Form 10Q 4-11-2006

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended February 25, 2006

 
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 no. 1-11107
 
FC Logo

FRANKLIN COVEY CO.
(Exact name of registrant as specified in its charter)

Utah
(State of incorporation)
 
87-0401551
(I.R.S. employer identification number)
     
2200 West Parkway Boulevard
Salt Lake City, Utah
(Address of principal executive offices)
 
84119-2099
(Zip Code)
     
Registrant’s telephone number,
Including area code
 
 
(801) 817-1776


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 (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer
 o
 
Accelerated filer
 o
 
Non-accelerated filer
x

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:

20,140,974 shares of Common Stock as of April 5, 2006

 
 
Table of Contents
 
Condensed Consolidated Balance Sheets
Condensed Consolidated Imcome Statements
Condensed Consolidated Statements of Cash Flows
Note 1 - Basis of Presentation
Note 2 - Accounting for Stock-Based Compensation
Note 3 - Inventories
Note 4 - Intangible Assets
Note 5 - Preferred Stock Redemption
Note 6 - Approval to Purchase Shares of Common Stock
Note 7 - Legal Settlement
Note 8 - Comprehensive Income
Note 9 - Earnings Per Share
Note 10 - Segment Information
Note 11 - Subsequent Events
Results of Operations
Liquidity and Capital Resources
Use of Estimates and Critical Accounting Policies
New Accounting Pronouncements
Market Risk of Financial Instruments
Controls and Procedures
Safe Harbor Statement
Other Information
Exhibit 31
Exhibit 32
Signatures
 
 
 
 PART I.  FINANCIAL INFORMATION
 ITEM 1.  FINANCIAL STATEMENTS
 
FRANKLIN COVEY CO.

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)

   
February 25,
2006
 
August 31,
2005
 
   
(unaudited)
 
ASSETS
         
Current assets:
         
Cash and cash equivalents
 
$
36,354
 
$
51,690
 
Restricted cash
   
-
   
699
 
Accounts receivable, less allowance for doubtful  accounts of $1,062 and $1,425
   
23,037
   
22,399
 
Inventories
   
22,905
   
20,975
 
Other current assets
   
9,925
   
9,419
 
Total current assets
   
92,221
   
105,182
 
               
Property and equipment, net
   
34,265
   
35,277
 
Intangible assets, net
   
81,341
   
83,348
 
Other long-term assets
   
9,951
   
9,426
 
   
$
217,778
 
$
233,233
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
             
Current liabilities:
             
Current portion of long-term debt and financing obligation
 
$
563
 
$
1,088
 
Accounts payable
   
11,774
   
13,704
 
Income taxes payable
   
5,516
   
3,996
 
Accrued liabilities
   
33,646
   
36,536
 
Total current liabilities
   
51,499
   
55,324
 
               
Long-term debt and financing obligation, less current portion
   
33,826
   
34,086
 
Other liabilities
   
1,277
   
1,282
 
Deferred income tax liability
   
9,715
   
9,715
 
Total liabilities
   
96,317
   
100,407
 
               
Shareholders’ equity:
             
Preferred stock - Series A, no par value; 4,000 shares authorized, 1,494 and 2,294 shares issued and outstanding; liquidation preference totaling $38,278 and $58,788
   
37,345
   
57,345
 
Common stock - $0.05 par value; 40,000 shares authorized, 27,056 shares issued and outstanding
   
1,353
   
1,353
 
Additional paid-in capital
   
187,484
   
190,760
 
Common stock warrants
   
7,611
   
7,611
 
Accumulated deficit
   
(2,052
)
 
(14,498
)
Deferred compensation on unvested stock grants
   
-
   
(1,055
)
Accumulated other comprehensive income
   
336
   
556
 
Treasury stock at cost, 6,673 and 6,465 shares
   
(110,616
)
 
(109,246
)
Total shareholders’ equity
   
121,461
   
132,826
 
   
$
217,778
 
$
233,233
 
               
 
See notes to condensed consolidated financial statements.

 

FRANKLIN COVEY CO.

CONDENSED CONSOLIDATED INCOME STATEMENTS
(in thousands, except per share amounts)

   
Quarter Ended
 
Two Quarters Ended
 
                   
   
February 25,
2006
 
February 26,
2005
 
February 25,
2006
 
February 26,
2005
 
   
(unaudited)
 
(unaudited)
 
Net sales:
                 
Products
 
$
50,841
 
$
55,175
 
$
94,244
 
$
99,226
 
Training and consulting services
   
27,492
   
27,348
   
56,440
   
52,401
 
     
78,333
   
82,523
   
150,684
   
151,627
 
Cost of sales:
                         
Products
   
22,288
   
24,581
   
40,952
   
44,389
 
Training and consulting services
   
7,872
   
7,725
   
17,152
   
15,586
 
     
30,160
   
32,306
   
58,104
   
59,975
 
Gross margin
   
48,173
   
50,217
   
92,580
   
91,652
 
                           
Selling, general, and administrative
   
35,488
   
38,939
   
73,255
   
74,868
 
Depreciation
   
1,221
   
2,320
   
2,629
   
4,498
 
Amortization
   
908
   
1,043
   
2,003
   
2,087
 
Income from operations
   
10,556
   
7,915
   
14,693
   
10,199
 
                           
Interest income
   
316
   
165
   
645
   
282
 
Interest expense
   
(660
)
 
(29
)
 
(1,303
)
 
(66
)
Legal settlement
   
873
   
-
   
873
   
-
 
Income before provision for income taxes
   
11,085
   
8,051
   
14,908
   
10,415
 
Provision for income taxes
   
1,872
   
965
   
2,462
   
1,803
 
Net income
   
9,213
   
7,086
   
12,446
   
8,612
 
Preferred stock dividends
   
1,139
   
2,184
   
2,518
   
4,368
 
Net income available to common shareholders
 
$
8,074
 
$
4,902
 
$
9,928
 
$
4,244
 
                           
Net income available to common
shareholders per share (Note 9):
                         
Basic
 
$
.40
 
$
.19
 
$
.49
 
$
.16
 
Diluted
 
$
.39
 
$
.19
 
$
.48
 
$
.16
 
                           
Weighted average number of common shares:
                         
Basic
   
20,311
   
19,880
   
20,321
   
19,790
 
Diluted
   
20,634
   
19,940
   
20,638
   
19,804
 
 
See notes to condensed consolidated financial statements.

 

FRANKLIN COVEY CO.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
   
Two Quarters Ended
 
   
February 25,
2006
 
February 26,
2005
 
   
(unaudited)
 
Cash flows from operating activities:
         
Net income
 
$
12,446
 
$
8,612
 
Adjustments to reconcile net income to net cash provided by operating activities:
             
Depreciation and amortization
   
5,571
   
7,665
 
Restructuring cost reversal
   
-
   
(306
)
Stock-based compensation cost
   
235
   
371
 
Compensation cost related to CEO common stock grant
   
-
   
404
 
Changes in assets and liabilities:
             
Decrease (increase) in accounts receivable, net
   
(774
)
 
627
 
Decrease (increase) in inventories
   
(1,974
)
 
365
 
Decrease (increase) in other assets
   
(134
)
 
1,025
 
Decrease in accounts payable and accrued liabilities
   
(5,569
)
 
(8,222
)
Increase (decrease) in other long-term liabilities
   
(102
)
 
169
 
Increase in income taxes payable
   
1,526
   
1,530
 
Net cash provided by operating activities
   
11,225
   
12,240
 
               
Cash flows from investing activities:
             
Purchases of property and equipment
   
(2,422
)
 
(1,120
)
Purchases of short-term investments
   
-
   
(10,653
)
Sales of short-term investments
   
-
   
8,963
 
Curriculum development costs
   
(961
)
 
(1,217
)
Net cash used for investing activities
   
(3,383
)
 
(4,027
)
               
Cash flows from financing activities:
             
Principal payments on long-term debt and financing obligation
   
(822
)
 
(62
)
Change in restricted cash
   
699
   
-
 
Proceeds from sales of common stock from treasury
   
173
   
35
 
Proceeds from management stock loan payments
   
134
   
-
 
Redemption of preferred stock
   
(20,000
)
 
-
 
Purchase of treasury shares
   
(224
)
 
(22
)
Payment of preferred stock dividends
   
(3,018
)
 
(4,368
)
Net cash used for financing activities
   
(23,058
)
 
(4,417
)
               
Effect of foreign exchange rates on cash and cash equivalents
   
(120
)
 
(128
)
Net increase (decrease) in cash and cash equivalents
   
(15,336
)
 
3,668
 
Cash and cash equivalents at beginning of the period
   
51,690
   
31,174
 
Cash and cash equivalents at end of the period
 
$
36,354
 
$
34,842
 
               
Supplemental disclosure of cash flow information:
             
Cash paid for interest
 
$
1,337
 
$
53
 
Cash paid for income taxes
 
$
1,093
 
$
602
 
               
Non-cash investing and financing activities:
             
Accrued preferred stock dividends
 
$
934
 
$
2,184
 
Issuance of unvested common stock for compensation plans
         
486
 
Capital lease financing of property and equipment purchases
   
109
       
 
See notes to condensed consolidated financial statements.

 

FRANKLIN COVEY CO.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

 
NOTE 1 - BASIS OF PRESENTATION

Franklin Covey Co. (hereafter referred to as us, we, our, or the Company) provides integrated consulting, training, and performance enhancement solutions to organizations and individuals in strategy execution, productivity, leadership, sales force effectiveness, effective communications, and other areas. Each integrated solution may include components of training and consulting, assessment, and other application tools that are generally available in electronic or paper-based formats. Our products and services are available through professional consulting services, public seminars, retail stores, catalogs, and the Internet at www.franklincovey.com. Historically, the Company’s best-known offerings include the FranklinCovey Planner™, and a suite of new and updated individual-effectiveness and leadership-development training products based on the best-selling book, The 7 Habits of Highly Effective People. We also offer a range of training and assessment products to help organizations achieve superior results by focusing and executing on top priorities, building the capability of knowledge workers, and aligning business processes. These offerings include the popular workshop FOCUS: Achieving Your Highest Priorities™, The 4 Disciplines of Execution™, The 4 Roles of Leadership™, Building Business Acumen: What the CEO Wants You to Know™, the Advantage Series communication workshops, and the Execution Quotient (xQ™) organizational assessment tool.

The accompanying unaudited condensed consolidated financial statements reflect, in the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position and results of operations of the Company as of the dates and for the periods indicated. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to Securities and Exchange Commission (SEC) rules and regulations. The information included in this quarterly report on Form 10-Q should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended August 31, 2005.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

The Company utilizes a modified 52/53-week fiscal year that ends on August 31 of each year. Corresponding quarterly periods generally consist of 13-week periods that end on November 26, 2005, February 25, 2006, and May 27, 2006 during fiscal 2006. Under the modified 52/53-week fiscal year, the quarter ended February 25, 2006 had one more business day than the quarter ended February 26, 2005 and the two quarters ended February 25, 2006 had the same number of business days as the two quarters ended February 26, 2005.

The results of operations for the quarter and two quarters ended February 25, 2006 are not necessarily indicative of results expected for the entire fiscal year ending August 31, 2006.

Certain reclassifications have been made to the fiscal 2005 financial statements to conform with the current period presentation.
 
NOTE 2 - ACCOUNTING FOR STOCK-BASED COMPENSATION

On September 1, 2005, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123R), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. Statement 123R supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Statement No. 123R requires all share based-payments to employees, including grants of stock options and the compensatory elements of employee stock purchase plans, to be recognized in the income statement based upon their fair values.

We previously accounted for our stock-based compensation using the intrinsic method as defined in APB Opinion No. 25 and accordingly, prior to September 1, 2005 we did not recognize any expense for our employee stock purchase plan or incentive stock option plan in our consolidated financial statements. We used the modified prospective transition method to adopt the provisions of SFAS No. 123R. Under this method, unvested awards at the date of adoption as well as awards that are granted, modified, or settled after the date of adoption will be measured and accounted for in accordance with Statement 123R. Based upon our analysis of the requirements of SFAS No. 123R, we reclassified our unamortized deferred compensation related to the issuance of unvested common stock awards that was reported in the equity section of our balance sheet to additional paid-in capital. The following table presents the stock-based compensation expense included in our selling, general, and administrative expenses for the quarter and two quarters ended February 25, 2006 and the pro forma stock-based compensation amounts that would have been included in our income statements for the comparable periods of the prior year had stock-based compensation expense been determined in accordance with the fair value method prescribed by SFAS No. 123 and SFAS No. 148, Accounting for Stock-Based Compensation: An Amendment of FASB Statement No. 123 (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 25,
2006
 
February 26, 2005
 
February 25,
2006
 
February 26, 2005
 
Compensation cost of stock options
 
$
2
 
$
1,915(1)
 
$
4
 
$
2,098
 
Discount on employee stock purchase plan
   
8
   
-
   
15
   
4
 
Compensation cost of unvested stock awards(2)
   
148
   
336
   
216
   
378
 
Compensation cost of fully vested stock award(2)
   
-
   
404(1)
 
 
-
   
404
 
Total stock-based compensation
 
$
158
 
$
2,655
 
$
235
 
$
2,884
 
                           
Net income available to common shareholders, as reported
       
$
4,902
       
$
4,244
 
Fair value of stock-based compensation excluded from net income, net of tax
         
(1,915
)
       
(2,102
)
Net income available to common shareholders, pro forma
       
$
2,987
       
$
2,142
 
                           
Basic earnings per share, as reported
       
$
.19
       
$
.16
 
Diluted earnings per share, as reported
       
$
.19
       
$
.16
 
                           
Basic earnings per share, pro forma
       
$
.11
       
$
.08
 
Diluted earnings per share pro forma
       
$
.11
       
$
.08
 

(1)
In connection with changes in the Company’s Chief Executive Officer (CEO) compensation plan during the quarter ended February 26, 2005, the CEO was granted 187,000 shares of fully-vested common stock and the Company accelerated the vesting of the CEO’s 1.6 million stock options with an exercise price of $14.00 per share.
(2)
The compensation cost of unvested stock awards and the fiscal 2005 fully vested stock award granted to the CEO was included in reported selling, general, and administrative expenses presented in the income statement for the respective fiscal periods.
 
The following is a description of activity in our stock-based compensation plans for the quarter and two quarters ended February 25, 2006.

Stock Options

The Company has an incentive stock option plan whereby options to purchase shares of our common stock are issued to key employees at an exercise price not less than the fair market value of the Company’s common stock on the date of grant. During the two quarters ended February 25, 2006 we did not issue any new stock options and the remaining unamortized service cost on previously issued stock options is immaterial in aggregate. The intrinsic value of stock options exercised during the two quarters ended February 25, 2006 was less than $0.1 million and there were no stock options exercised during the quarter ended February 25, 2006. The fair market value of options that vested during the quarter was zero and for the two quarters ended February 25, 2006 was approximately $6,000. The Company generally issues shares of common stock related to the exercise of stock options from shares held in treasury.

The Company did not issue any stock options to vendors or other non-employees during the two quarters ended February 25, 2006.

Employee Stock Purchase Plan

The Company has an employee stock purchase plan that offers qualified employees the opportunity to purchase shares of our common stock at a price equal to 85 percent of the average fair market value of the Company’s common stock on the last trading day of each fiscal quarter. Based upon SFAS No. 123R, we determined that the discount offered to employees is compensatory and the amount is therefore expensed each quarter. A total of 8,150 and 14,374 shares were issued under this plan in the quarter and two quarters ended February 25, 2006, respectively.

Unvested Stock Awards

Employee Awards - During fiscal 2006 and in prior periods, we have granted unvested stock awards to certain employees as long-term incentives. The following is a brief description of these unvested stock awards that have been granted to employees.

Awards Granted in Fiscal 2005 and Prior Periods - These awards cliff vest five years from the grant date or on an accelerated basis if we achieve specified earnings levels. The compensation cost of these unvested stock awards was based on the fair value of the shares on the grant date and is expensed on a straight-line basis over the vesting (service) period of the awards. The recognition of compensation cost will be accelerated when we believe that it is probable that we will achieve the specified earnings thresholds and the shares will vest. We did not accelerate the vesting of any of these awards during the two quarters ended February 25, 2006.

Fiscal 2006 Long-Term Incentive Plan - On January 20, 2006, the Company’s shareholders approved a stock-based long-term incentive plan (the LTIP) that permits the grant of unvested share awards of common stock to certain employees as directed by the Compensation Committee of the Board of Directors. The LTIP share awards granted during the quarter ended February 25, 2006 cliff vest on August 31, 2008, which is the completion of a three-year performance period. The number of shares that are finally awarded to LTIP participants is variable and is based entirely upon the achievement of a combination of performance objectives related to sales growth and operating income during the three-year performance period. The Compensation Committee initially granted awards for 377,665 shares (target award) of common stock; the number of shares finally awarded will range from zero shares, if a minimum level of performance is not achieved, to 200 percent of the target award, if specifically defined performance criteria is achieved during the three-year performance period.

The LTIP shares were valued at $6.60 per share, which was the closing price of our common stock on the grant date. The corresponding compensation cost of the award, based upon the target award number of shares, totaled $2.5 million, which is being expensed over the service period of the award. Due to the variable number of shares that may be issued under the LTIP, we reevaluate the LTIP on a quarterly basis and adjust the number of shares expected to be awarded based upon financial results of the Company as compared to the performance goals set for the award. Adjustments to the number of shares awarded, and to the corresponding compensation expense, are made on a cumulative basis at the date of adjustment based upon the probable number of shares to be awarded. The total compensation cost of the LTIP is equal to the number of shares finally issued multiplied by $6.60 per share, the fair value of the common shares determined at the grant date.

Board of Director Awards - During January 2006, the Company’s shareholders also approved changes to our non-employee directors’ stock incentive plan (the Directors’ Plan). The Directors’ plan was designed to provide non-employee directors of the Company, who are ineligible to participate in our employee stock incentive plan, an opportunity to acquire an interest in the Company through the acquisition of shares of common stock. Under the previous provisions of the Directors’ Plan, each non-employee director received an annual unvested stock award with a value (based on the trading price of the Company’s common stock on the date of the award) equal to $27,500. The primary modification to the Directors’ plan approved by the shareholders changes the annual unvested stock grant to 4,500 shares of common stock rather than the dollar value previously defined in the plan. The amendment also eliminates the limitation on the maximum dollar value of all awards made under the Directors’ Plan in any given year. No shares were issued to members of our Board of Directors under the Directors’ Plan during the quarter ended February 25, 2006.
 
A summary of our unvested stock awards for the two quarters ended February 25, 2006 is as follows (in thousands, except share amounts):

   
Number of Unvested Shares
 
 
Compensation Cost
 
Outstanding shares and unamortized compensation cost at August 31, 2005
   
409,295
 
$
1,055
 
Granted
   
-
   
-
 
Vested
   
-
   
-
 
Amortization of compensation
   
n/a
   
(68
)
 
Outstanding shares and unamortized compensation cost at November 26, 2005
   
409,295
   
987
 
Granted
   
377,655
   
2,493
 
Vested
   
-
   
-
 
Amortization of compensation
   
n/a
   
(148
)
 
Outstanding shares and unamortized compensation cost at February 25, 2006
   
786,950
 
$
3,332
 

The intrinsic value of our unvested stock awards (both employee and Board of Director awards) was $6.0 million, which was based upon our closing stock price of $7.60 per share on February 25, 2006.
 
NOTE 3 - INVENTORIES

Inventories are stated at the lower of cost or market, cost being determined using the first-in, first-out method, and were comprised of the following (in thousands):

   
February 25,
2006
 
August 31,
2005
 
           
Finished goods
 
$
19,803
 
$
18,161
 
Work in process
   
318
   
825
 
Raw materials
   
2,784
   
1,989
 
               
   
$
22,905
 
$
20,975
 
 
NOTE 4 - INTANGIBLE ASSETS

The Company’s intangible assets were comprised of the following (in thousands):

 
February 25, 2006
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
 
Definite-lived intangible assets:
             
License rights
 
$
27,000
 
$
(6,949
)
$
20,051
 
Curriculum
   
58,229
   
(26,055
)
 
32,174
 
Customer lists
   
18,774
   
(12,658
)
 
6,116
 
Trade names
   
1,277
   
(1,277
)
 
-
 
     
105,280
   
(46,939
)
 
58,341
 
                     
Indefinite-lived intangible asset:
                   
Covey trade name
   
23,000
   
-
   
23,000
 
Balance at February 25, 2006
 
$
128,280
 
$
(46,939
)
$
81,341
 
                     
August 31, 2005
                   
Definite-lived intangible assets:
                   
License rights
 
$
27,000
 
$
(6,480
)
$
20,520
 
Curriculum
   
58,232
   
(25,146
)
 
33,086
 
Customer lists
   
18,774
   
(12,032
)
 
6,742
 
Trade names
   
1,277
   
(1,277
)
 
-
 
     
105,283
   
(44,935
)
 
60,348
 
                     
Indefinite-lived intangible asset:
                   
Covey trade name
   
23,000
   
-
   
23,000
 
Balance at August 31, 2005
 
$
128,283
 
$
(44,935
)
$
83,348
 

The Company’s aggregate amortization expense totaled $0.9 million for the quarter ended February 25, 2006 and $1.0 million during the quarter ended February 26, 2005. For the two quarters ended February 25, 2006 our total amortization expense was $2.0 million compared to $2.1 million for the two quarters ended February 26, 2005.
 
NOTE 5 - PREFERRED STOCK REDEMPTIONS

On February 13, 2006 we redeemed $10.0 million, or approximately 400,000 shares, of our currently outstanding Series A Preferred Stock at its liquidation preference ($25 per share plus accrued dividends). For the two quarters ended February 25, 2006 we have redeemed $20.0 million, or approximately 800,000 shares of preferred stock. Since the recapitalization of our preferred stock in March 2005, we have redeemed a total of $50.0 million, or approximately 2.0 million shares, of our outstanding Series A preferred stock. These preferred stock redemptions have reduced the Company’s annual preferred dividend obligation by $5.0 million.

At our Annual Meeting of Shareholders held in January 2006, we obtained shareholder approval of an amendment to our articles of incorporation that extends the period during which we have the right to redeem outstanding shares of preferred stock at 100 percent of its liquidation preference. The amendment extends the current redemption deadline from March 8, 2006 to December 31, 2006 and also provides the right to extend the redemption period for an additional year to December 31, 2007, if another $10.0 million of preferred stock is redeemed before December 31, 2006. The February 13, 2006 preferred stock redemption satisfied the additional extension provision and the Company can redeem preferred stock at the liquidation preference through December 31, 2007.
 
NOTE 6 - APPROVAL TO PURCHASE SHARES OF COMMON STOCK

During January 2006, our Board of Directors authorized the purchase up to $10.0 million of our currently outstanding common stock. These purchases will be made at the Company’s discretion at prevailing market prices and will be subject to customary regulatory requirements and considerations. The Company does not have a timetable for the purchase of these common shares and the authorization by the Board of Directors does not have an expiration date. During the quarter ended February 25, 2006 we purchased 210,200 shares of our common stock under the terms of this newly authorized plan for $1.6 million.
 
NOTE 7 - LEGAL SETTLEMENT

In fiscal 2002, we filed legal action against World Marketing Alliance, Inc., a Georgia corporation (WMA), and World Financial Group, Inc., a Delaware corporation and purchaser of substantially all assets of WMA, for breach of contract. The case proceeded to trial and the jury rendered a verdict in our favor and against WMA on November 1, 2004 for the entire unpaid contract amount of approximately $1.1 million. In addition to the verdict, we recovered legal fees totaling $0.3 million and pre- and post-judgment interest of $0.3 million from WMA. During our fiscal quarter ended May 28, 2005, we received payment in cash from WMA for the total verdict amount, including legal fees and interest. However, shortly after paying the verdict amount, WMA appealed the jury decision to the 10th Circuit Court of Appeals and we recorded receipt of the verdict amount plus legal fees and interest with a corresponding increase to accrued liabilities and deferred the gain until the case was finally resolved. On December 30, 2005, the Company entered into a settlement agreement with WMA. Under the terms of the settlement agreement, WMA agreed to dismiss its appeal. As a result of this settlement agreement and dismissal of WMA’s appeal, we recorded a $0.9 million gain from the legal settlement in the quarter ended February 25, 2006. We also recorded a $0.3 million reduction in selling, general and, administrative expenses for recovered legal expenses.
 
NOTE 8 - COMPREHENSIVE INCOME

Comprehensive income is based on net income and includes charges and credits to equity accounts that are not the result of transactions with shareholders. Comprehensive income for the Company was calculated as follows (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 25,
2006
 
February 26,
2005
 
February 25, 2006
 
February 26, 2005
 
Net income
 
$
9,213
 
$
7,086
 
$
12,446
 
$
8,612
 
Other comprehensive income (loss) items:
                         
Adjustment for fair value of foreign currency hedge derivatives
   
-
   
(26
)
 
-
   
(318
)
Foreign currency translation adjustments
   
145
   
(232
)
 
(220
)
 
403
 
Comprehensive income
 
$
9,358
 
$
6,828
 
$
12,226
 
$
8,697
 
 
NOTE 9 - EARNINGS PER SHARE

Basic earnings per common share (EPS) is calculated by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS is calculated by dividing net income available to common shareholders by the weighted-average number of common shares outstanding plus the assumed exercise of all dilutive securities using the treasury stock method or the “as converted” method, as appropriate. Following the preferred stock recapitalization that was completed in March 2005, our preferred stock is no longer convertible into common stock or entitled to participate in dividends payable to holders of common stock. Accordingly, we no longer use the two-class method of calculating EPS as defined in SFAS No. 128, Earnings Per Share, and EITF Issue 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128, for periods after February 26, 2005.

The following table sets forth the computation of basic and diluted EPS for the periods indicated (in thousands, except per share amounts):


   
Quarter Ended
 
Two Quarters Ended
 
   
February 25,
2006
 
February 26,
2005
 
February 25,
2006
 
February 26,
2005
 
Net income
 
$
9,213
 
$
7,086
 
$
12,446
 
$
8,612
 
Non-convertible preferred stock dividends
   
(1,139
)
       
(2,518
)
     
Convertible preferred stock dividends
   
-
   
(2,184
)
 
-
   
(4,368
)
Net income available to common shareholders
 
$
8,074
 
$
4,902
 
$
9,928
 
$
4,244
 
                           
Convertible preferred stock dividends
 
$
-
 
$
2,184
 
$
-
 
$
4,368
 
Weighted average preferred shares on an as converted basis
   
-
   
6,239
   
-
   
6,239
 
Distributed EPS - preferred
 
$
-
 
$
.35
 
$
-
 
$
.70
 
                           
Undistributed income
 
$
-
 
$
4,902
 
$
-
 
$
4,244
 
Preferred ownership on an as converted basis
   
-
   
24
%
 
-
   
24
%
Preferred shareholders interest in undistributed income
   
-
   
1,176
   
-
   
1,019
 
Weighted average preferred shares on an as converted basis
   
-
   
6,239
   
-
   
6,239
 
Undistributed EPS - preferred
 
$
-
 
$
.19
 
$
-
 
$
.16
 
                           
Undistributed income
 
$
8,074
 
$
4,902
 
$
9,928
 
$
4,244
 
Common stock ownership
   
100
%
 
76
%
 
100
%
 
76
%
Common shareholder interest in undistributed income
 
$
8,074
 
$
3,726
 
$
9,928
 
$
3,225
 
Weighted average common shares outstanding - Basic
   
20,311
   
19,880
   
20,321
   
19,790
 
Effect of dilutive securities:
                         
Stock options
   
45
   
60
   
46
   
14
 
Unvested stock awards
   
278
   
-
   
271
   
-
 
Weighted average common shares outstanding - Diluted
   
20,634
   
19,940
   
20,638
   
19,804
 
                           
Basic EPS - Common
 
$
.40
 
$
.19
 
$
.49
 
$
.16
 
Diluted EPS - Common
 
$
.39
 
$
.19
 
$
.48
 
$
.16
 

At February 25, 2006, we had approximately 2.0 million stock options outstanding which were not included in the computation of diluted EPS because the options’ exercise prices were greater than the average market price of the Company’s common shares. We also had 6.2 million common stock warrants with an exercise price of $8.00 per share that were not included in the Company’s EPS calculation because their exercise price was higher than the average market price of our common stock during the quarter and two quarters ended February 25, 2006. At February 26, 2005, we had approximately 2.3 million stock options that were not considered in our calculation of diluted EPS that may have a dilutive effect on the Company’s EPS calculation in future periods.
 
NOTE 10 - SEGMENT INFORMATION

The Company has two segments: the Consumer and Small Business Unit (CSBU) and the Organizational Solutions Business Unit (OSBU). The following is a description of our segments, their primary operating components, and their significant business activities:

Consumer and Small Business Unit - This business unit is primarily focused on sales to individual customers and small business organizations and includes the results of our domestic retail stores, consumer direct operations (catalog, eCommerce, and public seminars programs), wholesale operations, and other related distribution channels, including government product sales and domestic printing and publishing sales. The CSBU results of operations also include the financial results of our paper planner manufacturing operations. Although CSBU sales primarily consist of products such as planners, binders, software, and handheld electronic planning devices, virtually any component of our leadership, productivity, and strategy execution solutions may be purchased through CSBU channels.

Organizational Solutions Business Unit - The OSBU is primarily responsible for the development, marketing, sale, and delivery of strategic execution, productivity, leadership, sales force performance, and communication training and consulting solutions directly to organizational clients, including other companies, the government, and educational institutions. The OSBU includes the financial results of our domestic sales force and our international operations. The domestic sales force is responsible for the sale and delivery of our training and consulting services in the United States. Our international sales group includes the financial results of our directly owned foreign offices and royalty revenues from licensees.

The Company’s chief operating decision maker is the CEO, and each of the segments has a president who reports directly to the CEO. The primary measurement tool used in business unit performance analysis is earnings before interest, taxes, depreciation, and amortization (EBITDA), which may not be calculated as similarly titled amounts calculated by other companies. For segment reporting purposes, the Company’s consolidated EBITDA can be calculated as its income from operations excluding depreciation and amortization charges.

In the normal course of business, the Company may make structural and cost allocation revisions to its segment information to reflect new reporting responsibilities within the organization. During the first quarter of fiscal 2006, we transferred our public seminar programs from the domestic unit of OSBU to the consumer direct channel in CSBU. We also transferred the operations of certain corporate departments, such as Franklin Covey travel and accounts payable, to the operating segments. All prior period segment information has been revised to conform to the most recent classifications and organizational changes. The Company accounts for its segment information on the same basis as the accompanying condensed consolidated financial statements.

SEGMENT INFORMATION
(in thousands)
                     
 
Quarter Ended
February 25, 2006
 
Sales to External Customers
 
 
 
Gross Margin
 
 
 
EBITDA
 
 
 
Depreciation
 
 
 
Amortization
 
Consumer and Small Business Unit:
                     
Retail
 
$
23,836
 
$
14,324
 
$
5,321
 
$
341
 
$
-
 
Consumer direct
   
19,200
   
11,427
   
9,179
   
15
   
-
 
Wholesale
   
3,620
   
1,917
   
1,734
   
-
   
-
 
Other CSBU
   
1,291
   
134
   
(7,267
)
 
309
   
-
 
Total CSBU
   
47,947
   
27,802
   
8,967
   
665
   
-
 
                                 
Organizational Solutions Business Unit:
                               
Domestic
   
15,223
   
10,295
   
1,706
   
84
   
907
 
International
   
15,163
   
10,076
   
3,957
   
320
   
1
 
Total OSBU
   
30,386
   
20,371
   
5,663
   
404
   
908
 
Total operating segments
   
78,333
   
48,173
   
14,630
   
1,069
   
908
 
Corporate and eliminations
   
-
   
-
   
(1,945
)
 
152
   
-
 
Consolidated
 
$
78,333
 
$
48,173
 
$
12,685
 
$
1,221
 
$
908
 
                                 
Quarter Ended
February 26, 2005
                               
Consumer and Small Business Unit:
                               
Retail
 
$
28,055
 
$
16,599
 
$
6,183
 
$
844
 
$
-
 
Consumer direct
   
18,387
   
10,914
   
7,526
   
248
   
-
 
Wholesale
   
4,897
   
2,318
   
2,157
   
-
   
-
 
Other CSBU
   
765
   
(894
)
 
(7,185
)
 
680
   
86
 
Total CSBU
   
52,104
   
28,937
   
8,681
   
1,772
   
86
 
                                 
Organizational Solutions Business Unit:
                               
Domestic
   
16,162
   
11,341
   
2,327
   
78
   
954
 
International
   
14,257
   
9,939
   
3,559
   
337
   
2
 
Total OSBU
   
30,419
   
21,280
   
5,886
   
415
   
956
 
Total operating segments
   
82,523
   
50,217
   
14,567
   
2,187
   
1,042
 
Corporate and eliminations
   
-
   
-
   
(3,289
)
 
133
   
1
 
Consolidated
 
$
82,523
 
$
50,217
 
$
11,278
 
$
2,320
 
$
1,043
 
                                 
Two Quarters Ended
February 25, 2006
                               
Consumer and Small Business Unit:
                               
Retail
 
$
38,506
 
$
23,012
 
$
5,422
 
$
782
 
$
-
 
Consumer direct
   
37,788
   
22,832
   
18,482
   
27
   
-
 
Wholesale
   
10,229
   
5,048
   
4,695
   
-
   
-
 
Other CSBU
   
2,454
   
512
   
(15,654
)
 
657
   
57
 
Total CSBU
   
88,977
   
51,404
   
12,945
   
1,466
   
57
 
                                 
Organizational Solutions Business Unit:
                               
Domestic
   
31,616
   
20,798
   
2,346
   
164
   
1,943
 
International
   
30,091
   
20,378
   
7,905
   
651
   
3
 
Total OSBU
   
61,707
   
41,176
   
10,251
   
815
   
1,946
 
Total operating segments
   
150,684
   
92,580
   
23,196
   
2,281
   
2,003
 
Corporate and eliminations
   
-
   
-
   
(3,871
)
 
348
   
-
 
Consolidated
 
$
150,684
 
$
92,580
 
$
19,325
 
$
2,629
 
$
2,003
 
                                 
Two Quarters Ended
February 26, 2005
                               
Consumer and Small Business Unit:
                               
Retail
 
$
46,443
 
$
26,977
 
$
6,536
 
$
1,522
 
$
-
 
Consumer direct
   
37,245
   
22,302
   
15,398
   
494
   
-
 
Wholesale
   
8,480
   
4,077
   
3,702
   
-
   
-
 
Other CSBU
   
1,750
   
(1,249
)
 
(14,491
)
 
1,366
   
172
 
Total CSBU
   
93,918
   
52,107
   
11,145
   
3,382
   
172
 
                                 
Organizational Solutions Business Unit:
                               
Domestic
   
29,568
   
20,127
   
2,980
   
153
   
1,907
 
International
   
28,141
   
19,418
   
7,158
   
663
   
4
 
Total OSBU
   
57,709
   
39,545
   
10,138
   
816
   
1,911
 
Total operating segments
   
151,627
   
91,652
   
21,283
   
4,198
   
2,083
 
Corporate and eliminations
   
-
   
-
   
(4,499
)
 
300
   
4
 
Consolidated
 
$
151,627
 
$
91,652
 
$
16,784
 
$
4,498
 
$
2,087
 

A reconciliation of operating segment EBITDA to consolidated income before taxes is provided below (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 25,
2006
 
February 26,
2005
 
February 25,
2006
 
February 26,
2005
 
Reportable segment EBITDA
 
$
14,630
 
$
14,567
 
$
23,196
 
$
21,283
 
Restructuring cost reversal
                     
306
 
Corporate expenses
   
(1,945
)
 
(3,289
)
 
(3,871
)
 
(4,805
)
Consolidated EBITDA
   
12,685
   
11,278
   
19,325
   
16,784
 
Depreciation
   
(1,221
)
 
(2,320
)
 
(2,629
)
 
(4,498
)
Amortization
   
(908
)
 
(1,043
)
 
(2,003
)
 
(2,087
)
Income from operations
   
10,556
   
7,915
   
14,693
   
10,199
 
Interest income
   
316
   
165
   
645
   
282
 
Interest expense
   
(660
)
 
(29
)
 
(1,303
)
 
(66
)
Legal settlement
   
873
       
873
     
Income before provision for income taxes
 
$
11,085
 
$
8,051
 
$
14,908
 
$
10,415
 


NOTE 11 - SUBSEQUENT EVENTS

Management Common Stock Loan Modifications

Subsequent to February 25, 2006, the Company offered participants in its management common stock loan program the opportunity to formally modify the terms of their loans in exchange for placing their shares of common stock obtained through the loan program in an escrow account that allows the Company to have a security interest in the loan program shares. The key modifications to the management common stock loans for the participants accepting the offer are as follows:

·  Modification of Promissory Note - The management stock loan due date will be changed to be the earlier of (a) March 30, 2013, or (b) the date on which the Company’s stock closes, as reported by the exchange or market that is the principal market for our common stock, at or above the price per share such that the value of the shares acquired by the participants under the program is equal to the principal and accrued interest on the participants’ promissory notes (Breakeven Date). The interest rate on the loans will increase from 3.16 percent compounded annually to 4.72 percent compounded annually.
 
·  Redemption of Management Loan Program Shares - The Company will have the right to redeem the shares on the due date in satisfaction of the promissory notes as follows:

(a)
On the Breakeven Date, the Company will purchase and redeem from the loan participants the number of loan program shares necessary to satisfy the participant’s obligation under the promissory note. The redemption price for each such loan program share will be equal to the closing price of our common stock on the Breakeven Date.
(b)
If the Company’s stock has not closed at or above the breakeven price on or before March 30, 2013, the Company will purchase and redeem from the participants all of their loan program shares at the closing price on that date as partial payment on the participant’s obligation.


Loan program participants may choose whether or not to place their loan program shares in the escrow account and accept the modification agreement. If a loan participant declines the offer to modify their management stock loan, their loan will continue to have the same terms and conditions that were previously approved in May 2004 by the Company’s Board of Directors and their loans will be due at the earlier of March 30, 2008 or the Breakeven Date. The Company believes that the new modifications improve its ability to collect the shares purchased by participants through establishing a security interest in the shares and facilitates redemption of the loan program shares from participants on the due date. Consistent with the May 2004 modifications, participants will be unable to realize a gain on the loan program shares unless they pay cash to satisfy the promissory note obligation prior to the due date.

Due to the loan program modifications that were approved in May 2004, we currently account for the management common stock loans as stock option arrangements. Under the provisions of SFAS No. 123R, which we adopted on September 1, 2005, additional compensation expense should be recognized only if the Company takes action that constitutes a modification that increases the fair value of the option arrangements. Since these new modifications do not increase the fair value of the option arrangements, no compensation expense was recognized.

Amendment to Information Systems Outsourcing Agreement

On April 1, 2006, the Company and Electronic Data Systems Corporation and EDS Information Services L.L.C. (collectively “EDS”) entered into an amendment (the Amendment) to the Information Technology Services Agreement, dated April 1, 2001, as previously amended (the Outsourcing Contract). Under terms of the Outsourcing Contract, EDS operates our primary call center, provides warehousing and distribution services, supports software products, and supports our information systems. The Outsourcing Contract expires on June 30, 2016.

The key provisions of the Amendment include the following:

·  Reduced pricing and decreased required minimum annual payments for information services support;
·  A modified provision increasing the Company’s contractual early termination charges if we elect to terminate the contract for convenience after September 1, 2007;
·  Clarification of existing requirements that the Company procure certain information services solely from EDS;
·  Clarification of existing provisions regarding the use of benchmarking services to measure the quality and cost effectiveness of services provided under the Outsourcing Contract; and
·  A new provision that allows EDS to share existing support personnel, whose services were previously dedicated solely to the Company, with other EDS customers.
 

 
 ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based upon management’s current expectations and are subject to various uncertainties and changes in circumstances. Important factors that could cause actual results to differ materially from those described in forward-looking statements are set forth below under the heading Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995.

The Company suggests that the following discussion and analysis be read in conjunction with the Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended August 31, 2005.
 
RESULTS OF OPERATIONS

Overview

Our second fiscal quarter, which includes the months of December, January, and February, historically represents our seasonally busiest months for product sales as many of our clients renew their planners on a calendar-year basis as well as purchase gifts, including binders, leather totes, and planning tools for the holiday season. As a result of these seasonally strong product sales, our second fiscal quarter generally has better operating results than other quarters of our fiscal year. Our financial results for the quarter ended February 25, 2006 represented another quarter of year-over-year improvement and maintained the favorable momentum that was realized in fiscal 2005 and the first quarter of fiscal 2006. Our income from operations improved to $10.6 million compared to $7.9 million in the prior year and we were able to increase our after-tax net income by $2.1 million to $9.2 million compared to $7.1 million in the comparable quarter of the prior year. Due to improved operating results and significantly reduced preferred dividends resulting from preferred stock redemptions, we recognized $8.1 million of net income available to common shareholders compared to $4.9 million in the corresponding quarter of fiscal 2005.

The primary factors that influenced our operating results for the quarter ended February 25, 2006 were as follows:

·  Sales Performance - Product sales declined $4.3 million due to fewer retail stores being open during the quarter and reduced technology and specialty product sales. Partially offsetting declines due to closed stores and technology and specialty products were improved comparable store sales performance and an increase in “core” product sales, including planners, binders, totes, and other planning tools and accessories. Training and consulting services sales increased by $0.1 million, which was the result of improved international sales and decreased sales effectiveness training. Other domestic training program sales increased compared to the prior year. As a result these performance factors, total sales decreased by $4.2 million, or 5 percent, compared to the corresponding quarter of the prior year.
 
·  Gross Margin - When compared to the prior year, our gross margin in dollars declined due to decreased sales. However, our gross margin improved when measured as a percent of sales due to favorable product mix changes and increased training sales as a percent of total sales.
 
·  Operating Costs - Our operating costs declined by $4.7 million compared to the prior year, which was the result of selling, general, and administrative expense decreases totaling $3.5 million, a $1.1 million decrease in depreciation expense, and a $0.1 million decrease in amortization expense.
 
·  Legal Settlement - During the quarter ended February 25, 2006, we settled a legal case that was originally awarded in our favor and subsequently appealed. The final settlement of this litigation resulted in other income of $0.9 million that was recorded in the quarter.
 
·  Preferred Stock Dividends - Due to preferred stock redemptions in fiscal 2005 and the first two quarters of fiscal 2006 totaling $50.0 million, our preferred stock dividend cost decreased by $1.0 million compared to the corresponding quarter of fiscal 2005.
 
Further details regarding these factors and their impact on our operating results and liquidity are provided throughout the following management’s discussion and analysis.

Quarter Ended February 25, 2006 Compared to the Quarter Ended February 26, 2005

Sales

The following table sets forth sales data by category and for our operating segments (in thousands):

   
Quarter Ended
 
Two Quarters Ended
 
   
February 25, 2006
 
February 26, 2005
 
Percent Change
 
February 25, 2006
 
February 26, 2005
 
Percent Change
 
Sales by Category:
                         
Products
 
$
50,841
 
$
55,175
   
(8)
 
$
94,244
 
$
99,226
   
(5)
 
Training and consulting services
   
27,492
   
27,348
   
1
   
56,440
   
52,401
   
8
 
   
$
78,333
 
$
82,523
   
(5)
 
$
150,684
 
$
151,627
   
(1)
 
                                       
Consumer and Small Business Unit:
                                     
Retail Stores
 
$
23,836
 
$
28,055
   
(15)
 
$
38,506
 
$
46,443
   
(17)
 
Consumer Direct
   
19,200
   
18,387
   
4
 
 
37,788
   
37,245
   
1
 
Wholesale
   
3,620
   
4,897
   
(26)
 
 
10,229
   
8,480
   
21
 
Other CSBU
   
1,291
   
765
   
69
   
2,454
   
1,750
   
40
 
     
47,947
   
52,104
   
(8)
 
 
88,977
   
93,918
   
(5)
 
Organizational Solutions Business Unit:
                                     
Domestic
   
15,223
   
16,162
   
(6)
 
 
31,616
   
29,568
   
7
 
International
   
15,163
   
14,257
   
6
   
30,091
   
28,141
   
7
 
     
30,386
   
30,419
   
-
   
61,707
   
57,709
   
7
 
Total Sales
 
$
78,333
 
$
82,523
   
(5)
 
$
150,684
 
$
151,627
   
(1)
 

Product Sales - Overall product sales, which primarily consist of planners, binders, software, and handheld electronic planning devices that are primarily sold through our Consumer and Small Business Unit (CSBU) channels, declined $4.3 million, or 8 percent, compared to the prior year. The decline in product sales was primarily due to the following performance in our CSBU channels:

·  Retail Stores - The $4.2 million decline in retail sales was due to fewer stores, which had a $4.9 million impact on sales, and reduced technology and specialty product sales, which totaled $0.4 million. Partially offsetting these declines were increased “core” product (e.g. planners, binders, and totes) sales during the quarter. At February 25, 2006, we were operating 97 retail stores compared to 121 stores at February 26, 2005. Improved core product sales trends were reflected in a three percent increase in comparable store (stores which were open during the comparable periods) sales compared to the prior year.
 
·  Consumer Direct - Sales through our consumer direct channels (catalog, eCommerce, and public seminars) increased primarily due to increased public seminar sales and the transition of clients from closed retail stores to consumer direct channels.
 
·  Wholesale - Sales through our wholesale channel, which includes sales to office superstores and other retail chains, decreased due to the timing of product sales to these entities.
 
·  Other CSBU - Other CSBU sales consist primarily of domestic printing and publishing sales and building sublease revenues. The increase in other CSBU sales was primarily due to increased sublease revenue. During fiscal 2005 we began subleasing a substantial portion of our corporate headquarters.
 
Training and Consulting Services - We offer a variety of training courses, training related products, and consulting services focused on productivity, leadership, strategy execution, sales force performance, and effective communications training programs that are provided both domestically and internationally through the Organizational Solutions Business Unit (OSBU). Our overall training and consulting service sales increased by $0.1 million, or one percent, compared to the same period of the prior year. The improvement in training and consulting service sales was primarily attributable to the following sales performance in our OSBU divisions:

·  Domestic - Our domestic training sales declined by $0.9 million, or six percent, primarily due to a $2.2 million decrease in our sales effectiveness training sales. This decrease was primarily due to a large sales transaction that was completed during the second quarter of the prior year. This decline was partially offset by increased sales of other training courses, especially those related to our The 7 Habits of Highly Effective People training courses. In addition, training manual sales increased by $0.8 million and the number of training and consulting days sold increased by nine percent over the prior year. We anticipate that domestic training will strengthen in fiscal 2006 as we began our third fiscal quarter with more training days booked than at the same period in the prior year.
 
·  International - International sales increased $0.9 million, or six percent, compared to the prior year. The increase was the result of increased sales at our directly owned offices in Japan and Brazil, as well as a 19 percent increased in licensee royalty revenues. The translation of foreign sales resulted in a $0.7 million unfavorable impact to our consolidated sales as certain foreign currencies, particularly the Japanese Yen, weakened against the United States dollar during much of the quarter ended February 25, 2006.
 
Gross Margin

Gross margin consists of net sales less the cost of goods sold or the cost of services provided. Our overall gross margin improved to 61.5 percent of sales for the quarter, compared to 60.9 percent in the comparable quarter of fiscal 2005. The improvement in our overall gross margin was primarily due to favorable product mix changes and increased training sales as a percent of total sales. Training and consulting service sales, which typically have higher gross margins than our product sales, increased to 35 percent of total sales during the quarter ended February 25, 2006 compared to 33 percent in the prior year.

Our gross margin on product sales improved to 56.2 percent compared to 55.4 percent in fiscal 2005 and was primarily due to a favorable shift in our product mix as sales of higher-margin paper products and binders increased as a percent of total sales, while sales of lower-margin technology and specialty products continue to decline.

Training solution and related services gross margin, as a percent of sales, declined slightly to 71.4 percent compared to 71.8 percent in the prior year.

Operating Expenses

Selling, General and Administrative - Our selling, general, and administrative (“SG&A”) expenses decreased $3.5 million, or nine percent, compared to the prior year. The decrease in SG&A expenses was primarily due to reduced retail store costs resulting from fewer stores, reduced compensation costs from stock-based compensation awards, reduced bad debt expense, the recovery of legal expenses from a legal settlement (refer to discussion below), and the favorable results of initiatives to reduce overall operating costs. Our retail store costs decreased $1.3 million due to store closures that occurred in prior periods. During the quarter ended February 26, 2005, we recognized $0.7 million of compensation expense from unvested stock awards resulting from changes in CEO compensation and the acceleration of previously issued unvested stock awards. These costs did not repeat in the quarter ended February 25, 2006. Through improvements in our accounts receivable collections we reduced our bad debt expense during the quarter and recovered $0.3 million of legal costs from the WMA settlement. In addition to these decreases, we continue to implement strategies designed to reduce our overall operating costs. Our cost-reduction efforts have included retail store closures, headcount reductions, and other measures designed to focus our resources on critical activities and projects related to growth opportunities. The favorable impact of these efforts resulted in reduced SG&A expenses in many areas of the Company during the quarter ended February 25, 2006.

Partially offsetting these expense reductions were costs related to our investment in various growth initiatives. These initiatives included hiring additional sales people in the OSBU and the CSBU, increased advertising and marketing programs, additional curriculum and product development, and increased spending on sales effectiveness training. Due to the time necessary to implement these growth strategies, including training new sales personnel and effectively rolling out new training offerings and products, these growth initiatives may not add material benefits to our fiscal 2006 operating results. However, we believe that these investments in additional sales personnel, increased marketing, and new consulting, training, and product offerings will allow us to increase our sales and improve our operating performance in future periods.

We regularly assess the operating performance of our retail stores, including previous operating performance trends and projected future profitability. During this assessment process, judgments are made as to whether under-performing or unprofitable stores should be closed. As a result of this evaluation process, we closed eight retail store locations near the conclusion of the quarter ended February 25, 2006 and have closed three additional retail locations subsequent to the end of the quarter. We incurred and expensed $0.3 million of costs related to closed stores during the quarter ended February 25, 2006 compared to $0.4 million for store closure costs in the prior year. The costs associated with closing retail stores are typically comprised of charges related to vacating the premises, which may include a provision for the remaining term on the lease, and severance and other personnel costs, which are included as a component of SG&A expenses. We may continue to incur store closing expenses in future periods if the Company determines to close additional retail locations.

During the quarter ended February 25, 2006 our shareholders approved a long-term incentive plan (LTIP) that permits the grant of unvested share awards of common stock to certain employees. The LTIP share awards granted during the quarter ended February 25, 2006 cliff vest on August 31, 2008, which is the completion of a three-year performance period. The number of shares that are finally awarded to participants is variable and is based entirely upon the achievement of a combination of performance objectives related to sales growth and operating income during the three-year performance period. The award was initially for 377,665 shares (target award) of common stock. The award shares were valued at $6.60 per share, and the corresponding initial compensation cost totaled $2.5 million. However, the number of shares that will ultimately vest under the LTIP will vary depending on whether the performance criteria are met or exceeded. The award will be reviewed quarterly and the value may be adjusted, depending on the performance of the Company compared to the award criteria. The compensation cost of the award is being expensed over the three-year service period of the award. As a result, the award will increase our SG&A expense during the vesting period.

Depreciation and Amortization - Depreciation expense decreased $1.1 million, or 47 percent, compared to the second quarter of fiscal 2005 primarily due to the full depreciation or disposal of certain property and equipment (including retail stores) and the effects of significantly reduced capital expenditures during preceding fiscal years. Based upon these events and current capital spending trends, we expect that depreciation expense will continue to decline during fiscal 2006 as compared to prior periods.

Amortization expense from definite-lived intangible assets totaled $0.9 million for the quarter ended February 25, 2006 compared to $1.0 million in the prior year. We expect intangible asset amortization expense to decline compared to the prior year as certain intangible assets become fully amortized during fiscal 2006.

Other Income and Expense Items

Interest Income - Our interest income increased $0.2 million primarily due to higher average cash balances and higher interest rates on our interest-bearing cash accounts.

Interest Expense - Our interest expense increased $0.6 million primarily due to the sale of our corporate headquarters facility and the resulting interest component of our lease payments to the landlord. We are accounting for the lease on the corporate facility as a financing obligation, which is accounted for similar to long-term debt.

Legal Settlement - In fiscal 2002, we filed legal action against World Marketing Alliance, Inc., a Georgia corporation (WMA), and World Financial Group, Inc., a Delaware corporation and purchaser of substantially all assets of WMA, for breach of contract. The case proceeded to trial and the jury rendered a verdict in our favor and against WMA for the entire unpaid contract amount of approximately $1.1 million. In addition to the verdict, we recovered legal fees totaling $0.3 million and pre- and post-judgment interest of $0.3 million from WMA. We received payment in cash from WMA for the total verdict amount, including legal fees and interest. However, shortly after paying the verdict amount, WMA appealed the jury decision to the 10th Circuit Court of Appeals and we recorded receipt of the verdict amount plus legal fees and interest with a corresponding increase to accrued liabilities and deferred the gain until the case was finally resolved. On December 30, 2005, we entered into a settlement agreement with WMA. Under the terms of the settlement agreement, WMA agreed to dismiss its appeal. As a result of this settlement agreement and dismissal of WMA’s appeal, we recorded a $0.9 million gain from the legal settlement.

Income Taxes

The provision for income taxes increased to $1.9 million compared to $1.0 million for the same quarter of the prior year. The increase in our income tax provision was primarily due to increased domestic income taxes resulting from improved domestic operating results and the Company’s inability to fully offset domestic taxable earnings with net operating loss carryforwards generated in prior years and an assessment received in a foreign jurisdiction. In addition, we were unable to offset our tax liabilities in foreign jurisdictions with our domestic operating loss carryforwards. Our history of significant operating losses has precluded us from demonstrating that it is more likely than not that the benefits of domestic operating loss carryforwards, together with the benefits of other deferred income tax assets will be realized. Accordingly, we have recorded valuation allowances on the majority of our domestic deferred income tax assets at February 25, 2006.

As our operating results continue to improve and our taxable income continues to increase, we are accumulating positive evidence which may allow the Company to reverse these valuation allowances on our deferred income tax assets in the future.

Two Quarters Ended February 25, 2006 Compared to the Two Quarters Ended February 26, 2005

Sales

Product Sales - Overall product sales, which primarily consist of planners, binders, software, and handheld electronic planning devices that are primarily sold through our Consumer and Small Business Unit (CSBU) channels, declined $5.0 million, or 5 percent, compared to the prior year. The decline in product sales was primarily due to the following performance in our CSBU channels:

·  Retail Stores - Retail sales declined $7.9 million compared to the prior year. The decrease was due to fewer stores, which had an $8.3 million impact on sales, and reduced technology and specialty product sales, which totaled $1.1 million. Partially offsetting these declines were increased “core” product sales. Improved core product sales trends were reflected in a one percent increase in comparable store sales compared to the prior year.
 
·  Consumer Direct - Year-to-date sales through our consumer direct channels (catalog, eCommerce, and public seminars) remained relatively consistent with the prior year and increased slightly due to increased public seminar sales and the transition of clients from closed retail stores to consumer direct channels.
 
·  Wholesale - Sales through our wholesale channel increased due to the timing of product sales to these entities and increased demand from wholesale channel customers.
 
·  Other CSBU - Other CSBU sales consist primarily of domestic printing and publishing sales and building sublease revenues. The increase in other CSBU revenues was primarily due to increased sublease revenue compared to the prior year.
 
Training and Consulting Services - Our overall training and consulting service sales increased by $4.0 million, or eight percent, compared to the same period of the prior year. The improvement in training and consulting service sales was primarily attributable to the following sales performance for the first two quarters of fiscal 2006 in our OSBU divisions:

·  Domestic - Our domestic training sales increased by $2.0 million, or seven percent, compared to fiscal 2005. The increase was primarily due to improved sales of training courses related to our The 7 Habits of Highly Effective People curriculum. Increased sales of these programs were partially offset by decreased sales effectiveness training sales. Training manual sales increased by $2.1 million and the number of training and consulting days sold increased by six percent over the prior year.
 
·  International - International sales increased $2.0 million, or seven percent, compared to the prior year. The increase was the result of increased sales at our directly owned offices in Japan, Mexico, and Brazil, as well as a 16 percent increase in licensee royalty revenues. The translation of foreign sales resulted in a $0.8 million unfavorable impact to our consolidated sales as certain foreign currencies, particularly in Japan, weakened against the United States dollar during the two quarters ended February 25, 2006.
 
Gross Margin

Our overall gross margin for the two quarters ended February 25, 2006 improved to 61.4 percent of sales, compared to 60.4 percent in the comparable period of fiscal 2005. The improvement in our overall gross margin was primarily due to increased training sales as a percent of total sales and favorable product sales mix changes. Training and consulting service sales, which typically have higher gross margins than our product sales, increased to 38 percent of total sales in fiscal 2006 compared to 35 percent in the prior year.

Our gross margin on product sales improved to 56.5 percent compared to 55.3 percent and was primarily due to a favorable shift in our product mix as sales of higher-margin paper products and binders increased as a percent of total sales, while sales of lower-margin technology and specialty products continue to decline.

Training and consulting services gross margin, as a percent of sales, declin