving loan commitments of $75.0 million available.

NOTE 7 — EMPLOYEE BENEFIT PLANS:

Under a defined benefit plan, which was frozen in 1991, we offer a comprehensive post-retirement medical plan to current and certain future retirees and their spouses until they become eligible for Medicare or a Medicare supplement plan.  We also offer life insurance to current and certain future retirees.  We also have an obligation under a defined benefit plan covering certain former officers.  See Note 7 “Employee Benefit Plans” to our consolidated financial statements in our most recently filed Annual Report on Form 10-K for further information.

The components of post-retirement life and medical benefit expense charged to operations are as follows:

 

The components of pension expense charged to operations are as follows:

 

The Company maintains two defined benefit pension plans acquired in connection with the Acquisition.  The benefits under these pension plans were frozen as of December 31, 2005, and cover certain current and former employees of OshKosh.

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The Company’s net periodic pension benefit related to these plans is comprised of the following components:

 

NOTE 8 — COMMON STOCK:

On May 12, 2006, the Company amended Article V of its certificate of incorporation.  The amendment increased the number of authorized shares of the Company’s common stock from 40,000,000 to 150,000,000.

On June 6, 2006, the Company effected a two-for-one stock split (the “stock split”) through a stock dividend to stockholders of record as of May 23, 2006, of one share of our common stock for each share of common stock outstanding.  Earnings per share for all prior periods presented have been adjusted to reflect the stock split.

During the second quarter of fiscal 2006, we issued 17,172 shares of common stock to our non-management Board members.

NOTE 9 — STOCK-BASED COMPENSATION:

Under our Amended and Restated 2003 Equity Incentive Plan (the “Plan”), the compensation committee of our Board of Directors may award incentive stock options (ISOs and non-ISOs), stock appreciation rights (SARs), restricted stock, unrestricted stock, stock deliverable on a deferred basis, performance-based stock awards, and cash payments intended to help defray the cost of awards.  All share and per share amounts have been adjusted to reflect the stock split discussed in Note 8 above.

On May 12, 2005, our Board of Directors implemented, and our stockholders approved an amendment to the Plan to increase the number of shares available to be delivered under the Plan by 2,800,000 to 11,488,392, with no more than 1,260,000 of such additional shares able to be used for awards other than stock options and to reduce the number of shares for which stock options may be granted to any individual or which can be subject to SARs granted to any individual in any calendar year from 8,000,000 to 2,000,000.  As of July 1, 2006, there were 2,222,283 shares available for grant under the Plan.  The Plan makes provision for the treatment of awards upon termination of service or in the case of a merger or similar corporate transaction.  Participation in the Plan is limited to Directors and those key employees selected by the compensation committee.  The limit on shares available under the Plan, the individual limits, and other award terms are subject to adjustment to reflect stock splits or stock dividends, combinations, and certain other events.  All stock options issued under the Plan expire no later than ten years from the date of grant.  The Company believes that the current level of authorized shares is sufficient to satisfy future option exercises.

There are currently three types of stock options outstanding under the Plan:  basic, performance, and retained options.  Basic options issued prior to May 12, 2005 vest in equal annual installments over a five-year period.  Basic options granted on and subsequently to May 12, 2005 vest in equal annual installments over a four-year period.  Performance options vest upon the achievement of pre-determined performance criteria.  Retained stock options are options that were outstanding prior to the Company’s 2001 acquisition by Berkshire Partners LLC and became fully vested in connection with the 2001 acquisition.

12

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which replaced SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”), and supercedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”).  SFAS 123R requires companies to expense the fair value of employee stock options and similar awards.  Effective January 1, 2006, the Company adopted SFAS 123R and began recognizing compensation expense for its share-based payments based on the fair value of the awards at the grant date.  Under SFAS 123R, the pro forma disclosures previously permitted under SFAS 123 are no longer an alternative to financial statement recognition.

The Company adopted SFAS 123R using the modified prospective application method of transition.  Therefore, prior period financial statements have not been restated.  Under the modified prospective application method, for awards granted prior to January 1, 2006, compensation expense is recorded as options vest subsequent to January 1, 2006 based upon the grant-date fair value estimated in accordance with the original provisions of SFAS 123, adjusted for estimated forfeitures.  For stock options granted subsequent to January 1, 2006, compensation expense will be recorded as options vest based upon the grant-date fair value estimated in accordance with SFAS 123R, with forfeitures estimated at the time of grant.  Forfeiture estimates will be adjusted periodically based on the extent to which actual forfeitures differ, or are expected to differ, from previous estimates.

The fair value of stock options under SFAS 123R is determined using the Black-Scholes option pricing model, which is consistent with our valuation techniques previously utilized for stock options in pro forma footnote disclosure required under SFAS 123.  Prior to the filing of our first Registration Statement on Form S-1 on August 23, 2002 in connection with our initial public offering, we used the minimum value method to value stock options, as provided by SFAS 123, as amended by SFAS 148.  Under SFAS 123R, no compensation expense has been recorded for options recorded under the minimum value method.

The fair value of restricted stock is determined based on the number of shares granted and the quoted closing price of our common stock on the date of grant, consistent with our treatment of such awards under APB 25 prior to the adoption of SFAS 123R.

In connection with the adoption and provisions of SFAS 123R, the Company reversed its deferred compensation balance of $2,749,000 on January 1, 2006 related to restricted stock awards.

The adoption of SFAS 123R has resulted in additional pre-tax, share-based compensation expense (a component of selling, general, and administrative expenses) in the amount of approximately $988,000 and $1.9 million related to stock options for the three and six-month periods ended July 1, 2006, than if the Company had continued to account for share-based compensation under APB 25.  The impact on net income for the three-month period ended July 1, 2006 was a reduction of approximately $615,000, or $0.01, on both basic and diluted earnings per share.  The impact on net income for the six-month period ended July 1, 2006 was a reduction of approximately $1.2 million, or $0.02, on both basic and diluted earnings per share.  For the fiscal year ended December 30, 2006, the adoption of SFAS 123R is expected to result in a reduction in net income of approximately $2.4 million, or $0.04 per basic and diluted earnings per share.

Prior to the adoption of SFAS 123R, we presented all tax benefits resulting from the exercise of stock options as operating cash inflows in the consolidated statements of cash flows, in accordance with the provisions of the EITF Issue No. 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.”  SFAS 123R requires the benefit of tax deductions in excess of the compensation cost recognized for exercised options and restricted stock that vests to be classified as financing cash inflows rather than operating cash inflows, on a prospective basis.  This amount is now shown as “Income tax benefit from exercised stock options” on the accompanying unaudited condensed consolidated statement of cash flows.

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The income tax benefit from exercised stock options during the six-month period ended July 1, 2006 was approximately $2.4 million.  Prior periods have not been restated.

Prior to the adoption of SFAS 123R, we accounted for stock-based compensation on stock options under the intrinsic value method consistent with APB 25.  Under this method, we recorded compensation expense equal to the difference between the exercise price of the stock option and the fair market value of the underlying stock as of the date of the option grant.  Forfeitures on stock option awards with expense recorded in accordance with APB 25 were accounted for as they occurred, rather than based on estimates of future forfeitures.  There was no material impact or cumulative effect adjustment required as a result of estimating the impact of future forfeitures on awards previously expensed in accordance with APB 25.  For disclosure purposes only, we also estimated the impact on our net income of applying the fair value method of measuring compensation cost on stock options with the fair value of the Company’s common stock.  In our pro forma disclosure we accounted for forfeitures as they occurred, rather than based on estimates of future forfeitures.

The following table provides supplemental information for the three and six-month periods ended July 2, 2005 as if stock-based compensation had been computed under SFAS 123, as amended by SFAS 148:

(dollars in thousands, except per share data)		For the three-month period ended July 2, 2005			For the six-month period ended July 2, 2005
Net income, as reported		$	5,450		$	19,299
Add:
Stock-based employee compensation (under APB 25) included in reported net income, net of related tax effects		433			477
Deduct:
Total stock-based employee compensation expense determined under the fair value based method (under SFAS 123 and SFAS 148) for all awards, net of related tax effects		(798		)	(1,181		)
Pro forma net income		$	5,085		$	18,595
Net income per common share:
Basic-as reported		$	0.10		$	0.34
Basic-pro forma		$	0.09		$	0.33
Diluted-as reported		$	0.09		$	0.32
Diluted-pro forma		$	0.08		$	0.31

 

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A summary of stock option activity under the Plan (in number of shares that may be purchased) is as follows for the six-month period ended July 1, 2006:

Basic Stock Options

 

During the three months ended July 1, 2006, the Company granted 37,800 basic stock options.  In connection with this grant of basic stock options, the Company recognized approximately $16,000 in compensation expense during the three-month period ended July 1, 2006.

During the six months ended July 1, 2006, the Company granted 184,600 basic stock options.  In connection with this grant of basic stock options, the Company recognized approximately $199,000 in compensation expense during the six-month period ended July 1, 2006.

A summary of basic stock options outstanding and exercisable at July 1, 2006 is as follows:

 

At July 1, 2006, the aggregate intrinsic value of all outstanding basic options is approximately $92.9 million, and the aggregate intrinsic value of currently exercisable basic options is approximately $64.5 million.  The intrinsic value of basic options exercised during the three and six-month periods ended July 1, 2006 was approximately $4.5 million and $6.7 million.  At July 1, 2006, the total estimated compensation cost related to non-vested basic options not yet recognized is approximately $7.4 million with a weighted-average expense recognition period of 3.06 years.

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Performance Stock Options

 

A summary of performance stock options outstanding and exercisable at July 1, 2006 is as follows:

		Outstanding										Exercisable
Range of exercise prices		Number		Weighted- average remaining contractual life		Weighted- average exercise price			Weighted- average grant-date fair value			Number		Weighted- average remaining contractual life		Weighted- average exercise price			Weighted average grant-date fair value
$22-$32		600,000		9.03 years		$	25.06		$	9.40		—		—		$	—		$	—

 

At July 1, 2006, the aggregate intrinsic value of all outstanding performance options is approximately $1.8 million.  No performance options are currently exercisable.  At July 1, 2006, the total estimated compensation cost related to non-vested performance options not yet recognized is approximately $4.3 million with a weighted-average expense recognition period of 2.91 years.

Retained Stock Options

 

The weighted-average contractual life of the 1,708,270 retained stock options outstanding and exercisable as of July 1, 2006 is 5.13 years.  At July 1, 2006, the aggregate intrinsic value of all outstanding retained options, which are all currently exercisable, is approximately $43.9 million.

The weighted-average contractual life for the basic, performance, and retained stock options in aggregate as of July 1, 2006 is approximately 6.13 years.

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The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing method with the following weighted-average assumptions used for grants issued during the six-month period ended July 1, 2006:

 

Volatility — This is a measure of the amount by which a stock price has fluctuated or is expected to fluctuate.  The Company uses actual monthly historical changes in the market value of our stock since the Company’s initial public offering on October 29, 2003, supplemented by peer company data for periods prior to our initial public offering covering the expected life of options being valued.  An increase in the expected volatility will increase compensation expense.

Risk-free interest rate — This is the U.S. Treasury rate as of the grant date having a term equal to the expected term of the option.  An increase in the risk-free interest rate will increase compensation expense.

Expected term — This is the period of time over which the options granted are expected to remain outstanding and is based on historical experience and estimated future exercise behavior.  Separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes.  An increase in the expected term will increase compensation expense.

Dividend yield — The Company does not have plans to pay dividends in the foreseeable future.  An increase in the dividend yield will decrease compensation expense.

Restricted Stock

All restricted stock awards issued under the plan vest based upon continued service.  Restricted stock awards vest in equal annual installments over a four-year period or cliff vest after a three or four-year period. As noted above, the fair value of restricted stock is determined based on the number of shares granted and the quoted closing price of our common stock on the date of grant.

The following table summarizes our restricted stock award activity during the six-month period ended July 1, 2006:

 

During the three-month period ended July 1, 2006, the Company granted 16,000 shares of restricted stock to employees.  In connection with this issuance, we recorded approximately $16,000 of compensation expense. 

During the six-month period ended July 1, 2006, the Company granted 90,200 shares of restricted stock to employees. Compensation expense recorded during the six-month period ended July 1, 2006 for all restricted stock awards totaled approximately $618,000.  The total amount of estimated compensation expense related to unvested restricted stock awards is approximately $4.8 million as of July 1, 2006.

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Unrecognized stock-based compensation expense related to outstanding stock options and restricted stock awards is expected to be recorded as follows:

 

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