1-800 Contacts, Inc (CTAC) - Description of business

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Company Description
This Annual Report on Form 10-K and the documents incorporated herin by reference contain forward-looking statements based on expectations, estimates and projections as of the date of this filing. Actual results may differ materially from those expressed in forward-looking statements. See Item 1A of Part I—“Risk Factors.” 1-800 CONTACTS, INC. (the “Company”) was incorporated under the laws of the State of Utah in February 1995 and was reincorporated under the laws of the State of Delaware in February 1998 in conjunction with its initial public offering of common stock. The Company’s principal executive office is located at 66 E. Wadsworth Park Drive, Draper, Utah 84020, and its telephone number is (801) 316-5000. The Company maintains various websites on the Internet, including, “www.1800contacts.com”, “www.contacts.com”, “www.contactlenses.com”, “www.evision.com” and “www.1800eyedoctor.com.” The Company provides on its primary website, free of charge through various links, periodic and current reports as soon as is reasonably practicable after such material is filed with or furnished to the SEC. Through its U.S. retail operations (referred to as “U.S. Retail”), the Company is a direct marketer of replacement contact lenses and, through its wholly-owned subsidiary ClearLab, is also a manufacturer, developer and distributor of its own branded and private label contact lenses through its operations in Singapore and the United Kingdom. The Company’s U.S. Retail operations sells all of the popular brands of contacts lenses, including those manufactured by Johnson & Johnson Vision Care, CIBA Vision, CooperVision and Bausch & Lomb. On July 26, 2006 ClearLab introduced its AquaSoft Singles product. The Company engaged an investment banking firm to evaluate a broad range of strategic alternatives in an effort to capitalize on the value of ClearLab and this new product. Based on this review, the Company is now committed to a separation of ClearLab from the U.S. Retail business and is currently assessing various strategic options. The Company has also undergone an extensive review of ClearLab’s manufacturing operations. Based on this review, on February 16, 2007, the Board of Directors of the Company authorized management to close the Company’s ClearLab manufacturing operations in the United Kingdom, and to consolidate ClearLab operations in Singapore upon completion of the consultation process mandated by United Kingdom law. That consultation process has been satisfied, and the Company is proceeding with the closure and consolidation. The Company expects to complete the UK site closure (except for ongoing lease commitments and disposal of surplus equipment) in the first fiscal quarter of 2007, and anticipates that all ongoing obligations relating to the UK operations (including lease commitments and disposal of surplus equipment) will cease no later than the end of 2007. The Company anticipates that all manufacturing activity will be consolidated in Singapore by the end of the third fiscal quarter of 2007. The Company recently announced that its strategic review to determine how to maximize value through a ClearLab separation has been broadened to include a strategic review of the U.S. Retail business. U.S. Retail Operations The Company’s U.S. Retail operations sells contact lenses primarily through its easy-to-remember, toll-free telephone number, “1-800 CONTACTS” (1-800-266-8228), and through its Internet addresses. It sells all of the popular brands of contact lenses, including those manufactured by Johnson & Johnson Vision Care, CIBA Vision, Bausch & Lomb and CooperVision. The Company has shipped more than fifteen million orders since inception. The Company’s high-volume, cost-efficient operations, supported by its proprietary management information systems, enable it to offer consumers an attractive alternative for obtaining replacement contact lenses in terms of convenience, price, speed of delivery and customer service. As a result of its extensive inventory of more than 35,000 SKUs, the Company generally ships approximately 95% of its orders within one business day of verification of prescriptions. The Company’s U.S. Retail Internet sales channel continued to grow in fiscal 2006 and enhances the Company’s ability to cost effectively serve its customers. The Company’s Internet sales accounted for more than half of its total revenue during fiscal 2006. Its online presence enables the Company to operate more efficiently by substantially reducing the payroll and long distance costs associated with telephone orders. This increased efficiency allows the Company to offer Internet customers generally lower prices and free shipping on most orders in addition to other services such as e-mail shipping confirmation, online order tracking and e-mail correspondence. The Company’s U.S. Retail operations markets its products through national advertising campaigns that aim to increase awareness of the 1-800 CONTACTS brand name, increase traffic on its website, add new customers, continue to build strong customer loyalty and maximize repeat purchases. As compared to other direct marketers of replacement contact lenses, the Company believes that its toll-free telephone number and Internet addresses afford it a significant competitive advantage in generating consumer recall and repeat business. The Company spent approximately $13.6 million on advertising in fiscal 2006 and has invested nearly $200 million in its national advertising campaign since inception. The Company’s experience has been that increases in advertising expenditures have a direct impact on the growth of net sales not only in the current period but also in future periods. International Manufacturing Operations ClearLab is the Company’s international contact lens development, manufacturing and distribution business, focusing on the marketing and selling of its own contact lens products to major retailers and distributors, as well as providing some contract manufacturing capacity for other contact lens manufacturers. ClearLab manufactures a wide range of frequent replacement and daily lenses and is focused on developing a wide range of new lens materials and designs. ClearLab maintains a website on the Internet, “www.clearlab.com.” ClearLab has facilities in Singapore and the United Kingdom. The Singapore facility was acquired on July 24, 2002, when the Company completed the acquisition of certain net assets and the majority of the business operations of IGEL (subsequently renamed ClearLab International), a developer and manufacturer of contact lenses based in Singapore. ClearLab expanded its manufacturing capabilities on February 24, 2004 when the Company acquired VisionTec (subsequently renamed ClearLab UK), a developer and manufacturer of daily contact lenses based in the United Kingdom. The Company has undergone an extensive review of ClearLab’s manufacturing operations. Based on this review, on February 16, 2007, the Board of Directors of the Company authorized management to close the Company’s ClearLab manufacturing operations in the United Kingdom, and to consolidate ClearLab operations in Singapore upon completion of the consultation process mandated by United Kingdom law. That consultation process has been satisfied, and the Company is proceeding with the closure and consolidation. The Company expects to complete the UK site closure (except for ongoing lease commitments and disposal of surplus equipment) in the first fiscal quarter of 2007, and anticipates that all ongoing obligations relating to the UK operations (including lease commitments and disposal of surplus equipment) will cease no later than the end of 2007. The Company anticipates that all manufacturing activity will be consolidated in Singapore by the end of the third fiscal quarter of 2007. Industry Overview Industry analysts estimate that over 50% of the United States population needs some form of corrective eyewear. Contact lenses are a convenient, cost-effective alternative to eyeglasses. The number of contact lens wearers is expected to increase as technology further improves the convenience, comfort and fit of contact lenses. As a result, the contact lens market is large and growing. Growth in the disposable market is largely due to the shift in the contact lens market away from traditional soft lenses, which generally are replaced on an annual basis, to disposable lenses, which are generally replaced on a daily, weekly or bi-weekly basis. Traditionally, contact lenses were sold to consumers almost exclusively by either ophthalmologists or optometrists (referred to herein collectively as “eye care practitioners”). Eye care practitioners would typically supply a patient with his or her initial pair of contact lenses in connection with providing the patient an eye examination and subsequently provide replacement lenses. Because the initial fitting of contact lenses requires a prescription written by an eye care practitioner, the initial sale of contact lenses still takes place primarily in this manner. Over the last two decades, however, a number of alternative sellers of replacement contact lenses have emerged, including direct marketers. In November 2003, Congress passed the Fairness to Contact Lens Consumer Act (“FCLCA”), which establishes a national uniform standard for both eye care practitioners and direct marketers with regard to releasing and verifying consumer contact lens prescriptions as well as other requirements relating to the sale of contact lenses. The FCLCA became effective February 4, 2004, and now requires all eye care practitioners to give patients a copy of their prescription as soon as they have been fitted for contact lenses, whether the patients ask for it or not. It also directs contact lens sellers either to obtain a copy of the prescription itself or to request verification of the prescription by direct communication with the eye care practitioners before shipping all orders (if the prescription is not already on file), and it provides that failure to respond within eight business hours shall result in the prescription being presumed valid, thereby eliminating the ability of eye care practitioners to impede sales by direct marketers simply by ignoring or refusing to respond to their requests to verify prescriptions. The FCLCA also provides that prescriptions will be valid for a minimum of at least one year (absent some special medical reason justifying a shorter period). It also directed the Federal Trade Commission (“FTC”) to conduct a study examining the strength of competition in the market for contact lenses and to submit a report to Congress within twelve months of the FCLCA effective date. The FTC completed and published this study on February 15, 2005, with no recommendations for further changes in federal law. Historically, sales of contact lenses by direct marketers have been impeded by eye care practitioners and contact lens manufacturers. Many eye care practitioners have been reluctant to provide patients with a copy of their prescription or to release such information to direct marketers upon request, thereby limiting a patient’s choice to purchase lenses from a direct marketer. Until a few years ago, substantially all of the major manufacturers of contact lenses refused to sell contact lenses directly to direct marketing companies and sought to prohibit their distributors from doing so. These traditional barriers to the direct marketing of contact lenses were reduced, but not completely eliminated, through the pro-competitive effects of the FCLCA described above. Likewise, on January 31, 2007, the Company announced that it had recently signed long-term supply agreements with the three largest contact lens manufacturers/suppliers. The Company has purchased directly from the fourth largest manufacturer/supplier, without a written agreement since 2001 and based on its longstanding relationship and recent discussions with this supplier, the Company does not expect this direct relationship to change. See “Purchasing and Principal Suppliers” and “Government Regulation.” The Company believes that increased consumer awareness of the benefits of the direct marketing of contact lenses will lead to further growth of this method of buying and selling contact lenses. Purchasing replacement contact lenses from a direct marketer offers the convenience of shopping at home, rapid home delivery, quick and easy telephone or Internet ordering and competitive pricing. In addition, the growth in popularity of disposable contact lenses, which require patients to purchase replacement lenses more frequently, has contributed to the growth of the direct marketing channel. The direct marketing industry continues to grow as many retail customers have migrated towards the convenience and service offered by home shopping, and the Company expects the direct marketing segment of the contact lens industry to grow in tandem with the overall growth in the direct marketing industry. The Company believes that the growth and acceptance of the Internet presents significant opportunities for direct marketers of contact lenses such as the Company. The factors driving this growth include the increasing number, power of, and decreasing cost of personal computers in homes and offices, technological innovations providing easier, faster and cheaper access to the Internet, the proliferation of content and services being provided on the Internet and the increasing use of the Internet by businesses and consumers as a medium for conducting business. The Internet possesses a number of unique and commercially powerful characteristics that differentiate it from traditional media: users communicate or access information without geographic limitations; user’s access dynamic and interactive content on a real-time basis; and users communicate and interact instantaneously. The Internet has created a dynamic and particularly attractive medium for commerce; empowering customers to gather more comparative purchasing data than is feasible with traditional commerce systems, to shop in a more convenient manner and to interact with sellers in many new ways. The Company believes that the Internet provides a convenient and efficient medium for the sale of replacement contact lenses. Product Offerings U.S. Retail Operations Contact lenses can be divided into two categories: soft lenses and hard lenses (primarily rigid gas permeable). There are three principal wearing regimes for soft contact lenses: conventional, frequent replacement and disposable lenses. Conventional lenses have a life span of greater than six months, frequent replacement lenses have a life span of one to three months and disposable lenses have a life span of one day to two weeks. There are two wear patterns for contact lenses: daily wear and extended wear. Daily wear lenses are designed to be taken out before sleeping and must be cleaned and disinfected if worn again. Extended wear lenses are designed to be worn multiple days without removal and must be approved by the Food and Drug Administration for that purpose. Disposable soft contact lenses were introduced in the late 1980s based on the concept that changing lenses on a more regular basis was important to comfort, convenience, eye health and patient compliance. Disposable lenses are changed as often as daily and up to every two weeks, depending on the product. Planned replacement lenses are designed to be changed as often as every two weeks and up to every three months. The Company has access to every major brand and product type in the industry, including spherical, toric, multifocal and colored lenses either directly from the manufacturer or through distributors. The Company’s sales by brand and product type are generally representative of the industry with the exception of contact lenses sold under restricted distribution polices by the respective manufacturer. The Company offers all contact lenses produced by the leading contact lens manufacturers, including Johnson & Johnson Vision Care, CIBA Vision, Bausch & Lomb and CooperVision. Given the proliferation of SKUs in the industry via numerous brands, colored and specialty lenses, the Company’s substantial inventory provides contact lens wearers with ready access to their lenses. The Company can ship approximately 95% of its orders within one business day of verification of prescriptions. The Company believes that its large inventory of contact lenses provides it with a competitive advantage over eye care practitioners, optical chains and discount stores and serves as a customer service advantage for the Company versus potential entrants and smaller competitors in direct marketing of contact lenses. The Company purchases products directly from manufacturers, including Johnson & Johnson Vision Care, CIBA Vision, Bausch & Lomb and CooperVision as well as from distributors. See “Purchasing and Principal Suppliers.” The Company’s products are delivered in the same sterile, safety sealed containers in which the lenses were packaged by the manufacturer. The Company is currently expanding its national doctor referral network with select optical retail chains and independent practitioners and currently has nearly 1,000 locations. Under this referral program, when a current or potential customer needs a new contact lens prescription, the Company can facilitate the process of obtaining an eye examination through this network of providers. This process minimizes the interruptions in product consumption for the consumer and improves the Company’s ability to capture new customers and retain its current customers. The Company also offers certain products related to contact lenses including solutions and lens cases for storing contact lenses that are produced by and purchased from an outside party on a contract basis. International Manufacturing Operations The Company’s wholly owned subsidiary, ClearLab, is the Company’s principal marketing organization for its wholesale manufacturing and distribution business, focusing on the marketing of its own contact lens products to major retailers and distributors, as well as providing some contract manufacturing capacity for other contact lens manufacturers. ClearLab manufactures a wide range of frequent replacement and daily lenses and is focused on developing a wide range of new lens materials and designs. In December 2004, the Company signed an agreement which grants Menicon Co., Ltd. (Menicon), Japan’s largest independent contact lens manufacturer, exclusive rights to develop, manufacture and market certain disposable contact lenses and related intellectual property in Japan. Under the terms of the agreement, Menicon licenses from the Company different types of intellectual property, including contact lens material, manufacturing technology and related knowledge. The Company recognizes the license fees as revenue as it fulfills its obligations and certain milestones are achieved. Menicon will also pay royalties for a period of at least 15 years once the licensed products are launched in Japan. On July 26, 2006 ClearLab introduced its AquaSoft Singles product, which is currently under development. The Company engaged an investment banking firm to evaluate a broad range of strategic alternatives in an effort to capitalize on the value of ClearLab and this new product. Based on this review, the Company is now committed to a separation of ClearLab from the U.S. Retail business and is currently assessing various strategic options. Customers and Marketing U.S. Retail Operations The Company’s direct marketing customers are located principally throughout the United States. The percentage of the Company’s customers that are located in each state is approximately equal to the percentage of the United States population, which resides in such state, with the largest concentration of the Company’s customers residing in California. The Company strives to deliver a high level of customer service in an effort to maintain and expand its loyal customer base. The Company utilizes a focused marketing strategy that is designed to enhance the awareness and value of its brand. The Company continually researches and analyzes new ways in which to advertise its products. After identifying an attractive potential new advertisement or advertising medium, the Company commits to such advertising for an initial test period. After the initial test period, the Company continues to closely monitor its advertising in order to identify and react to trends and patterns as appropriate. The majority of contact lens wearers are between the ages of 14 and 49. Approximately two-thirds of contact lens wearers are women and contact lens wearers generally have higher incomes than eyeglass wearers. Through its national advertising campaign, the Company is able to target its advertising to contact lens wearers in these key demographic groups, as well as certain other persons based on other important demographics. During fiscal 2006, the Company spent approximately $13.6 million on advertising. The Company’s advertising campaign targets both its traditional telephone customers and its online customers and is designed to drive new and repeat purchases. A brief description of the principal components of the Company’s national advertising campaign is set forth below: Broadcast. The Company utilizes a nationwide broadcast advertising campaign with significant purchases on both cable and network television and radio. The Company’s broadcast ads typically focus on making the process of replacing contact lenses easier for consumers by rapidly delivering to customers the same contact lenses offered by eye care practitioners and by streamlining an otherwise complicated process of ordering prescription medical devices from an alternative seller. The Company believes that its easy-to-remember phone number and Internet addresses make television a particularly effective marketing vehicle and that television advertising will continue to be the key to building awareness for its 1-800 CONTACTS brand name. Internet. The Company uses the Internet as a means of marketing in an effort to drive new and repeat traffic. The Company utilizes a comprehensive paid advertising search engine campaign on the major U.S. search engine platforms. The Company uses e-mails as an effective tool to provide reminders to existing customers when it is time to reorder. The Company leverages current relationships and continues to seek opportunities to expand its presence within highly trafficked content sites. Cooperative Mailings. The Company advertises its products in cooperative mail programs sponsored by the leading cooperative mail companies in the United States. This advertising medium permits the Company to target consumers in specific zip codes according to age, income and other important demographics. International Manufacturing Operations ClearLab markets its own branded and private label contact lenses internationally to its customers including various international retailers and distributors. Operations U.S. Retail Operations The primary components of the Company’s U.S. Retail operations include its teleservices, order entry, Internet order taking, prescription verification, doctor referral network, customer service and distribution and fulfillment. Teleservices, Order Entry, Internet Order Taking and Customer Service. The Company provides its customers with toll-free telephone access to its Customer Service Representatives (“CSRs”). The Company’s call center generally operates 24 hours a day, 7 days a week. Customers may also place orders via the Internet 24 hours a day, 7 days a week. In addition, potential customers may also obtain product, pricing or other information over the Internet or through the Company’s call center. The Company’s orders are received by phone, Internet, mail, facsimile and electronic mail. CSRs process orders directly into the Company’s proprietary management information systems, which provide customer order history and information, product specifications, product availability, expected shipping date and order number. CSRs are provided with a sales script and are trained to provide information about promotional items. Additionally, CSRs are trained to provide customer service and are authorized to resolve all customer service issues, including accepting returns and issuing refunds, as appropriate. The Company believes its customers are particularly sensitive to the way merchants and salespeople communicate with them. The Company strives to hire energetic, service-oriented CSRs who can understand and relate to customers. CSRs participate in an extensive training program. The Company also has a quality assurance department. This department monitors and reviews the CSRs’ performance and coaches the CSRs as necessary. The Company continually upgrades and enhances its management information systems. The Company believes its management information systems have the capacity to handle up to 30,000 calls per day. The Company’s CSRs currently handle approximately 7,000 calls per day. Prescription Verification. The sale and delivery of contact lenses are governed by both federal and state laws and regulations, including the federal Fairness to Contact Lens Consumers Act (“FCLCA”). The FCLCA requires that contact lenses only be sold to customers based on the seller obtaining a copy of the prescription itself or verifying the prescription by direct communication with the customer’s prescriber. Consistent with this requirement, the Company requires all customers to provide either a valid copy of their prescription or the contact information for their prescriber so that the Company can verify their prescription by direct communication with their prescriber. If the Company does not have a valid copy of the customer’s prescription, the Company directly communicates to the customer’s prescriber the precise prescription information received from the customer and, in accordance with the FCLCA, informs the prescriber that it will proceed with the sale based on this prescription information unless the prescriber advises it within eight business hours that such prescription information is expired or otherwise invalid. If the prescriber properly advises the Company within this time period that the customer’s prescription is expired or otherwise invalid, the Company cancels the customer’s order. On the other hand, if the prescriber either advises the Company that the prescription is valid or fails to respond properly within the required time period, the Company completes the sale based on the prescription information communicated to the prescriber, as expressly permitted by the FCLCA. The Company retains copies of the written prescriptions that it receives and maintains records of its communications with the customer’s prescriber. See also “Government Regulation.” Website. The Company’s principal website provides customers with a quick, efficient and cost-effective source for obtaining replacement contact lenses 24 hours a day, 7 days a week. The Company is continually upgrading the content and functionality of its website which allows customers to easily browse and purchase substantially all of the Company’s products, promotes brand loyalty and encourages repeat purchases by providing an inviting customer experience. The Company has designed its website to be fast, secure and easy to use and to enable its customers to purchase products with minimal effort. The Company also offers Internet customers services such as free shipping offers, shipping confirmation and online order tracking. During the call center’s operating hours, the Company offers service and support to its Internet customers over the telephone. The Company also provides e-mail support to customers 24 hours a day, 7 days a week. The Company’s website allows customers to dispense with providing personal profile information after their initial order. The website has permitted the Company to expand its customer base through better service while reducing transaction costs. The Company’s online service automates the processing of customer orders, interacts with the management information systems and allows the Company to gather, store and use customer and transaction information in a comprehensive and cost-efficient manner. The Company’s website contains customized software applications that interface with the Company’s management information systems. The Company maintains a database containing information compiled from customer profiles, shopping patterns, sales data and eye care practitioner prescribing habits. The Company analyzes information in this database to develop targeted marketing programs and provide personalized and enhanced customer service. This database is scaleable to permit large transaction volumes. The Company’s systems support automated e-mail communications with customers to facilitate confirmations of orders, provide customer support, obtain customer feedback and engage in targeted marketing programs. The Company uses a combination of proprietary and industry-standard encryption and authentication measures designed to protect a customer’s information. The Company maintains an Internet firewall to protect its internal systems as well as all credit card and other customer information. Optical Retail Store Partnership. During the latter part of 2004, the Company entered into an agreement with a regional optical retail chain in Utah. Under the terms of the agreement, the companies effectively combined their contact lens business in Utah and began jointly serving these customers in December 2004. The objective of this agreement was to partner with an optical retailer to create a seamless experience for consumers that included exams as well as in-store, phone and online service. Although this agreement expired in January 2006, both parties continued to operate their contact lens businesses under the arrangement described above through October 2006, at which time the Company decided not to renew this agreement. Doctor Referral Network. The Company is currently expanding its national doctor referral network with select independent practitioners and optical retail chains and currently has nearly 1,000 locations. Under this referral program, when a current or potential customer needs a new contact lens prescription, the Company can facilitate the process of obtaining an eye examination through this network of providers. This process minimizes the interruptions in product consumption for the consumer and improves the Company’s ability to capture new customers and retain its current customers. The Company believes its current referral program is a unique offering for Internet, phone or mail order companies, allowing it to capture orders from new customers who need an updated prescription and recapture customer orders that might otherwise need to be cancelled under federal law. Distribution and Fulfillment. Approximately 95% of the Company’s orders are shipped within one business day of the verification of prescriptions. Customers generally receive orders within one to five business days after shipping, depending upon the method of delivery chosen by the customer. A shipping and handling fee is generally charged on each customer order, except most orders received via the Internet and those received by mail with an enclosed check. Customers have the option of having their order delivered by overnight courier for an additional charge. The Company’s management information systems automatically determine the anticipated delivery date for each order. The Company uses an integrated packing and shipping system via a direct connection to the Company’s management information systems. This system monitors the in-stock status of each item ordered, processes the order and generates warehouse selection tickets and packing slips for order fulfillment operations. The Company’s management information systems are specifically designed with a number of quality control features to help ensure the accuracy of each order. The Company’s retail distribution center is approximately 84,000 square feet and is strategically located near the Salt Lake City, Utah, international airport. International Manufacturing Operations ClearLab’s products are manufactured in production facilities located in Singapore and the United Kingdom. The Singapore facility currently has the capacity to produce in excess of 48 million lenses annually. Clearlab’s manufacturing and research and development operations which were previously carried out in the United Kingdom are in the process of being consolidated into Singapore. Both of ClearLab’s manufacturing operations were operating at approximately 50 percent during fiscal 2006. ClearLab manufactures its frequent replacement soft contact lenses by way of injection cast molding of plastic molds in which it doses various polymers and daily soft contact lenses through a proprietary free-forming process. In both processes, dry lenses are hydrated to their final wet state in order to become a complete lens. ClearLab also has the ability to wet cast mold lenses where the lenses are formed partially hydrated. Management Information Systems The Company has developed proprietary management information systems that integrate the Company’s U.S. Retail direct marketing, order entry and order fulfillment operations. The Company is continually upgrading and enhancing these systems and believes that these systems enable it to operate efficiently and provide enhanced customer service. The key features of these management information systems are their ability to: (i) process numerous types of orders, including telephone, Internet and others; (ii) continually monitor and track the Company’s inventory levels for substantially all of its products; (iii) rapidly process credit card orders; (iv) increase the speed of the shipping process with integrated and automated shipping functions; (v) increase accuracy through the scanning of each order prior to shipment to ensure it contains the correct quantity and type of lenses; and (vi) communicate directly with eye care providers’ offices to accurately and timely verify contact lens prescriptions. These management information systems provide the Company’s CSR with real-time product availability information for substantially all of its products through a direct connection with the Company’s distribution center; whereupon information is immediately updated as lenses are shipped. In addition, Internet customers can obtain real-time product availability information for many products. The management information systems also have an integrated direct connection for processing credit card payments which allows the CSR to ensure that a valid card number and authorization have been received in approximately five seconds while the CSR is on the phone with the customer. CSRs also have access to records of all prior contact with a customer, including the customer’s address, prescription information, order history and payment history and notes of any prior contact with the customer made by phone, Internet, e-mail, mail or fax. Based on product availability provided by the management information systems, the CSR provides the customer with an estimated date of delivery of their lenses. If a customer’s order will not be shipped by the promised delivery date, the management information systems notify the CSR who entered the order and provide any information explaining the delay, and the CSR contacts the customer to inform the customer of the delay. After an order has been entered into the management information systems either by a CSR or directly by a customer through the Company’s order entry system on its Internet website, it is sent through the Company’s verification process to attempt to confirm the validity of the prescription. Once the prescription is verified or the verification hold time has elapsed (see “Government Regulations” section), the order is sent to the Company’s distribution center via a direct connection. If the prescription is expired or determined to be invalid during the verification process, the order is then cancelled and the customer’s information is made available to one of the Company’s CSRs to inform the customer of the cancellation. At this time, one of the Company’s CSRs offers to assist the customer by referring the customer to an eye care practitioner within the Company’s national doctor referral network, and provides the customer with promotional offers which may include, for example, an offer for a discounted eye exam. After the distribution center receives an order, the invoice for the order is printed and the customer’s credit card is charged, if applicable. The invoice for each order contains the type and quantity of the lenses, as well as a shipping label for the order. Tracking, manifesting, billing and other shipping functions are integrated into the Company’s management information systems so that all necessary bar codes and tracking information for shipment via independent couriers are printed directly on the Company’s shipping label. After the invoice for an order is printed at the Company’s distribution center, the order is pulled from inventory and scanned to ensure that the prescription and quantity of each item matches the order in the Company’s management information systems. Audible notices inform the shipping agent of any errors in the order. After the order has been scanned for accuracy, the management information systems update the Company’s inventory level. Then the order is placed in a box folded by the Company’s automated box folder and is sent to an automatic sealer. After the package leaves the sealer, another scanner reads the bar code on the shipping label to determine which method of shipment is being used, adds the package to the appropriate carrier’s manifest and directs the appropriate hydraulic diverter to push the package into the appropriate carrier’s shipping bin. The Company has installed a battery powered back-up system capable of supporting its entire call center, computer room and phone switch. This system is further protected by a generator capable of supporting the Company’s call center operations for a period of five days. All critical data is stored on high-availability, redundant storage platforms, and backed up daily to near-line disk and to tape. In addition, tape backups of all critical data are stored at a secure offsite location. Purchasing and Principal Suppliers U.S. Retail Operations The Company purchases products directly from manufacturers, including Johnson & Johnson Vision Care, CIBA Vision, CooperVision and Bausch & Lomb, as well as from distributors. On January 31, 2007 the Company announced that it had recently signed long-term supply agreements with the three largest contact lens manufacturers/suppliers, Johnson & Johnson Vision Care, CIBA Vision and CooperVision. The Company believes that it will be able to satisfy the various conditions of these agreements which will allow the Company to operate under these agreements through 2016. The Company has purchased directly from the fourth largest manufacturer/supplier, Bausch & Lomb, without a written agreement since 2001 and based on its longstanding relationship and recent discussions with this manufacturer, the Company does not expect this direct relationship to change. Currently, the Company purchases the majority of its products directly from these four manufacturers. However, the Company occasionally purchases products of one of these manufacturers through unauthorized distributors. The Company also purchases certain other products through unauthorized distributors that are marketed as “doctors only” and sold only to eye care practitioners. The Company can purchase almost all remaining, “doctors only” lenses through unauthorized distributors. As a result of “doctors only” marketing practices, the Company is not an authorized dealer for some of the products it sells. The factors of price, availability and source of the contact lenses are all considerations in deciding which lenses to offer for sale. During the latter part of fiscal 2004, the Company decided to suspend sales of a specific brand of lens, as the Company was unable to obtain sufficient quantities of this lens from anyone other than the manufacturer, who refused to sell the Company this lens. With the before mentioned signing of the long-term supply agreements, the Company recently began to sell this lens again in 2007, as well as other lenses previously not available to the Company. The Company believes that the price which it pays for certain manufacturers’ products is sometimes higher than those paid by eye care practitioners, retail chains and mass merchandisers, and believes that these parties also benefit from being allowed to participate in certain manufacturers’ cooperative advertising funds, coupon, sample, rebate and other marketing and promotional programs not available to the Company. Although the Company has been able to obtain most contact lens brands at competitive prices in sufficient quantities on a regular basis, there can be no assurance that the Company will not encounter difficulties in the future. The inability of the Company to obtain sufficient quantities of contact lenses at competitive prices would have a material adverse effect on the Company’s business, financial condition and results of operations. Although the Company seeks to reduce its reliance on any one supplier by establishing relationships with a number of distributors, manufacturers and other sources, the Company acquired from a single distributor approximately 44 percent, 42 percent and 48 percent of its contact lenses purchased in fiscal 2004, 2005 and 2006, respectively. The Company’s top three suppliers accounted for approximately 83 percent, 81 percent and 87 percent of the Company’s inventory purchased in fiscal 2004, 2005 and 2006, respectively. In the event that these suppliers could no longer supply the Company with contact lenses, there can be no assurance that the Company could secure other adequate sources of supply, or that such supply could be obtained on terms no less favorable to the Company than its current supply, which could adversely affect the Company by increasing its costs or, in the event adequate replacement supply cannot be secured, reducing its net sales. The Company also has agreements with certain suppliers for improved pricing and marketing support. This support has come and will come in the form of cooperative marketing and rebate programs designed to promote the manufacturer’s products and build sales. As part of its ongoing relationship with its suppliers, the Company periodically reviews its specific marketing plans and negotiates cooperative marketing programs and product pricing. Competition U.S. Retail Operations The retail sale of contact lenses is a highly competitive and fragmented industry. Traditionally, contact lenses were sold to customers almost exclusively by eye care practitioners in connection with providing them an eye examination. Competition for patients and the revenue related to providing contact lenses to those customers significantly increased as optical chains and large discount retailers began providing optical services and has further intensified with the entry of direct marketers such as the Company. To a lesser extent, the Company also competes with manufacturers of eyeglasses and providers of other vision correction, including refractive surgical procedures. The Company’s principal competitors include ophthalmologists and optometrists in private practice. The Company also competes with national optical chains, such as Pearle Vision, LensCrafters and National Vision Association and mass merchandisers, such as Wal-Mart, Sam’s Club and Costco. In addition, the Company competes with other direct marketers of contact lenses, including on-line direct marketers. The Company may face increased competition in the future from new entrants in the direct marketing business, which may include national optical chains and mass merchandisers, some of which may have significantly greater resources than the Company. The Company believes that some of its competitors, including eye care practitioners, national optical chains and mass merchandisers, have better pricing terms, access to supply and other sales and marketing programs not available to the Company. In addition, some of the competitors are significantly larger in overall revenues and have significantly greater resources than the Company. The Company believes that the principal elements of competition in the industry include price, product availability, customer service and consumer awareness. International Manufacturing Operations The manufacturing of contact lenses is also highly competitive. With respect to its manufacturing operations, the Company faces competition from other contact lens manufacturers, including Johnson & Johnson Vision Care, CIBA Vision, Bausch & Lomb and CooperVision. Most of the Company’s competitors have substantially greater resources to invest in product development and customer support and greater access to financial and other resources than the Company. Government Regulation U.S. Retail Operations Federal Regulation Contact lenses are regulated by the Food and Drug Administration (“FDA”) as “medical devices.” The FDA classifies medical devices as Class I, Class II or Class III and regulates them to varying degrees, with Class I medical devices subject to the least amount of regulation and Class III medical devices subject to the most stringent regulations. Rigid gas permeable and soft contact lenses are classified as Class II medical devices if intended only for daily wear and as Class III medical devices if intended for extended wear. These regulations generally apply only to the manufacturing of contact lenses and, therefore, do not directly impact the direct marketing operations of the Company. Federal regulations also require the labels on “medical devices” to contain adequate instructions for their safe and proper use. However, there is an exemption from this requirement for medical devices the use of which is not safe except under the supervision of a practitioner licensed by law to direct the use of such device. Devices which fall within this exception must contain as part of their labeling the statement “Caution: Federal law restricts this device to sale by or on the order of (physician or other licensed practitioner),” the blank to be filled in with the word physician or other practitioner authorized by the law of the state in which the practitioner practices to use or order the use of the device. The FDA considers contact lenses to qualify for this labeling exemption; however, a device bearing this legend that is dispensed without a prescription may be considered misbranded by the FDA. Potential penalties for misbranding include warning letters from the FDA, seizure, injunction, civil penalties or prosecution. To date, the FDA has not taken any such action against the Company. In November 2003, Congress passed the Fairness to Contact Lens Consumers Act (“FCLCA”), which establishes a national uniform standard for both eye care practitioners and direct marketers with regard to releasing and verifying consumer contact lens prescriptions as well as other requirements relating to the sale of contact lenses. The FCLCA became effective February 4, 2004, and now requires all eye care practitioners to give patients a copy of their prescription as soon as they have been fitted for contact lenses, whether the patients ask for it or not. It also directs contact lens sellers to contact eye care practitioners to request verification of consumer prescriptions before shipping all orders (if the prescription is not already on file), and it provides that failure to respond within eight business hours shall result in the prescription being presumed valid, thereby eliminating the ability of eye care practitioners to impede sales by direct marketers simply by ignoring or refusing to respond to their requests to verify prescriptions. The FCLCA also provides that prescriptions will be valid for a minimum of at least one year (absent some special medical reason justifying a shorter period). It also directed the Federal Trade Commission (“FTC”) to conduct a study examining the strength of competition in the market for contact lenses and to submit a report to Congress within twelve months of the FCLCA effective date. The FTC completed and published this study on February 15, 2005, with no recommendations for further changes in federal law. To satisfy the prescription verification requirement of the FCLCA, a contact lens seller must either obtain a copy of the prescription or verify the prescription by direct communication with the customer’s prescriber. Consistent with this requirement, the Company requires all customers to provide either a valid copy of their prescription or the contact information for their prescriber so that the Company can verify their prescription by direct communication with their prescriber. If the Company does not have a valid copy of the customer’s prescription, the Company directly communicates to the customer’s prescriber the precise prescription information received from the customer and, in accordance with the FCLCA, informs the prescriber that it will proceed with the sale based on this prescription information unless the prescriber advises it within eight business hours that such prescription information is expired or otherwise invalid. If the prescriber properly advises the Company within this time period that the customer’s prescription is expired or otherwise invalid, the Company cancels the customer’s order. On the other hand, if the prescriber either advises the Company that the prescription is valid or fails to respond properly within the required time period, the Company completes the sale based on the prescription information communicated to the prescriber, as expressly permitted by the FCLCA. The Company retains copies of the written prescriptions that it receives and maintains records of its communications with the customer’s prescriber. The FCLCA provides for several means of direct communication with eye care practitioners, and the Company may alter its prescription verification procedures from time to time in keeping with the FCLCA and FTC guidelines. State Regulation Although the FCLCA overrides state laws or regulations that purport to impose stricter prescription verification procedures on direct marketers or that otherwise conflict with the general purposes and objectives of the FCLCA, the sale and delivery of contact lenses to consumers may also be subject to limited regulation by the state where the customer is located. For example, a substantial number of states require that contact lenses only be sold by persons licensed or registered to do so under that state’s laws. A dispenser may be required to be licensed as an eye care professional (i.e., optometrist, ophthalmologist or optician) or to be licensed or registered as a contact lens seller depending on the requirements of the particular state in which the customer is located. Also, the FCLCA allows states to set the prescription length—as long as it is longer than one year. Such state laws or regulations may or may not run afoul of the FCLCA or other federal or constitutional requirements depending on their particular provisions. Neither the Company nor any of its employees is a licensed eye care professional in many of the states in which the Company does business. Any action brought against the Company based on its failure to comply with applicable state laws and regulations could result in significant fines to the Company, the Company being prohibited from making sales in a particular state, the Company being required to comply with such laws, or could constitute a misdemeanor. Such required compliance could result in (i) increased costs to the Company, (ii) the inability to sell to customers at all in a particular state if the Company cannot comply with such state’s laws and (iii) misdemeanor penalties and civil fines. The occurrence of any of the above results could have a material adverse effect on the Company’s ability to sell contact lenses and to continue to operate profitably. The Company has not obtained an opinion of counsel with regard to its compliance with all applicable state laws and regulations or the enforceability of such state laws and regulations, and information contained herein regarding the Company’s compliance with applicable state laws and regulations should not be construed as being based on an opinion of counsel. The Company has in the past, and intends in the future, to vigorously defend any actions brought against it. From time to time the Company receives notices, inquiries or other correspondence from states or their regulatory bodies charged with overseeing the sale of contact lenses. The Company reviews such notices with legal counsel to determine the appropriate response on a case-by-case basis. It is the opinion of management, after discussion with legal counsel, that the Company has formulated an appropriate policy and, as needed, takes appropriate steps to address the various notices it has received or may in the future receive. See “Legal Proceedings” for explanation of formal complaints filed against the Company concerning its business practices. International Manufacturing Operations The Company’s products are generally regulated in the United States and in foreign countries as “medical devices.” As a manufacturer of medical devices, the Company is subject to regulation in the United States by the FDA and corresponding state and foreign regulatory agencies where the Company sells products. These regulations generally govern the introduction of new medical devices, the maintenance of certain records, the labeling of devices and other matters. The regulatory environment in which the Company operates can be expensive, time-consuming and uncertain. FDA Regulation Pursuant to the Federal Food, Drug, and Cosmetic Act (“FDC Act”), and implementing regulations, the FDA regulates the testing, manufacturing, labeling, distribution, importation and promotion of medical devices. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of product distribution or importation, failure of the government to grant premarket clearance or approval for devices, withdrawal of marketing clearances or approvals and criminal prosecution. The FDA also has the authority to request the recall, repair, replacement or refund of the cost of any device manufactured or distributed by the Company. Under the FDC Act, clearance or approval by the FDA is required prior to the commercialization of a medical device. The FDA classifies medical devices as Class I, Class II or Class III, depending on the nature of the medical device and the existence in the market of any similar devices. The nature of the clearance or approval procedures is dependent on the classification of the medical device in question. Class I medical devices are subject to general controls, including labeling, premarket notification and adherence to the FDA’s quality systems regulations governing all medical device manufacturing. Class II medical devices are subject to general and special controls, including performance standards, postmarket surveillance, patient registries and FDA guidelines. Class III medical devices are those which must receive premarket approval by the FDA to ensure their safety and effectiveness, are generally life-sustaining, life-supporting devices or implantable devices or new devices which have been found not to be substantially equivalent to currently marketed medical devices. Before a new device can be introduced into the U.S. market, it must receive from the FDA premarket notification clearance under Section 510(k) of the FDC Act or premarket approval pursuant to the more costly and time-consuming premarket approval application (PMA) procedure. The FDA grants a 510(k) clearance if the submitted information establishes that the proposed device is “substantially equivalent” to a legally marketed Class I or Class II medical device or a Class III medical device for which the FDA has not called for PMAs. For any devices that are cleared through the 510(k) process, modifications or enhancements that could significantly affect safety or effectiveness, or constitute a major change in the intended use of the device, will require new 510(k) submissions. While less expensive and time-consuming than obtaining PMA clearance, securing 510(k) clearance may involve the submission of a substantive review of six months or more. Any products manufactured or distributed pursuant to 510(k) clearance are subject to pervasive and continuing regulation by the FDA, including record keeping requirements and reporting of adverse experience with the use of the device. Most of ClearLab’s products have 510(k) clearance, and any new products under development to be marketed in the United States will undergo clinical studies to support a 510(k) or PMA. The Company can offer no assurance that any new products under development by ClearLab will receive 510(k), PMA, or any other necessary regulatory clearance or approval. However, the Company has made a strategic decision to refrain from importing products manufactured by ClearLab into the United States for resale. Moreover, as stated previously, the Company has committed to a separation of ClearLab from the U.S. Retail business and is currently assessing various strategic options. ClearLab’s products are subject to regulation in the countries in which its products are sold. The laws and regulations of such countries range from comprehensive medical device approval procedures to simple requests for product data or certifications. The number and scope of these laws and regulations are increasing. In particular, medical devices in the EU are subject to the EU’s medical devices directive (“Directive”). Under the system established by the Directive, all medical devices other than active implants and in vitro diagnostic products currently must qualify for CE marking. “CE marking” means the manufacturer certifies that its product bearing the CE mark satisfies all requirements essential for the product to be considered safe and fit for its intended purpose. In order to qualify for CE marking, the manufacturer must comply with the “Essential Requirements” of the Directive, relating to the safety and performance of the product. In order to demonstrate compliance, a manufacturer is required to undergo a conformity assessment, which includes assessment of the manufacturer’s quality assurance system by self-selected certification organizations referred to as a “Notified Body.” After all necessary conformity assessment tests have been completed to the satisfaction of the Notified Body and the manufacturer is convinced that it is in full compliance with the Directive, CE marking may be affixed on the products concerned. “National Competent Authorities” who are required to enforce compliance with the requirements of the Directive, can restrict, prohibit and recall CE-marked products if they are unsafe. Such a decision must be confirmed by the European Commission in order to be valid. ClearLab International has undergone such conformity assessment and has received CE marking authorization for all products that it currently markets in the EU. Although member countries must accept for marketing medical devices bearing a CE marking without imposing further requirements related to product safety and performance, each country may require the use of its own language or labels and instructions for use. Member countries can impose additional requirements as long as they do not violate the Directive or constitute technical barriers to trade. Additional approvals from foreign regulatory authorities may be required for international sale of the Company’s products in non-EU countries. Failure to comply with applicable regulatory requirements can result in the loss of previously received approvals and other sanctions and could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company can offer no assurance that it will be able to obtain necessary approvals from foreign regulatory authorities. Intellectual Property U.S. Retail Operations The Company conducts its direct marketing business under various trade names and service marks, including “1-800 CONTACTS.” The Company has taken steps to register and protect these marks and believes that such marks have significant value and are an important factor in the marketing of its products. To this end, the Company has secured trademark registration for the “1-800 CONTACTS” name. The Company has obtained the rights to various telephone numbers, including but not limited to the 1-800 CONTACTS telephone number. However, under applicable Federal Communications Commission (“FCC”) rules and regulations, the Company does not have and cannot acquire any property rights to the telephone numbers. The Company does not expect to lose the right to use the telephone numbers; however, there can be no assurance in this regard. The loss of the right to use the 1-800 CONTACTS number or other specific telephone numbers would have a material adverse effect on the Company’s business, financial condition and results of operations. In addition, the Company has obtained the rights to international equivalents for the 1-800 CONTACTS phone number; however, like the 1-800 CONTACTS number, the Company do

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