Oakley Inc - Quarterly Report (10-Q)

Share Name	Share Symbol	Market	Type
Oakley	NYSE:OO	NYSE	Ordinary Share

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

þ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Quarterly Period Ended September 30, 2007

o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Transition Period From To

Commission File Number: 1-13848

OAKLEY, INC.

(Exact name of registrant as specified in its charter)


Washington (State or other jurisdiction of incorporation or organization)		95-3194947 (IRS Employer Identification No.)

One Icon Foothill Ranch, California (Address of principal executive offices)		92610 (Zip Code)

(949) 951-0991

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

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

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

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

The number of shares of the registrant’s Common Stock, par value $.01 per share, outstanding as of November 2, 2007 was 69,746,436.

Oakley, Inc.
Index


PART I.	FINANCIAL INFORMATION

ITEM 1.	Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets as of September 30, 2007 and December 31, 2006	3

	Condensed Consolidated Statements of Income for the three months and nine months ended September 30, 2007 and 2006	4

	Condensed Consolidated Statements of Comprehensive Income for the three months and nine months ended September 30, 2007 and 2006	4

	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2007 and 2006	5

	Notes to Condensed Consolidated Financial Statements	6

ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18

ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	32

ITEM 4.	Controls and Procedures	33

PART II.	OTHER INFORMATION

ITEM 1.	Legal Proceedings	34

ITEM 1A.	Risk Factors	35

ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	36

ITEM 6.	Exhibits	37

	Signatures	38
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

Special Note Regarding Forward-Looking Statements

Certain statements in this Quarterly Report on Form 10-Q are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and are made pursuant to the “safe harbor” created by those sections. All statements in this report, other than those that are purely historical, are forward-looking statements. Forward-looking statements typically are identified by the use of terms such as “expect,” “believe,” “plan,” “intend,” “seek,” “anticipate,” “outlook,” “estimate,” “assume,” “project,” “target,” “could,” “will,” “should,” “may” and “continue,” as well as variations of such words and similar expressions, although some forward-looking statements are expressed differently. Forward-looking statements in this Quarterly Report on Form 10-Q include, without limitation, statements regarding:

	•		competition and the factors we believe provide a competitive advantage;

	•		the importance of our ability to develop new and/or innovative products;

	•		our proposed merger with Luxottica Group S.p.A.;

	•		the effects of business acquisitions;

	•		product line extensions and new product lines;

	•		the effect of seasonality on our business;

	•		anticipated increases in interest expense and amortization of intangible assets;

	•		our expected effective income tax rate and the effect of interest expense and other items on our provision for income taxes;

	•		the resolution of uncertain tax positions, including coverage under applicable insurance policies, and the effect of changes in related income tax liabilities on our results of operations and financial position;

	•		our beliefs concerning the outcome of litigation and the resolution of claims, complaints and other legal matters;

	•		our hedging strategy and the anticipated effectiveness thereof;

	•		the anticipated amounts of stock-based compensation expense;

	•		our expectations regarding future performance by the counterparties to foreign exchange contracts we have entered into;

	•		the amount and timing of future payments under contractual obligations;

	•		the sufficiency of our existing sources of liquidity and anticipated cash flows from operations to fund our operations, capital expenditures and other working capital requirements for the next twelve months; and

	•		the circumstances under which we may seek additional financing, our ability to obtain any such financing and any consideration of acquisition opportunities.

Our expectations, beliefs, anticipations, objectives, intentions, plans and strategies regarding the future are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results, and actual events that occur, to differ materially from results contemplated by the forward-looking statement. These risks and uncertainties include, but are not limited to:

	•		the highly competitive markets for our products and our ability to develop innovative new products and introduce them in a timely manner;

	•		risks associated with our proposed merger with Luxottica, including the satisfaction of conditions necessary to complete the merger, the outcome of outstanding or future litigation and the effects of the merger on our business, results of operations and stock price;

	•		consumer acceptance of our new products and our ability to respond to changing consumer preferences;

	•		order and demand uncertainty, which may result in cancellations of advance orders, or a reduction in the rate of reorders placed by retailers, or result in a buildup of inventory;

	•		our ability to attract and retain qualified personnel;

	•		intellectual property infringement claims by others and our ability to protect our intellectual property;

	•		our dependence on key suppliers for materials we use in our products, including lens blanks;

	•		our ability to successfully integrate acquired businesses into our operations;

	•		our dependence on athletes and personalities for the endorsement of our products; and

	•		risks associated with our international operations, including foreign currency exchange rate fluctuations and the impact of quotas, tariffs, or other restrictions on the importation or exportation of our products.

The forward-looking statements in this report are subject to additional risks and uncertainties, including those set forth in Part II, Item 1A. “Risk Factors” of this Quarterly Report on Form 10-Q, Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2006 and those detailed from time to time in our other filings with the Securities and Exchange Commission. These forward-looking statements are made only as of the date hereof and, except as required by law, we undertake no obligation to update or revise any of them, whether as a result of new information, future events or otherwise.

Oakley ^® , Dragon ^® , Eye Safety Systems ^® , Mosley Tribes ^® , Oakley ^® Store, Oakley Vault ^® , Oliver Peoples ^® , Sunglass Icon™ and The Optical Shop of Aspen™ are trademarks of Oakley, Inc. and its subsidiaries. Fox ^® , Paul Smith ^® and other brands, names and trademarks contained in this report are the property of their respective owners.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

OAKLEY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except per share amounts)


	September 30,		December 31,
	2007		2006
ASSETS
Current Assets
Cash and cash equivalents	$	53,677	$	31,313
Accounts receivable, less allowances of $17,950 (2007) and $15,262 (2006)		140,835		109,168
Inventories		208,056		155,377
Other receivables		4,773		6,375
Deferred income taxes		20,814		17,933
Prepaid expenses and other current assets		15,670		13,947

Total current assets		443,825		334,113

Property and equipment, net		207,053		177,400
Deposits		3,566		2,799
Goodwill		127,555		64,652
Intangible assets		115,572		52,302
Other assets		3,136		2,568

Total assets	$	900,707	$	633,834


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities
Lines of credit	$	205,013	$	38,116
Accounts payable		48,673		45,955
Accrued expenses and other current liabilities		70,122		57,244
Accrued warranty		3,126		3,153
Income taxes payable		534		1,167
Current portion of long-term debt		25		8,732

Total current liabilities		327,493		154,367

Deferred income taxes		17,939		17,457
Other long-term liabilities		25,654		3,119

Total liabilities		371,086		174,943

Commitments and contingencies (Note 7)

Shareholders’ Equity
Preferred stock, par value $.01 per share; 10,000 shares authorized; no shares issued		—		—
Common stock, par value $.01 per share; 200,000 shares authorized; 69,698 (2007) and 68,972 (2006) issued and outstanding		697		690
Additional paid-in capital		57,128		41,711
Retained earnings		447,673		405,120
Accumulated other comprehensive income		24,123		11,370

Total shareholders’ equity		529,621		458,891

Total liabilities and shareholders’ equity	$	900,707	$	633,834

See accompanying notes to condensed consolidated financial statements.

OAKLEY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited, in thousands, except per share data)


	Three months ended						Nine months ended
	September 30,						September 30,
	2007			2006			2007			2006
Net sales	$	263,789		$	210,219		$	726,115		$	565,501
Cost of goods sold		117,284			97,120			319,895			257,164

Gross profit		146,505			113,099			406,220			308,337

Operating expenses:
Research and development		7,140			6,281			19,791			17,298
Selling		61,520			50,975			187,981			150,718
Shipping and warehousing		6,044			5,448			16,881			15,359
General and administrative		30,972			24,318			93,639			67,996

Total operating expenses		105,676			87,022			318,292			251,371


Operating income		40,829			26,077			87,928			56,966

Interest expense		3,586			584			9,536			1,952
Interest income		(596	)		(321	)		(1,386	)		(1,228	)


Income before provision for income taxes		37,839			25,814			79,778			56,242
Provision for income taxes		14,143			8,472			28,887			19,122

Net income	$	23,696		$	17,342		$	50,891		$	37,120


Basic net income per common share	$	0.34		$	0.25		$	0.74		$	0.54

Basic weighted-average common shares		69,074			68,267			68,808			68,431


Diluted net income per common share	$	0.34		$	0.25		$	0.73		$	0.54

Diluted weighted-average common shares		70,304			68,827			69,908			69,017


Dividends declared per common share	$	—		$	0.16		$	—		$	0.16

OAKLEY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(unaudited, in thousands)


	Three months ended						Nine months ended
	September 30,						September 30,
	2007			2006			2007			2006
Net income	$	23,696		$	17,342		$	50,891		$	37,120

Other comprehensive income:
Net unrealized gains (losses) on derivative instruments, net of tax		(618	)		133			(577	)		(221	)
Foreign currency translation adjustments		7,044			(1,062	)		13,330			3,003


Other comprehensive income		6,426			(929	)		12,753			2,782


Comprehensive income	$	30,122		$	16,413		$	63,644		$	39,902

See accompanying notes to condensed consolidated financial statements.

OAKLEY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)


	Nine months ended
	September 30,
	2007			2006
Cash Flows from Operating Activities
Net income	$	50,891		$	37,120
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		28,160			24,002
Amortization		7,718			3,514
Changes in fair value of derivative instruments		496			3,702
Provision for bad debts		1,469			1,136
Stock-based compensation expense		5,009			3,236
Excess tax benefits related to stock-based compensation		(2,830	)		(445	)
Loss on disposition of equipment		985			13
Deferred income taxes, net		1,204			3
Changes in assets and liabilities, net of effects of business acquisitions:
Accounts receivable		(23,098	)		(9,464	)
Inventories		(45,748	)		(23,242	)
Other receivables		2,615			(947	)
Prepaid expenses and other current assets		(1,279	)		(897	)
Deposits and other assets		(1,987	)		(1,783	)
Accounts payable		766			(1,067	)
Accrued expenses and other current liabilities		8,033			16,814
Income taxes payable/receivable		7,218			2,271

Net cash provided by operating activities		39,622			53,966

Cash Flows from Investing Activities
Acquisitions of businesses, net of cash acquired		(131,679	)		(83,157	)
Purchases of property and equipment		(55,711	)		(33,001	)
Proceeds from sales of property and equipment		389			193
Other assets		(391	)		559

Net cash used in investing activities		(187,392	)		(115,406	)

Cash Flows from Financing Activities
Proceeds from bank borrowings		293,006			189,180
Repayment of bank borrowings		(126,547	)		(170,618	)
Principal payments on long-term debt		(8,732	)		(1,139	)
Exercise of stock options		7,803			2,322
Excess tax benefits related to stock-based compensation		2,830			445
Repurchase of common shares		—			(10,351	)
Payment of cash dividends		—			(19	)

Net cash provided by financing activities		168,360			9,820

Effect of exchange rate changes on cash		1,774			178


Net increase (decrease) in cash and cash equivalents		22,364			(51,442	)
Cash and cash equivalents, beginning of period		31,313			82,157

Cash and cash equivalents, end of period	$	53,677		$	30,715

See accompanying notes to condensed consolidated financial statements.

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 1 — Basis of Presentation and Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Oakley, Inc. and its subsidiaries (Oakley or the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the United States Securities and Exchange Commission (SEC). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

In the opinion of management, the unaudited condensed consolidated financial statements contain all adjustments, consisting of adjustments of a normal recurring nature necessary to present fairly the Company’s financial position, results of operations, comprehensive income and cash flows. The results of operations for the interim periods are not necessarily indicative of the results of operations that may be expected for a full year. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

Recent Accounting Pronouncements

Effective January 1, 2007, the Company adopted Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 provides guidance on the recognition and measurement in financial statements of uncertain tax positions taken in tax returns previously filed or expected to be taken in tax returns. FIN 48 requires that the financial statement effects of a tax position be recognized when it is more likely than not that, based on the technical merits, the position will be sustained upon examination. A tax position that meets the more-likely-than-not recognition threshold shall initially and subsequently be measured as the largest amount of tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. Through December 31, 2006, the Company evaluated contingent gains and losses associated with uncertain tax positions in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, “Accounting for Income Taxes” and SFAS No. 5, “Accounting for Contingencies.” See Note 6.

Net Income Per Share

Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common shares outstanding, including the dilutive effect of potential common shares outstanding. The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share data):


	Three months ended September 30,				Nine months ended September 30,
	2007		2006		2007			2006
Net income	$	23,696	$	17,342	$	50,891		$	37,120


Weighted-average shares outstanding:
Basic		69,074		68,267		68,808			68,431
Effect of dilutive securities		1,230		560		1,100			586

Diluted		70,304		68,827		69,908			69,017


Net income per share:
Basic	$	0.34	$	0.25	$	0.74		$	0.54
Effect of dilutive securities		—		—		(0.01	)		—

Diluted	$	0.34	$	0.25	$	0.73		$	0.54

For the three months ended September 30, 2007 and 2006, options to purchase an aggregate of 53,000 and 1.2 million shares of common stock, respectively, were excluded from computation of diluted earnings per share because their effect would be antidilutive. For the nine months ended September 30, 2007 and 2006, options to purchase an aggregate of 0.4 million and 1.2 million shares of common stock, respectively, were excluded from computation of diluted earnings per share because their effect would be antidilutive.

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

Supplemental Cash Flow Information

Interest paid for the nine months ended September 30, 2007 and 2006 was $9.4 million and $2.3 million, respectively. Income taxes paid, net of refunds received, for the nine months ended September 30, 2007 and 2006 were $16.0 million and $16.7 million, respectively.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current period presentation.

Note 2 — Agreement and Plan of Merger

On June 20, 2007, Oakley entered into an Agreement and Plan of Merger (the Merger Agreement) with Luxottica Group S.p.A., an Italian corporation (Luxottica), and Norma Acquisition Corp., a Washington corporation and an indirect wholly owned subsidiary of Luxottica formed for the purpose of effecting the transactions contemplated by the Merger Agreement (Merger Sub), by which Luxottica has agreed to acquire Oakley (the Merger). The Merger Agreement has been adopted by the Boards of Directors of Oakley, Luxottica and Merger Sub.

Subject to the terms and conditions of the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of common stock of Oakley will be converted into the right to receive $29.30 per share in cash without interest (the Merger Price), and each outstanding option, whether or not vested, will be converted into the right to receive the Merger Price less the applicable option exercise price of such option for each share of common stock underlying such option. Shares of restricted stock shall vest at the effective time of the Merger and will also be converted into the right to receive the Merger Price.

On October 17, 2007, the Company filed with the SEC definitive proxy materials relating to a special meeting of the Company’s shareholders, held on November 7, 2007, to consider and vote upon a proposal to approve the Merger Agreement and the Merger. At the special meeting, the Merger Agreement and the Merger were approved by the affirmative vote of holders of two-thirds of the outstanding shares of the Company’s common stock.

In addition to the required shareholder approval discussed above, the Merger is conditioned upon the completion of the review and clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the HSR Act), and by the Committee on Foreign Investment in the United States (CFIUS) pursuant to the requirements of the 1988 Exon-Florio provision (Exon-Florio) of the Defense Production Act of 1950, as amended, and clearance under the antitrust, trade regulation or competition laws of the United Kingdom, Germany, Australia and South Africa. Early termination of the applicable waiting period under the HSR Act was granted on August 24, 2007 and clearance was obtained in Germany on August 28, 2007, in the United Kingdom on October 12, 2007 and in Australia on October 15, 2007. The Company filed for approval under Exon-Florio on August 16, 2007 and received approval from CFIUS on September 17, 2007.

The Merger Agreement contains certain termination rights for both Oakley and Luxottica. The Merger Agreement provides that, under certain circumstances, Oakley must pay Luxottica a termination fee of $69.0 million (generally in the event the Board of Directors of Oakley changes its recommendation that Oakley shareholders approve the principal terms of the Merger Agreement and the Merger or elects to pursue a superior acquisition proposal from a third party). The Merger Agreement also obligates Merger Sub to pay Oakley a termination fee of $80.0 million under separate sets of circumstances where there has been a failure to obtain certain antitrust regulatory clearances.

Concurrently with the execution of the Merger Agreement, Luxottica and Merger Sub entered into a voting agreement (the Voting Agreement) with Jim Jannard, Chairman of the Board of Directors and majority shareholder of Oakley, pursuant to which Mr. Jannard agreed to vote his shares of Oakley common stock in favor of the Merger and the approval and adoption of the Merger Agreement. On November 7, 2007, Oakley’s shareholders approved the Merger and the Merger Agreement.

Concurrently with the execution of the Merger Agreement, Luxottica, Merger Sub and the Company entered into a Non-Competition Agreement (the Non-Competition Agreement) with Jim Jannard, pursuant to which Mr. Jannard has agreed not to participate, directly or indirectly, in specified activities considered to be in competition with Oakley or any of its subsidiaries for a period of five years, subject to certain exceptions.

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 3 — Stock-Based Compensation

The Company accounts for awards of stock-based compensation to employees under the fair-value method required by SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). The fair value of each award of stock-based compensation is measured at the date of grant. Stock-based compensation awards generally vest over time, subject to continued service to the Company and/or the satisfaction of certain performance conditions. The Company recognizes the estimated fair value of employee stock options over the service period using the straight-line method. The amount of compensation expense recognized is based upon the number of awards that are expected to vest and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company estimates applicable forfeiture rates based upon the characteristics of the awards and past experience.

Total stock-based compensation expense was recorded as follows (in thousands):


	Three months ended September 30,				Nine months ended September 30,
	2007		2006		2007		2006
Cost of goods sold	$	198	$	117	$	524	$	322
Research and development		249		130		676		375
Selling		281		172		756		476
Shipping and warehousing		4		4		10		8
General and administrative		1,071		666		3,043		2,055

	$	1,803	$	1,089	$	5,009	$	3,236

No adjustment has been made to stock-based compensation expense for the three months or nine months ended September 30, 2007 for any modifications to stock-based compensation awards that may occur upon the completion of the Merger.

Stock Option Valuation

The Company estimates the grant date fair value of stock options using a binomial option-pricing model. The expected volatility is based on a weighted average of historical and implied volatility from traded options on the Company’s stock as the Company believes that implied volatility is more reflective of market conditions and a better indicator of expected volatility than historical volatility. The risk-free interest rate derives implied forward rates from U.S. treasury zero-coupon issues. Yearly cash flows corresponding to each year of the contractual term of the option are then discounted by the resultant implied forward rate. The expected dividend yield is estimated based on historical experience and expected future changes. Actual future dividends, if any, are at the discretion, and subject to the approval, of the Company’s board of directors.

The binomial model also incorporates assumptions of expected stock option exercise behavior and expected cancellations of vested stock options due to employee terminations. The Company bases these assumptions on an analysis of historical data and other available information. The expected life of stock options granted is derived from the output of the binomial model and represents the period of time that options granted are expected to be outstanding. The following table summarizes the weighted-average assumptions used to estimate the fair value of stock options and the resulting fair values of stock option awards:


	Nine months ended September 30,
	2007			2006
Weighted-average fair value of options granted	$	7.56		$	5.76
Weighted-average assumptions:
Expected volatility		31.6	%		34.6	%
Expected term	6.3 years			6.5 years
Risk-free interest rate		4.6	%		5.0	%
Dividend yield		1.0	%		1.0	%

1995 Stock Incentive Plan

The Company’s 1995 Stock Incentive Plan, as amended (the Plan) provides for stock-based incentive awards, including incentive stock options, nonqualified stock options, restricted stock, performance shares, stock appreciation rights and deferred stock to Company officers, employees, advisors and consultants. The Compensation and Stock Option Committee of the Board of Directors administers the Plan and has the authority to determine the

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

employees to whom awards will be made, the amount of the awards and the other terms and conditions of the awards. At September 30, 2007, approximately 3.0 million shares were available for issuance under the Plan. The Company issues new shares upon the exercise of stock options or the granting of restricted stock.

Stock Option Awards

Stock options are granted at an exercise price equal to the closing market price of the Company’s common stock on the date of grant. These options vest over periods ranging from one to five years and expire ten years after the grant date. Stock option activity for the nine months ended September 30, 2007 is as follows (shares in thousands):


				Weighted-		Weighted- average
	Number			average		remaining contractual
	of shares			exercise price		term (years)
Outstanding at January 1, 2007		3,733		$	14.37
Granted		530			20.95
Exercised		(619	)		12.61
Forfeited/expired		(64	)		15.06

Outstanding at September 30, 2007		3,580			15.64		6.7

Vested at September 30, 2007 or expected to vest in the future		3,399			15.54		6.6

Exercisable at September 30, 2007		1,847			14.14		5.0

Unrecognized compensation expense related to stock options, totaling $8.3 million as of September 30, 2007, is expected to be recognized over a weighted-average period of 3.4 years. The aggregate intrinsic value of options outstanding and options exercisable as of September 30, 2007 was $47.9 million and $27.5 million, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2007 and 2006 was $8.1 million and $1.4 million, respectively. Cash proceeds from the exercise of stock options during the nine months ended September 30, 2007 and 2006 totaled $7.8 million and $2.3 million, respectively. The actual tax benefit realized for stock-based compensation arrangements during the nine months ended September 30, 2007 and 2006 was $3.7 million and $1.2 million, respectively.

Restricted Stock Awards

The Company also grants restricted stock awards under the Plan. Restricted stock awards are subject to time-based vesting and are subject to forfeiture if employment terminates prior to the end of the service period. Holders of restricted stock awards are entitled to vote their respective shares throughout the restriction period and, upon vesting, are entitled to payment of any cash dividends from the grant date. Restricted stock activity for the nine months ended September 30, 2007 is as follows (shares in thousands):


				Weighted-
				average
	Number			grant date
	of shares			fair value
Nonvested shares at January 1, 2007		463		$	15.76
Granted		124			23.78
Vested		(59	)		16.52
Forfeited		(8	)		19.51

Nonvested shares at September 30, 2007		520			17.53

Unrecognized compensation expense related to restricted stock awards, totaling $5.7 million at September 30, 2007, is expected to be recognized over a weighted-average period of 1.9 years. The total fair value of shares vested during the nine months ended September 30, 2007 and 2006 was $1.0 million and $1.8 million, respectively.

Performance Unit Awards

During the nine months ended September 30, 2007, the Company awarded an aggregate of 130,697 performance units to certain executive officers and management. The performance units were issued under the Plan and constitute shares of deferred stock as defined therein. Each performance unit represents the right to receive up to 2.7 shares of the Company’s common stock. The actual number of shares to which each holder of a performance unit will ultimately be entitled, if any, is dependent upon the attainment of certain specified levels of earnings per share and return on invested capital through fiscal 2008. The performance unit awards are subject to forfeiture if employment terminates prior to the end of the service period, or if the prescribed performance criteria are not met. Performance unit awards are valued at the grant date based upon the closing market price of the Company’s common stock and

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

the fair value of each award is charged to expense over the service period. No performance units vested during the nine months ended September 30, 2007. An aggregate of 128,035 performance units are outstanding at September 30, 2007. Unrecognized compensation expense related to performance unit awards, totaling $3.3 million at September 30, 2007, is expected to be recognized over a weighted-average period of 2.2 years.

Note 4 — Acquisitions

Eye Safety Systems, Inc.

On January 12, 2007, the Company acquired substantially all of the assets of Eye Safety Systems, Inc. (ESS). ESS designs, develops and markets advanced eye protection systems for military, firefighting and law enforcement professionals and is a leading supplier of protective eyewear to the U.S. military and firefighting markets. The purchase price of approximately $114.4 million consisted of cash consideration of $110.7 million and $3.7 million in transaction costs. Of the cash consideration, $10.0 million was placed in escrow for the satisfaction of contingent indemnification obligations. The Company funded the acquisition of ESS with borrowings under the $246.5 million multicurrency revolving credit facility (the Credit Agreement) with JPMorgan Chase Bank, N.A., as Administrative Agent, and a syndicate of lenders. The Company expects the acquisition of ESS will expand its product offerings in protective eyewear and provide increased distribution opportunities in the military, firefighting and law enforcement markets.

The assets and liabilities of ESS were recorded at estimated fair value as of the date of acquisition under the purchase method of accounting. The results of operations of ESS have been included in the Company’s condensed consolidated statement of operations beginning on the effective date of the acquisition. The following table summarizes the preliminary allocation of the purchase price to the fair values of the assets acquired and the liabilities assumed as of the date of acquisition (in thousands):


Accounts receivable	$	3,244
Inventory		922
Other current assets		160
Property and equipment		792
Identified intangible assets		63,665
Goodwill		46,833

Total assets acquired		115,616

Current liabilities		1,241

Net assets acquired	$	114,375

An independent appraisal was utilized to identify and estimate the fair values of the intangible assets acquired. The intangible assets acquired included customer relationships, technology, tradenames and an agreement not to compete. The acquired intangible assets are amortized on a straight-line basis over their estimated useful lives, ranging from five years to twenty years.

The Bright Eyes Group

On April 2, 2007, the Company acquired all of the capital stock of the Bright Eyes Group (Bright Eyes). Bright Eyes’ operations include wholesale, retail and franchise eyewear businesses in Australia. As of September 30, 2007, Bright Eyes operates 32 specialty eyewear retail locations in addition to over 100 locations operated by franchisees. The purchase price of approximately $15.4 million consisted of cash consideration of $15.1 million and $0.3 million in transaction costs. The Company funded the acquisition of Bright Eyes with borrowings under the Credit Agreement. The Company expects this acquisition will expand its retail and wholesale distribution capabilities in the South Pacific region.

The assets and liabilities of Bright Eyes were recorded at estimated fair value as of the date of acquisition under the purchase method of accounting. The results of operations of Bright Eyes have been included in the Company’s condensed consolidated statement of operations beginning on the effective date of the acquisition.

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

The following table summarizes the preliminary allocation of the purchase price to the fair values of the assets acquired and the liabilities assumed as of the date of acquisition (in thousands):


Cash	$	953
Accounts receivable		888
Inventory		2,137
Other current assets		750
Property and equipment		1,283
Identified intangible assets		5,253
Goodwill		8,852

Total assets acquired		20,116

Current liabilities		2,563
Long-term liabilities		572
Deferred income tax liability		1,535

Net assets acquired	$	15,446

This preliminary purchase price allocation is subject to revision upon the completion of the Company’s estimates of the fair values of assets acquired and liabilities assumed, including an independent appraisal to identify and estimate the fair values of the intangible assets acquired. The intangible assets acquired included franchises, customer relationships, tradenames and leasehold interests. The acquired tradenames were determined to have an indefinite life and are not being amortized, but will be subject to periodic impairment testing. All other acquired intangible assets are amortized on a straight-line basis over their estimated useful lives ranging from approximately three years to seven years.

Supplemental Pro Forma Information

The financial information below summarizes the combined results of operations of the Company, ESS and Bright Eyes, on a pro forma basis, as though the acquisitions of ESS and Bright Eyes had been completed as of the beginning of each period presented. This pro forma financial information is presented for informational purposes only and is not necessarily indicative of the results of operations that would have been achieved had the acquisition taken place at such dates (in thousands, except per share amounts).


	Three months ended September 30,				Nine months ended September 30,
	2007		2006		2007		2006
Pro forma net sales	$	263,789	$	226,499	$	730,753	$	607,337
Pro forma net income		23,696		20,478		51,079		44,102
Pro forma basic net income per share	$	0.34	$	0.30	$	0.74	$	0.64
Pro forma diluted net income per share	$	0.34	$	0.30	$	0.73	$	0.64

The pro forma results of operations include the results of the Company combined with the separate, pre-acquisition results of operations of ESS and Bright Eyes. The pro forma results also include amortization of acquired intangible assets for the periods prior to the dates of acquisition.

Note 5 — Supplemental Financial Statement Data

Inventories

Inventories consist of the following (in thousands):


	September 30,		December 31,
	2007		2006
Raw materials	$	41,415	$	24,223
Finished goods		166,641		131,154

	$	208,056	$	155,377

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

Property and equipment

Property and equipment consists of the following (in thousands):


	September 30,			December 31,
	2007			2006
Land	$	8,953		$	8,953
Buildings and improvements		79,834			72,251
Leasehold improvements		83,370			64,183
Equipment and furniture		261,840			232,484
Tooling		40,223			36,320

		474,220			414,191

Accumulated depreciation and amortization		(267,167	)		(236,791	)

	$	207,053		$	177,400

Intangible Assets

The Company tests goodwill and indefinite-lived intangible assets for impairment at least annually, and more frequently if an event occurs which indicates that the value of goodwill or indefinite-lived intangible assets may be impaired. The Company evaluates definite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. As of September 30, 2007, no events have occurred which indicate that goodwill or intangible assets may be impaired. Intangible assets consist of the following (in thousands):


	September 30, 2007					December 31, 2006
	Gross carrying		Accumulated			Gross carrying		Accumulated
	amount		amortization			amount		amortization
Definite-lived intangible assets:
Covenants not to compete	$	10,426	$	(6,427	)	$	7,102	$	(4,943	)
Distribution rights		3,567		(2,728	)		3,567		(2,532	)
Patents		4,361		(3,298	)		4,359		(2,849	)
Customer relationships		60,694		(3,470	)		16,020		(728	)
Sub-licenses		1,300		(217	)		1,300		(119	)
Trade name		8,935		(990	)		1,235		(240	)
Technology		9,600		(988	)		—		—
Other		12,266		(2,916	)		9,234		(1,904	)

	$	111,149	$	(21,034	)	$	42,817	$	(13,315	)


Indefinite-lived intangible assets:
Trade names	$	25,457				$	22,800

Intangible assets, other than goodwill and indefinite-lived intangible assets, are amortized over estimated useful lives principally ranging from five years to twenty years, with no residual values. The weighted-average useful life of intangible assets is approximately 8.4 years. Amortization expense for the nine months ended September 30, 2007 and 2006 was approximately $7.7 million and $3.5 million, respectively. Estimated annual amortization expense by fiscal year, based on the Company’s intangible assets at September 30, 2007, is as follows (in thousands):


	Estimated amortization
	expense
Fiscal 2007	$	10,369
Fiscal 2008		9,801
Fiscal 2009		9,001
Fiscal 2010		8,716
Fiscal 2011		8,318
Thereafter		51,628

Goodwill

Changes in goodwill are as follows (in thousands):


	Wholesale		U. S. Retail
	Segment		Segment			Total
Balance, December 31, 2006	$	37,344	$	27,308	$	64,652
Goodwill additions		58,816		1,276		60,092
Foreign currency translation adjustments		2,811		—		2,811

Balance, September 30, 2007	$	98,971	$	28,584	$	127,555

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities consist of the following (in thousands):


	September 30,		December 31,
	2007		2006
Accrued employee compensation and benefits	$	28,850	$	24,197
Derivative financial instruments		2,343		674
Other liabilities		38,929		32,373

	$	70,122	$	57,244

Accrued Warranty

Warranty liability activity was as follows (in thousands):


	Nine months ended September 30,
	2007			2006
Warranty liability, beginning of period	$	3,153		$	3,068
Provision for warranty expense		1,692			2,965
Warranty claims and costs		(1,696	)		(2,884	)
Changes due to foreign currency translation		(23	)		14

Warranty liability, end of period	$	3,126		$	3,163

Comprehensive Income

The components of accumulated other comprehensive income, net of tax, are as follows (in thousands):


	September 30,			December 31,
	2007			2006
Unrealized gains (losses) on derivative financial instruments	$	(1,387	)	$	(810	)
Foreign currency translation adjustments		25,510			12,180

	$	24,123		$	11,370

Note 6 — Income Taxes

Effective January 1, 2007, the Company adopted FIN 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” Upon adoption of FIN 48, the Company recorded additional income tax liabilities of $14.4 million, additional deferred income tax assets of $6.1 million and a charge against retained earnings of approximately $8.3 million representing the cumulative effect of the change in accounting principle. As of January 1, 2007, unrecognized income tax benefits totaled approximately $16.1 million. Of that amount, approximately $10.0 million (net of the federal benefit on state income tax matters) represents the amount of unrecognized tax benefits that would, if recognized, favorably affect the Company’s effective income tax rate in any future periods.

The Company and its subsidiaries are subject to U.S. federal, state, local and/or foreign income tax, and in the normal course of business its income tax returns are subject to examination by the relevant taxing authorities. While specific matters discussed below are currently under appeal, the Company has concluded all U.S. federal income tax examinations for years through 2001. Substantially all material state and local income tax matters have been concluded for years through 2000. Major foreign jurisdictions include Brazil, France, Japan and the United Kingdom. Substantially all material foreign income tax matters have been concluded for years through 2001.

On August 2, 2004, the Internal Revenue Service (IRS) notified the Company of a proposed audit adjustment related to advance payment transactions executed in December 2000 with its foreign sales corporation, Oakley International Inc., and two wholly owned foreign subsidiaries, Oakley U.K. Ltd. and Oakley Holding S.A.S. This proposed adjustment resulted from the IRS audit for the tax years ended December 31, 2000 and 2001. The proposed adjustment could result in the payment of taxes and penalties (exclusive of interest) totaling approximately $11.2 million. The Company continues to protest this proposed adjustment with the IRS and intends to continue to assert and defend its position through applicable IRS administrative and/or judicial procedures.

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

The resolution of tax matters such as this is subject to a number of risks beyond the Company’s control, including that the IRS or others may interpret applicable tax laws or regulations in a manner that is adverse to the Company during the appeals process or that the courts may rule against the Company in any judicial proceedings. Considering these risks, and based upon analysis of the tax laws and other relevant factors, it is reasonably possible that the amount of the related unrecognized income tax benefits could differ significantly from the Company’s estimate. However, it is not possible to estimate the amount of any such changes to previously recorded liabilities for such uncertain tax positions. In the event that the Company does not prevail, it expects that the proposed adjustment should not have a material impact on its consolidated financial position because the Company has insurance in place that it believes will cover such adjustment and associated expenses.

In March 2007, the Company was notified of the resolution of a state income tax matter which resulted in the recognition of approximately $1.1 million of previously unrecognized income tax benefits, which reduced the provision for income taxes for the nine months ended September 30, 2007. As of September 30, 2007, unrecognized income tax benefits totaled approximately $17.2 million.

Estimated interest and penalties related to the underpayment of income taxes are included in income tax expense and totaled $1.0 million for the nine months ended September 30, 2007; no such amounts were recorded in the nine months ended September 30, 2006. Accrued interest and penalties were $4.1 million and $5.1 million as of January 1, 2007 and September 30, 2007, respectively.

Note 7 — Commitments and Contingencies

Indemnities, Commitments and Guarantees

In the normal course of business, the Company has made certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include indemnities to the Company’s customers in connection with the sales of its products, indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease, indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Washington, and routine guarantees between the Company and its subsidiaries. At September 30, 2007, the Company has outstanding letters of credit totaling $2.1 million for product purchases and as security for contingent liabilities under certain workers’ compensation insurance policies. The durations of these indemnities, commitments and guarantees vary. Some of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. It is not possible to determine the maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Historically, payments made related to these indemnifications have been immaterial. At September 30, 2007, the Company has determined that no liability is necessary related to these indemnities, commitments and guarantees.

Litigation

In January 2007, a class action complaint was filed against the Company in the Central District of the United States District Court of California, alleging willful violations of The Fair Credit Reporting Act related to the inclusion of credit card expiration dates on sales receipts. This complaint has not been granted class action status. The Company believes the allegations are without merit and intends to vigorously defend itself against this matter.

On June 26, 2007, Pipefitters Local No. 636 Defined Benefit Plan filed a purported class action complaint, Case No. 07CC01306, in the Superior Court of California, County of Orange, on behalf of itself and all other shareholders of Oakley except those named as defendants and any person, firm, trust, corporation or other entity related to or affiliated with any defendant, against Oakley and each of its directors (Defendants). The complaint alleges, among other things, that Defendants violated their fiduciary duties to shareholders by approving a transaction with Luxottica and claims that the price per share fixed by the Merger Agreement is inadequate and unfair. The complaint seeks, among other things, (1) class action status; (2) to enjoin the Defendants from consummating the proposed Merger; (3) to declare that the Merger Agreement was entered into in breach of Defendants’ fiduciary duties; (4) to rescind, to the extent already implemented, the proposed Merger; and (5) to award plaintiffs the costs and disbursements of the action, including reasonable attorneys’ and experts’ fees.

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

On July 30 and July 31, 2007, Defendants filed demurrers to the complaint. On August 30, 2007, the Court sustained Defendants’ demurrers and granted plaintiff 15 days’ leave to amend. On September 14, 2007, the plaintiff filed an amended complaint, seeking the same relief as the original complaint. The amended complaint contains similar allegations as the original complaint and also adds allegations for breach of fiduciary duty based on a purported failure to disclose certain information in the Company’s preliminary proxy statement filed with the SEC on September 7, 2007 in connection with the Merger. On October 9, 2007, Defendants filed a demurrer to the amended complaint, which is currently scheduled to be heard by the Superior Court on December 13, 2007. The Company believes that the allegations are without merit and intends to vigorously defend this action.

The Company is also a party to various claims, complaints and other legal actions that arise from time to time in the normal course of business. The outcome of such matters cannot be predicted with certainty and some claims, complaints or other legal actions may be disposed of unfavorably to the Company. Based on its evaluation of the relevant facts and circumstances of matters that are pending or asserted, management believes the disposition of these matters, individually and in the aggregate, will not have a material adverse effect on its financial condition or results of operations.

Note 8 — Derivative Financial Instruments

The Company is exposed to gains and losses that result from the effect of changes in foreign currency exchange rates on foreign currency denominated transactions and transactions of its international subsidiaries. As part of its strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, the Company and its subsidiaries use derivative financial instruments in the form of foreign currency forward contracts and foreign currency option contracts.

The Company accounts for derivative instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” All derivative instruments, whether designated as cash flow hedges or not, are recorded on the balance sheet at fair value. The accounting for changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation.

Cash Flow Hedges

The Company’s foreign exchange contracts are principally designated as cash flow hedges. For all derivatives designated as cash flow hedges, changes in the fair value of the derivative are initially recorded in accumulated other comprehensive income. The gains or losses that arise under these derivatives are recognized in earnings in the period in which the hedged item is also recognized in earnings. Any gains or losses from the ineffective portion of the derivative are reported in earnings immediately. The Company is currently hedging forecasted foreign currency transactions that could result in the recognition of $2.2 million of losses over the next twelve months.

On the date the Company enters into a derivative contract, management designates the derivative as a hedge of an identified exposure. The Company formally documents all relationships between hedging instruments and hedged items, as well as the risk-management objective and strategy for undertaking various hedge transactions. In this documentation, the Company specifically identifies the asset, liability, firm commitment or forecasted transaction that has been designated as a hedged item and states how the hedging instrument is expected to hedge the risks related to the hedged item. The Company formally measures effectiveness of its hedging relationships both at the hedge inception and on an ongoing basis in accordance with its risk management policy. The Company would discontinue hedge accounting prospectively (i) if it is determined that the derivative is no longer effective in offsetting changes in the cash flows of a hedged item, (ii) when the derivative expires or is sold, terminated, or exercised, (iii) when the derivative is no longer designated as a hedge instrument, because it is probable that the forecasted transaction will not occur, (iv) because a hedged firm commitment no longer meets the definition of a firm commitment, or (v) if management determines that designation of the derivative as a hedge instrument is no longer appropriate. During the nine months ended September 30, 2007, the Company recognized losses of $2.4 million resulting from the expiration, sale, termination or exercise of derivatives designated as cash flow hedges; no such gains or losses were recognized during the nine months ended September 30, 2006.

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

The following is a summary of the foreign exchange contracts (to purchase U.S. dollars for the respective foreign currencies) designated as cash flow hedges outstanding at September 30, 2007 (in thousands):


			Weighted-average
	U.S. Dollar		rate per			Fair Value
Currency	Equivalent		US $1.00		Maturity Dates	Gain (Loss)
British pound	$	17,671		0.5090	Oct. 2007 – Oct. 2008	$	(625	)
Canadian dollar		15,651		1.0310	Oct. 2007 – Jun. 2008		(588	)
Euro		17,296		0.7450	Oct. 2007 – Dec. 2008		(1,115	)
Japanese yen		18,105		112.1250	Oct. 2007 – Mar. 2009		(15	)

	$	68,723				$	(2,343	)

Other Derivatives

Derivatives not qualifying as hedges are recorded at fair value, and changes in the fair value of such derivatives are included in cost of goods sold in the consolidated statements of operations each period. For the nine months ended September 30, 2006, losses resulting from changes in the fair value of such derivatives of $3.7 million are included in cost of goods sold; no such gains or losses were recognized during the nine months ended September 30, 2007. As of September 30, 2007, the Company held no foreign exchange contracts not designated as hedges.

The Company has exposure to credit losses in the event of nonperformance by counterparties to its derivative contracts but has no off-balance sheet credit risk of accounting loss. To mitigate such credit risks, the Company enters into derivative financial instruments with counterparties who are leading global financial institutions. The Company anticipates that the counterparties will be able to fully satisfy their obligations under the contracts. The Company does not obtain collateral or other security to support the derivative contracts subject to credit risk, but monitors the credit standing of the counterparties.

Note 9 — Related Party Information

During the nine months ended September 30, 2007 and 2006, the Company paid approximately $139,000 and $65,000, respectively, to N2T, Inc., an Oregon corporation owned by Jim Jannard, Chairman of the Board of Oakley, for the rental and maintenance of an aircraft. During the nine months ended September 30, 2007 and 2006, the Company incurred approximately $319,000 and $554,000, respectively, in costs and expenses associated with the aircraft, net of amounts reimbursed by Mr. Jannard and his affiliates of approximately $1.4 million and $1.1 million, respectively, for operating costs related to use of the aircraft unrelated to the Company’s business.

Certain of the Company’s employees perform services for Red.com, Inc. (Red), a company owned by Mr. Jannard. Red reimburses the Company for such services at an hourly rate that the Company believes approximates fair market value. The Company also incurs other costs on Red’s behalf, for which Red reimburses the Company at cost. The aggregate amount billed to Red by the Company for costs incurred and services rendered during the nine months ended September 30, 2007 was approximately $465,000; no amounts were billed to Red for the nine months ended September 30, 2006. The Company periodically incurs other costs on Mr. Jannard’s behalf for various matters unrelated to the Company’s business. Mr. Jannard and Red maintain deposits with the Company to prepay any such items that are replenished on a periodic basis as needed. As of September 30, 2007 and December 31, 2006, the Company’s net liability to Mr. Jannard and Red for such deposits was approximately $287,000 and $177,000, respectively.

In September 2007, the Company’s Board of Directors, upon the recommendation of the Company’s Audit Committee, approved a Shared Services Agreement between the Company and Red (the Agreement). Under the Agreement, the Company will provide to Red, from time to time, defined, agreed-upon services of certain of the Company’s employees at a fair market value hourly rate. In addition, Red agreed to reimburse the Company at cost for all other out-of-pocket costs incurred by the Company on behalf of Red. Furthermore, Red agreed to maintain a deposit with the Company to prepay any costs incurred, which deposit shall be replenished on an as needed basis. The term of the Agreement is for one year from September 20, 2007 and shall automatically be renewed for additional one year terms unless terminated at any time, including within the first year, by either party, with or without cause, pursuant to thirty days written notice.

Oakley, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 10 — Segment Information

The Company’s operations consist of two reportable segments: wholesale and U.S. retail. The wholesale segment consists of the design, manufacture and distribution of the Company’s products to wholesale customers in the United States and abroad and retail operations outside the United States. The U.S. retail segment consists of the Company-owned specialty retail stores, Internet sales and telesales operations within the United States. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates segment performance and allocates resources to segments based on net sales and operating income, which represents income before interest and income taxes. Segment net sales and operating income of the Company’s wholesale segment include Oakley product sales to its subsidiaries at transfer price and other intercompany corporate charges. Such transfer prices do not necessarily reflect arms-length pricing between the segments. The U.S. retail segment operating income excludes any allocations for corporate operating expenses as these expenses are included in the wholesale segment. Financial information for the Company’s reportable segments is as follows (in thousands):


	Wholesale		U.S. Retail		Consolidated
Three months ended September 30, 2007:
Net sales to external customers	$	200,484	$	63,305	$	263,789
Intersegment sales		11,204		—		11,204
Operating income		26,939		13,890		40,829
Acquisitions of property and equipment		12,036		8,585		20,621
Depreciation and amortization		9,310		2,995		12,305

Three months ended September 30, 2006:
Net sales to external customers	$	163,396	$	46,823	$	210,219
Intersegment sales		11,132		—		11,132
Operating income		16,494		9,583		26,077
Acquisitions of property and equipment		7,265		6,032		13,297
Depreciation and amortization		7,036		2,480		9,516

Nine months ended September 30, 2007:
Net sales to external customers	$	554,978	$	171,137	$	726,115
Intersegment sales		31,747		—		31,747
Operating income		54,747		33,181		87,928
Acquisitions of property and equipment		34,947		20,764		55,711
Depreciation and amortization		27,398		8,480		35,878

Nine months ended September 30, 2006:
Net sales to external customers	$	443,918	$	121,583	$	565,501
Intersegment sales		26,123		—		26,123
Operating income		33,063		23,903		56,966
Acquisitions of property and equipment		18,908		14,093		33,001
Depreciation and amortization		21,975		5,541		27,516

Identifiable assets as of September 30, 2007	$	754,392	$	146,315	$	900,707
Identifiable assets as of December 31, 2006		508,886		124,948		633,834

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This information should be read in conjunction with our unaudited condensed consolidated financial statements and the notes thereto included in this Quarterly Report and our audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2006.

Overview

Oakley is a worldwide leader in the design, development, manufacture, distribution and worldwide marketing of performance optics products including market-leading, premium sunglasses, prescription eyewear, goggles, and electronically enabled eyewear. In addition to Oakley ^® -branded optics products, our eyewear portfolio also includes the Dragon ^® , Eye Safety Systems ^® , Fox ^® , Mosley Tribes ^® , Oliver Peoples ^® , and Paul Smith ^® Spectacles brands. We also offer an array of Oakley-branded apparel, footwear, watches and accessories. We believe a principal strength is our ability to develop products that demonstrate superior performance and aesthetics through proprietary technology, manufacturing processes and styling. We manufacture or assemble the majority of our performance optics products at our manufacturing facility located at our headquarters in Foothill Ranch, California. We utilize third-party manufacturers located in the United States and abroad to produce our internally designed apparel, footwear, watches and accessories as well as our electronically enabled eyewear products and certain goggles.

In the United States, we distribute our products through a network of approximately 11,000 retail accounts, comprising approximately 15,600 locations. Our retail accounts are comprised of optical stores, sunglass retailers, department stores, sporting goods stores and specialty sports stores, including bike, surf, snow, skate, golf and motor sports stores. Our products are sold in more than 100 countries outside the United States. We sell our products through our subsidiaries in Australia, Brazil, Canada, France, Germany, Italy, Japan, Mexico, South Africa, Switzerland and the United Kingdom. In countries not serviced directly by us or our subsidiaries, Oakley products are sold through distributors who provide local expertise. These distributors sell our products either exclusively or with complementary products and agree to comply with our marketing philosophy and practices. Our optical lens laboratories in the United States, Japan and Ireland produce prescription eyewear products.

Our U.S. retail operations consist of Oakley, Sunglass Icon™, The Optical Shop of Aspen™ (OSA) and Oliver Peoples retail stores, as well as Internet and telesales operations. During the nine months ended September 30, 2007, we opened 26 new stores. In the United States, we operate 75 Oakley ^® Store retail locations, including 25 Oakley Vault ^® outlet stores, offering a full range of Oakley-branded products and 128 Sunglass Icon multi-branded sunglass specialty retail stores. OSA operates 21 luxury optical retail stores. Outside the United States, we operate an additional 22 Oakley ^® Store retail locations. In Australia, the Bright Eyes Group, which we acquired in April 2007, operates 32 specialty eyewear retail locations in addition to over 100 locations operated by franchisees. The following table summarizes the number of retail stores we operated as of the end of each period (excluding stores operated by others under license):


	September 30,		December 31,		September 30,
	2007		2006		2006
United States:
Oakley Stores		75		65		58
Sunglass Icon		128		121		115
Oliver Peoples		3		2		2
The Optical Shop of Aspen		21		20		18

		227		208		193

International:
Oakley Stores		22		15		10
Bright Eyes		32		—		—

		54		15		10

		281		223		203

Recent Developments

Agreement and Plan of Merger

On June 20, 2007, we entered into an Agreement and Plan of Merger (the Merger Agreement) with Luxottica Group S.p.A., an Italian corporation (Luxottica), and Norma Acquisition Corp., a Washington corporation and an indirect wholly owned subsidiary of Luxottica formed for the purpose of effecting the transactions contemplated by the

Merger Agreement (Merger Sub), by which Luxottica has agreed to acquire Oakley (the Merger). The Merger Agreement has been adopted by the Boards of Directors of Oakley, Luxottica and Merger Sub.

Subject to the terms and conditions of the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of our common stock will be converted into the right to receive $29.30 per share in cash without interest (the Merger Price), and each outstanding option, whether or not vested, will be converted into the right to receive the Merger Price less the applicable option exercise price of such option for each share of common stock underlying such option. Shares of restricted stock shall vest at the effective time of the Merger and will also be converted into the right to receive the Merger Price.

On October 17, 2007, we filed with the SEC definitive proxy materials relating to a special meeting of our shareholders, to be held on November 7, 2007, to consider and vote upon a proposal to approve the Merger Agreement and the Merger. At the special meeting, the Merger Agreement and the Merger were approved by the affirmative vote of holders of two-thirds of the outstanding shares of our common stock.

In addition to the required shareholder approval discussed above, the Merger is conditioned upon the completion of the review and clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the HSR Act), and by the Committee on Foreign Investment in the United States (CFIUS) pursuant to the requirements of the 1988 Exon-Florio provision (Exon-Florio) of the Defense Production Act of 1950, as amended, and clearance under the antitrust, trade regulation or competition laws of the United Kingdom, Germany, Australia and South Africa. Early termination of the applicable waiting period under the HSR Act was granted on August 24, 2007 and clearance was obtained in Germany on August 28, 2007, in the United Kingdom on October 12, 2007 and in Australia on October 15, 2007. We filed for approval under Exon-Florio on August 16, 2007 and received approval from CFIUS on September 17, 2007.

The Merger Agreement contains certain termination rights for both us and Luxottica. The Merger Agreement provides that, under certain circumstances, we must pay Luxottica a termination fee of $69.0 million (generally in the event our Board of Directors changes its recommendation that our shareholders approve the principal terms of the Merger Agreement and the Merger or elects to pursue a superior acquisition proposal from a third party). The Merger Agreement also obligates Merger Sub to pay us a termination fee of $80.0 million under separate sets of circumstances where there has been a failure to obtain certain antitrust regulatory clearances.

Concurrently with the execution of the Merger Agreement, Luxottica and Merger Sub entered into a voting agreement (the Voting Agreement) with Jim Jannard, Chairman of the Board of Directors and majority shareholder of Oakley, pursuant to which Mr. Jannard agreed to vote his shares of Oakley common stock in favor of the Merger and the approval and adoption of the Merger Agreement. On November 7, 2007, our shareholders approved the Merger and the Merger Agreement.

Concurrently with the execution of the Merger Agreement, we, Luxottica and Merger Sub entered into a Non-Competition Agreement (the Non-Competition Agreement) with Jim Jannard, pursuant to which Mr. Jannard has agreed not to participate, directly or indirectly, in specified activities considered to be in competition with us or any of our subsidiaries for a period of five years, subject to certain exceptions.

Acquisitions

In February 2006, we acquired Oliver Peoples. Oliver Peoples designs, produces and sells luxury eyewear, primarily to wholesale accounts. Through this transaction, we acquired Oliver Peoples’ three eyewear brands: Oliver Peoples, Mosley Tribes, and the licensed Paul Smith Spectacles eyewear brand. In April 2006, we acquired OSA Holding, Inc. and its wholly owned subsidiary, The Optical Shop of Aspen (OSA). OSA operates 21 luxury optical retail stores as of September 30, 2007. Also during 2006, we acquired four independent optical retail stores in the United States and substantially all of the operations of our exclusive distributor in Switzerland. We expect these acquisitions to strengthen our capabilities in premium and luxury eyewear, provide growth opportunities within the optics category and complement our multi-branding strategy.

On January 12, 2007, we acquired substantially all of the assets of Eye Safety Systems, Inc. (ESS). ESS designs, develops and markets advanced eye protection systems for military, firefighting and law enforcement professionals

and is a leading supplier of protective eyewear to the U.S. military and firefighting markets. The purchase price of approximately $114.4 million consisted of cash consideration of $110.7 million and $3.7 million in transaction costs. Of the cash consideration, $10.0 million was placed in escrow for the satisfaction of contingent indemnification obligations. We funded the acquisition of ESS with borrowings under our $246.5 million multicurrency revolving credit facility (the Credit Agreement) with JPMorgan Chase Bank, N.A., as Administrative Agent, and a syndicate of lenders. We expect the acquisition of ESS will expand our product offerings in protective eyewear and provide increased distribution opportunities in the military, firefighting and law enforcement markets.

On April 2, 2007, we acquired all of the capital stock of the Bright Eyes Group (Bright Eyes). Bright Eyes’ operations include wholesale, retail and franchise eyewear businesses in Australia. As of September 30, 2007, Bright Eyes operates 34 specialty eyewear retail locations in addition to over 100 locations operated by franchisees. The purchase price of approximately $15.4 million consisted of cash consideration of $15.1 million and $0.3 million in transaction costs. We funded the acquisition of Bright Eyes with borrowings under the Credit Agreement. We expect this acquisition will expand our retail and wholesale distribution capabilities in the South Pacific region.

Footwear Restructuring

In June 2006, we approved a restructuring plan, under which we have restructured a significant portion of our footwear business. The restructuring included the discontinuance of a significant portion of our lifestyle footwear products. Under this restructuring plan, we have concentrated our footwear sales efforts principally on key accounts served by our internal sales force and narrowed our footwear reseller base. During the nine months ended September 30, 2006, we recorded charges totaling $3.4 million under the footwear restructuring plan. The charges included approximately $1.8 million for estimated sales returns and markdown allowances, which are included in net sales. Additional charges of approximately $1.5 million for write-downs of inventories and footwear-specific tooling, displays and equipment are included in cost of goods sold. The remainder of the charges (approximately $0.1 million), principally for employee separation costs, is included in operating expenses. The footwear restructuring plan was substantially completed in 2006 and we do not expect to record any additional charges in connection therewith.

Change in Accounting for Uncertain Tax Positions

Effective January 1, 2007, we adopted Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 provides guidance on the recognition and measurement in financial statements of uncertain tax positions taken in tax returns previously filed or expected to be taken in tax returns. FIN 48 requires that the financial statement effects of a tax position be recognized when it is more likely than not that, based on the technical merits, the position will be sustained upon examination. A tax position that meets the more-likely-than-not recognition threshold shall initially and subsequently be measured as the largest amount of tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. Through December 31, 2006, we evaluated contingent gains and losses associated with uncertain tax positions in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, “Accounting for Income Taxes” and SFAS No. 5, “Accounting for Contingencies.”

Upon adoption of FIN 48, we recorded additional income tax liabilities of $14.4 million, additional deferred income tax assets of $6.1 million and a charge against retained earnings of approximately $8.3 million, representing the cumulative effect of the change in accounting principle. As of January 1, 2007, unrecognized income tax benefits totaled approximately $16.1 million. Of that amount, approximately $10.0 million (net of the federal benefit on state income tax matters) represents the amount of unrecognized tax benefits that would, if recognized, favorably affect our effective income tax rate in any future periods.

The income tax assets and liabilities we recognize for uncertain tax positions will be adjusted when the related income tax liabilities are paid, the income tax positions are settled with the taxing authorities, the related statutes of limitations expire or under other circumstances as provided in FIN 48. Our assessment of uncertain tax positions requires that we make estimates and judgments about the application of tax law, the expected resolution of uncertain tax positions and other matters. In the event that uncertain tax positions are resolved for amounts different than our estimates, or the related statutes of limitations expire without our being assessed additional income taxes, we will be required to adjust the amounts of the related assets and liabilities in the period in which such events occur. Such adjustments may have a material impact on our provision for income taxes and our results of operations. FIN 48 also

requires that we recognize additional interest expense each period on the liabilities we have recognized for uncertain tax positions. We include interest and penalties associated with income tax liabilities in the provision for income taxes in our consolidated income statement.

Critical Accounting Policies

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America (GAAP) requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities as of the balance sheet dates and the reported amounts of revenues and expenses for each fiscal period. We regularly evaluate our estimates and assumptions based upon historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. To the extent actual results differ from those estimates, our future results of operations may be affected.

Revenue Recognition

We recognize wholesale revenue when the following criteria are met: (1) there is persuasive evidence of an arrangement with the customer; (2) the sales price is fixed or determinable; (3) merchandise is shipped and title and risk of loss have passed to the customer in accordance with the terms of sale; and (4) collection of the sales price is reasonably assured. We also license to third parties the rights to certain intellectual property and other proprietary information and recognize royalty revenues when earned. Generally, we extend credit to our wholesale customers and do not require collateral. We perform ongoing credit evaluations of our wholesale customers and, historically, credit losses have been insignificant and within our expectations.

Our standard sales agreements with wholesale customers do not provide for any rights of return by the customer, other than returns for product warranty related issues. In addition to these product warranty related returns, we may, at our discretion, accept other returns. We record a provision for estimated warranty related product returns based upon historical data. We record provisions for other returns or sales discounts based upon analysis of, and decisions made regarding, reseller inventories in the distribution channels. Actual returns and claims in future periods may differ from our estimates.

Our standard sales agreements with wholesale customers do not provide for price protection or margin guarantees. We have at times, and at our discretion, provided our wholesale customers with sales discounts or markdown allowances to assist the sell-through of their slow moving inventories. We record provisions for estimated sales discounts, markdown allowances, rebates and similar commitments based upon analysis of, and decisions made regarding, reseller inventories in the distribution channels.

We recognize revenue from our retail operations upon purchase by customers at the point of sale. We record a provision for estimated returns on retail sales based upon our historical experience. Sales taxes we collect from customers and remit to governmental agencies are excluded from net sales.

Inventory Sale and Purchase Transactions with the Same Third Party

In certain cases, in the electronically enabled eyewear category, we sell eyewear components to a third party electronics vendor and subsequently purchase from the same electronics vendor finished goods containing such eyewear components. The electronics vendor principally sells the finished goods through its distribution channels. We have the right, but no obligation, to purchase finished goods from the electronics vendor, at a defined price, for sale to our own wholesale and retail customers. The electronics vendor has no right to return eyewear components to us.

To the extent that we have purchased, or intend to purchase, finished goods from the electronics vendor, we defer the recognition of revenue on the sale of the eyewear components to the electronics vendor. If the actual amount of finished goods we purchase from the electronics vendor differs from our estimates, our net sales will be affected. Eyewear components sold to the electronics vendor that we expect to repurchase as part of finished goods are recorded on our balance sheet as consignment inventory held by the electronics vendor. Finished goods purchased from the electronics vendor are placed into our inventory at cost, calculated as the invoice value from the electronics vendor less our margin on the sale of the related eyewear components to such vendor. We recognize the sale of the finished goods, and relieve the related inventory, when we sell such finished goods to our wholesale or retail customers.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined using a first-in, first-out or moving average cost method; market is based upon estimated net realizable value. We regularly review inventory quantities on hand and write down any excess or obsolete inventories to net realizable value. The valuation of inventories at the lower of cost or market requires the use of estimates as to expected product demand, production requirements and selling prices. These estimates are dependent on our assessment of current and expected orders from our customers and other factors. Demand for our products can fluctuate significantly, and can be affected by a number of factors outside our control that may result in cancellations of advance orders or a reduction in the rate of reorders placed by retailers. If actual future product demand or market conditions are less favorable than our current expectations, additional inventory write-downs may be required.

Impairment of Goodwill and Long-Lived Assets

We continually monitor and review long-lived assets (including intangible assets) for impairment whenever events or changes in circumstances indicate that the carrying amount of any such asset may not be recoverable. The determination of recoverability is based on an estimate of the undiscounted cash flows expected to result from the use of an asset and its eventual disposition. If the sum of the undiscounted cash flows (excluding interest) is less than the carrying value, we recognize an impairment loss, measured as the amount by which the carrying value exceeds the fair value of the asset. Our estimates of the undiscounted cash flows used to assess impairment and the fair values of assets are dependent on assumptions and estimates we make about expected future operating performance, growth rates, the intended use of assets and other factors. Changes in our assumptions and estimates could have a significant impact on the amounts of any resulting impairment losses. Numerous factors, including changes in our business, industry segment or the global economy could also significantly impact our plans to retain, dispose of or idle certain of our long-lived assets.

We test goodwill and intangible assets with indefinite lives for impairment at least annually, using the fair value based test prescribed by SFAS No. 142, “Goodwill and Other Intangible Assets.” Fair value is determined based on estimated future cash flows, discounted at a rate that approximates our cost of capital. Our estimates of fair value and the amounts of any impairment losses are subject to the same assumptions and estimates discussed above. If our future operating performance, or the plans and estimates used in future impairment analyses, are lower than the estimates we have used to assess the potential impairment of these assets, we may be required to recognize impairment losses in the future.

Stock-Based Compensation

We account for stock-based compensation in accordance with SFAS No. 123 (revised 2004) “Share-Based Payment” (SFAS 123R). SFAS 123R requires that we account for all stock-based compensation transactions using a fair-value method and recognize the fair value of each award as an expense over the service period. The fair value of restricted stock awards and performance unit awards is based upon the market price of our common stock at the grant date. We estimate the fair value of stock option awards, as of the grant date, using a binomial option-pricing model. The use of a binomial model requires that we make a number of estimates, including expected stock option exercise behavior, expected option cancellations due to employee terminations, the expected volatility in the price of our common stock, the risk-free rate of interest and the dividend yield on our common stock. If our expectations of stock option exercise behavior, stock price volatility and other factors were different, the resulting determination of the fair value of stock option awards could be materially different. In addition, judgment is also required in estimating the number of share-based awards that we expect will ultimately vest upon the fulfillment of service conditions (such as time-based vesting) and the number of shares of our common stock that will be issuable upon the achievement of specific performance conditions applicable to the performance unit awards. If the actual number of awards that ultimately vest or the number of shares that are ultimately issuable differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.

Income Taxes and Uncertain Tax Positions

Current income tax expense is the amount of income taxes we expect will be payable for the current year applying the provisions of the enacted tax laws. We record a deferred income tax asset or liability for the expected future

consequences of temporary differences in the financial reporting and tax bases of assets and liabilities. We assess the value of our deferred tax assets based on expected future taxable income and ongoing, prudent and feasible tax planning strategies. Our evaluation of the value of these assets is necessarily based on our judgment. When we determine that it is more likely than not that these assets will not be realized, we record a valuation allowance to reduce the carrying value of these assets to their expected realizable value. If we subsequently determine that the amount of such deferred tax assets that will be realized differs from our current expectations, we may be required to increase or decrease the valuation allowance, which would affect our provision for income taxes and net income in the period that such a determination is made.

On an ongoing basis, we must evaluate the income tax positions we take, or expect to take, on our income tax returns against the recognition and measurement criteria prescribed in FIN 48. Our assessment of uncertain tax positions requires that we make estimates and judgments about the application of tax law, the expected resolution of uncertain tax positions and other matters. In the event that uncertain tax positions are resolved for amounts different than our estimates, or the related statutes of limitations expire without our being assessed additional income taxes, we will be required to adjust the amounts of the related assets and liabilities in the period in which such events occur. Such adjustments may have a material impact on our provision for income taxes and our results of operations.

Results of Operations

Three months ended September 30, 2007 and 2006

Net sales

We report net sales in three product categories—optics; apparel, footwear and accessories (AFA); and other. The optics category includes our sunglasses, prescription eyewear, goggles, electronically enabled eyewear and eyewear-related accessories. The AFA category includes our apparel, footwear, watches and accessories. The other products category represents sales of eyewear brands not owned or licensed by us, but sold through our specialty eyewear retail stores.

Net sales increased to $263.8 million for the three months ended September 30, 2007 from $210.2 million for the three months ended September 30, 2006, an increase of $53.6 million, or 25.5%.

Net sales by product category

Optics category net sales were $192.2 million for the three months ended September 30, 2007 compared to $148.8 million for the three months ended September 30, 2006, an increase of $43.3 million or 29.1%. The increase in optics net sales reflects increased sales of sunglasses and prescription eyewear, as well as higher goggle sales principally resulting from our acquisition of ESS. ESS and Bright Eyes, each acquired in 2007, represented an aggregate of approximately $12.4 million of the $43.3 million increase in optics category net sales. The optics category generated 72.8% of our total net sales during the three months ended September 30, 2007 compared to 70.8% for the comparable 2006 period.

Net sales in our AFA category were $52.2 million for the three months ended September 30, 2007 compared to $46.3 million for the three months ended September 30, 2006, an increase of $5.9 million or 12.8%. The increase reflects continued strong sales growth in key southern hemisphere markets including Brazil and Australia, and in our U.S. retail segment. The AFA category represented 19.8% of our total net sales during the three months ended September 30, 2007 compared to 22.0% for the comparable 2006 period.

Other products category net sales were $19.4 million for the three months ended September 30, 2007 compared to $15.1 million for the three months ended September 30, 2006, an increase of $4.3 million or 28.7%. The increase principally reflects an increase in the number of sunglass and optical specialty retail stores we operate and the sales contribution of Bright Eyes. The other products category represented 7.3% of our total net sales during the three months ended September 30, 2007 compared to 7.2% for the comparable 2006 period.

Net sales by geographic region

Our U.S. net sales were $148.9 million for the three months ended September 30, 2007, compared to $116.7 million for the three months ended September 30, 2006, an increase of $32.1 million, or 27.5%. U.S. net sales in our wholesale operations increased $15.7 million, or 22.4%, to $85.6 million for the three months ended September 30, 2007, compared to $69.9 million for the comparable 2006 period, principally due to increased sales volume in the optics category discussed above.

Net sales in our U.S. retail operations, which include our Internet and telesales operations, were $63.3 million for the three months ended September 30, 2007, compared to $46.8 million for the three months ended September 30, 2006, an increase of $16.5 million or 35.2%. The increase in retail sales principally reflects an increase in the number of Oakley, Sunglass Icon and OSA retail stores we operate and increased sales volume in our Internet and telesales operations.

Our international net sales were $114.9 million for the three months ended September 30, 2007, compared to $93.5 million for the comparable 2006 period, an increase of $21.4 million, or 22.9%. A weaker U.S. dollar relative to foreign currencies increased reported international net sales growth by approximately $5.7 million, or 6.1%. The Americas (non-U.S.) and Asia Pacific regions reported significant sales growth in both the optics and AFA categories. In the EMEA (Europe, Middle East, and Africa) region, we experienced substantial growth in the optics category, with AFA sales approximating prior year levels.

Gross profit

Gross profit increased to $146.5 million for the three months ended September 30, 2007 from $113.1 million for the three months ended September 30, 2006, an increase of $33.4 million, or 29.5%. Gross margin, or gross profit as a percentage of net sales, increased to 55.5% for the three months ended September 30, 2007 from 53.8% in the comparable 2006 period. Gross profit for the three months ended September 30, 2006 was adversely affected by $0.3 million in unrealized losses from changes in the fair value of foreign currency derivatives and charges of $0.2 million in connection with the footwear restructuring discussed above. No such unrealized gains or losses or footwear restructuring charges are included in the 2007 period.

Non-GAAP gross margin excludes the footwear restructuring charges and the impact of changes in the fair value of foreign currency derivatives. Non-GAAP gross margin was 55.5% for the three months ended September 30, 2007 compared to 54.0% for the three months ended September 30, 2006. The increase in non-GAAP gross margin primarily resulted from increased sales mix in the optics category, which generates a relatively higher gross profit as a percentage of net sales, and the favorable impact of increased manufacturing volumes. These factors were partially offset by the addition of Bright Eyes and ESS, which generate lower gross margins relative to our other optics products. See “Management’s Discussion and Analysis of Results of Operations and Financial Condition—Non-GAAP Financial Measures,” included in this report.

Operating expenses

Operating expenses for the three months ended September 30, 2007 were $105.7 million compared to $87.0 million for the three months ended September 30, 2006, an increase of $18.7 million, or 21.4%. As a percentage of net sales, operating expenses decreased to 40.1% of net sales for the three months ended September 30, 2007 compared to 41.4% of net sales for the comparable 2006 period. The overall increase in operating expenses principally reflects higher operating expenses of $6.1 million in our expanded retail operations (including Bright Eyes), $8.1 million in increased non-retail operating expenses, $1.7 million in transaction costs related to the Merger, $1.5 million of additional operating expenses resulting from our acquisition of ESS and a $1.2 million increase in amortization of intangible assets related to the businesses we acquired in 2007 and 2006.

Research and development expenses increased $0.9 million to $7.1 million for the three months ended September 30, 2007 compared to $6.3 million for the comparable 2006 period. As a percentage of net sales, research and development expenses decreased to 2.7% of net sales for the three months ended September 30, 2007 compared to 3.0% of net sales for the three months ended September 30, 2006. The overall increase in research and development expenses principally reflects a $0.5 million increase in compensation and related benefit costs and increased design consulting fees.

Selling expenses increased $10.5 million to $61.5 million for the three months ended September 30, 2007 from $51.0 million for the three months ended September 30, 2006. As a percentage of net sales, selling expenses decreased to 23.3% of net sales for the three months ended September 30, 2007 compared to 24.2% of net sales for the three months ended September 30, 2006. Selling expenses increased primarily due to a $4.8 million increase in

retail selling expenses over the comparable 2006 period, resulting from the increase in the number of retail stores we operate and the acquisition of Bright Eyes. Additional increases in non-retail selling expenses include a $1.9 million increase in personnel costs and related benefits and a $1.8 million increase in advertising and marketing costs. The acquisition of ESS accounted for an additional $1.1 million increase in selling expenses.

Shipping and warehousing expenses increased $0.6 million to $6.0 million for the three months ended September 30, 2007 from $5.4 million for the three months ended September 30, 2006. The increase principally reflects the increased sales volume we experienced in 2007. As a percentage of net sales, shipping expenses decreased to 2.3% of net sales for the three months ended September 30, 2007 compared to 2.6% of net sales for the three months ended September 30, 2006. The decrease in shipping and warehousing expenses as a percentage of net sales is due to the inclusion of ESS, which charges shipping costs to customers and includes the related expenses in cost of goods sold, an increase in our retail sales mix and an increase in our optics sales mix.

General and administrative expenses increased $6.7 million to $31.0 million for the three months ended September 30, 2007 from $24.3 million for the three months ended September 30, 2006. As a percentage of net sales, general and administrative expenses increased to 11.7% of net sales for the three months ended September 30, 2007 compared to 11.6% of net sales for the three months ended September 30, 2006. General and administrative expenses related to our retail operations increased $1.1 million, principally reflecting the increase in the number of retail stores we operate and the acquisition of Bright Eyes. General and administrative expenses for the three months ended September 30, 2007 also include $1.7 million in transaction costs related to the Merger. Additional increases in non-retail general and administrative expenses included a $1.2 million increase in amortization of intangible assets related to the businesses we acquired in 2007 and 2006 and a $1.3 million increase in personnel and related benefit costs.

Operating income

Our operating income increased to $40.8 million, or 15.5% of net sales, for the three months ended September 30, 2007 from $26.1 million, or 12.4% of net sales for the three months ended September 30, 2006, an increase of $14.8 million or 56.6%. The increase in operating income as a percentage of net sales principally reflects the strong optics sales growth we experienced during the 2007 period.

Interest expense and interest income

Interest expense, net of interest income, was $3.0 million for the three months ended September 30, 2007 compared to net interest expense of $0.3 million for the three months ended September 30, 2006. Interest expense totaled $3.6 million for the three months ended September 30, 2007 compared to $0.6 million for the three months ended September 30, 2006, principally due to higher outstanding borrowings under the Credit Agreement during the 2007 period. Interest income was $0.6 million for the three months ended September 30, 2007 compared to $0.3 million for the three months ended September 30, 2006.

Income taxes

The provision for income taxes was $14.1 million for the three months ended September 30, 2007, compared to $8.5 million for the three months ended September 30, 2006. Our effective tax rate for the three months ended September 30, 2007 was 37.4% compared to 32.8% for the three months ended September 30, 2006. The increase in our effective tax rate principally reflects the unfavorable impact of non-deductible transaction costs related to the Merger and approximately $0.3 million of interest expense on income tax liabilities we have recorded under FIN 48. The provision for income taxes for the three months ended September 30, 2006 included the benefit of a change in our estimated effective tax rate for fiscal year 2006 from 35% to 34%.

We expect that our effective tax rate for 2007 will be approximately 36.1%. However, our actual provision for income taxes will fluctuate from time to time as a result of changes in the estimated income tax liabilities we have recorded under FIN 48, changes in the valuation of deferred income tax assets and liabilities and other factors. As of September 30, 2007, we have recorded income tax liabilities, including interest and penalties, totaling approximately $22.3 million related to uncertain tax positions. In the event that uncertain tax positions are resolved for amounts different than our estimates, or the related statutes of limitations expire without our being assessed additional income taxes, we will be required to adjust the amounts of the related income tax liabilities in the period in which such events occur. Such adjustments may have a material impact on our provision for income taxes and our results of

operations. We also expect to recognize additional interest expense of approximately $1.4 million annually on the liabilities we have recognized for uncertain tax positions.

Net income

Net income increased to $23.7 million for the three months ended September 30, 2007 from $17.3 million for the three months ended September 30, 2006, an increase of $6.4 million or 36.6%, due to the factors discussed above.

Nine months ended September 30, 2007 and 2006

Net sales

Net sales increased to $726.1 million for the nine months ended September 30, 2007 from $565.5 million for the nine months ended September 30, 2006, an increase of $160.6 million, or 28.4%.

Net sales by product category

Optics category net sales were $544.0 million for the nine months ended September 30, 2007 compared to $414.2 million for the nine months ended September 30, 2006, an increase of $129.8 million or 31.3%. The increase in optics net sales reflects increased sales of sunglasses and prescription eyewear, as well as higher goggle sales principally resulting from our acquisition of ESS. The sales contribution of the businesses we acquired in 2007 and 2006 represented approximately $38.5 million of the $129.8 million increase in optics category net sales. The optics category generated 74.9% of our total net sales during the nine months ended September 30, 2007 compared to 73.2% for the comparable 2006 period.

Net sales in our AFA category were $129.1 million for the nine months ended September 30, 2007 compared to $113.6 million for the nine months ended September 30, 2006, an increase of $15.5 million or 13.6%. The increase reflects strong sales growth in key southern hemisphere markets including Brazil and Australia, and in our U.S. retail segment. The AFA category represented 17.8% of our total net sales during the nine months ended September 30, 2007 compared to 20.1% for the comparable 2006 period.

Other products category net sales were $53.0 million for the nine months ended September 30, 2007 compared to $37.7 million for the nine months ended September 30, 2006, an increase of $15.3 million or 40.8%. The increase reflects the greater number of sunglass and optical specialty retail stores we operate and higher comparable store sales. In addition, the sales contribution of the businesses we acquired in 2007 and 2006 represented approximately $6.4 million of the $15.3 million increase in other category sales. The other products category represented 7.3% of our total net sales during the nine months ended September 30, 2007 compared to 6.7% for the comparable 2006 period.

Net sales by geographic region

Our U.S. net sales were $415.6 million for the nine months ended September 30, 2007, compared to $317.7 million for the nine months ended September 30, 2006, an increase of $98.0 million, or 30.8%. U.S. net sales in our wholesale operations increased $48.4 million, or 24.7%, to $244.5 million for the nine months ended September 30, 2007, compared to $196.1 million for the comparable 2006 period, principally due to increased sales volume in the optics category discussed above.

Net sales in our U.S. retail operations, which include our Internet and telesales operations, were $171.1 million for the nine months ended September 30, 2007, compared to $121.6 million for the nine months ended September 30, 2006, an increase of $49.6 million or 40.8%. The increase in retail sales reflects increase in the number of Oakley and Sunglass Icon retail stores we operate, higher comparable store sales, increased sales volume in our Internet and telesales operations and the sales contribution of the OSA and Oliver Peoples retail stores we acquired in 2006.

Our international net sales were $310.5 million for the nine months ended September 30, 2007, compared to $247.8 million for the comparable 2006 period, an increase of $62.7 million, or 25.3%. A weaker U.S. dollar relative to foreign currencies increased reported international net sales growth by approximately $13.3 million, or 5.4%. The Americas (non-U.S.) and Asia Pacific regions reported significant sales growth in both the optics and AFA categories. In the EMEA region, we experienced substantial growth in the optics category, partially offset by modestly lower sales of footwear and other AFA products.

Gross profit

Gross profit increased to $406.2 million for the nine months ended September 30, 2007 from $308.3 million for the nine months ended September 30, 2006, an increase of $97.9 million, or 31.7%. Gross margin, or gross profit as a percentage of net sales, increased to 55.9% for the nine months ended September 30, 2007 from 54.5% in the comparable 2006 period. Gross profit for the nine months ended September 30, 2006 was adversely affected by $3.7 million in unrealized losses from changes in the fair value of foreign currency derivatives and charges of $3.3 million in connection with the footwear restructuring discussed above. No such unrealized gains or losses or footwear restructuring charges are included in the 2007 period.

Non-GAAP gross margin excludes the footwear restructuring charges and the impact of changes in the fair value of foreign currency derivatives. Non-GAAP gross margin was 55.9% for the nine months ended September 30, 2007 compared to 55.6% for the nine months ended September 30, 2006. The increase in non-GAAP gross margin primarily resulted from improved sales mix in the optics category, which generates a relatively higher gross profit as a percentage of net sales, and the favorable impact of increased manufacturing volumes. These favorable factors were partially offset by the addition of Bright Eyes and ESS, which generate relatively lower gross margins than our existing optics products. See “Management’s Discussion and Analysis of Results of Operations and Financial Condition—Non-GAAP Financial Measures,” included in this report.

Operating expenses

Operating expenses for the nine months ended September 30, 2007 were $318.3 million compared to $251.4 million for the nine months ended September 30, 2006, an increase of $66.9 million, or 26.6%. As a percentage of net sales, operating expenses decreased to 43.8% of net sales for the nine months ended September 30, 2007 compared to 44.5% of net sales for the comparable 2006 period. The overall increase in operating expenses principally reflects higher operating expenses of $18.9 million in our expanded retail operations (including OSA and Bright Eyes), $35.7 million in increased non-retail operating expenses, a $4.2 million increase in amortization of intangible assets related to the businesses we acquired in 2007 and 2006, $4.0 million of additional operating expenses resulting from our acquisition of ESS and $4.1 million in transaction costs related to the Merger.

Research and development expenses increased $2.5 million to $19.8 million for the nine months ended September 30, 2007 compared to $17.3 million for the comparable 2006 period. As a percentage of net sales, research and development expenses decreased to 2.7% of net sales for the nine months ended September 30, 2007 compared to 3.1% of net sales for the nine months ended September 30, 2006. The overall increase in research and development expenses reflects a $1.0 million increase in compensation and related benefit costs, a $0.8 million of additional expenses resulting from our acquisitions of ESS and Oliver Peoples and increased design consulting fees.

Selling expenses increased $37.3 million to $188.0 million for the nine months ended September 30, 2007 from $150.7 million for the nine months ended September 30, 2006. As a percentage of net sales, selling expenses were 25.9% of net sales for the nine months ended September 30, 2007 compared to 26.7% of net sales for the nine months ended September 30, 2006. Retail selling expenses for the nine months ended September 30, 2007 increased $14.7 million over the comparable 2006 period, principally reflecting the increase in the number of retail stores we operate, including OSA and Bright Eyes. Additional increases in non-retail selling expenses include a $7.0 million increase in advertising and marketing costs, a $5.4 million increase in personnel costs and related benefits and a $2.8 million increase in sales commissions due to higher sales volume. The acquisitions of ESS and Oliver Peoples accounted for an additional $5.1 million increase in selling expenses.

Shipping and warehousing expenses increased $1.5 million to $16.9 million for the nine months ended September 30, 2007 from $15.4 million for the nine months ended September 30, 2006. The increase principally reflects the increased sales volume we experienced in 2007. As a percentage of net sales, shipping expenses were 2.3% of net sales for the nine months ended September 30, 2007 compared to 2.7% of net sales for the nine months ended September 30, 2006. The decrease in shipping and warehousing expenses as a percentage of net sales is due to the inclusion of ESS, which charges shipping costs to customers and includes the related expenses in cost of goods sold, an increase in our retail sales mix and an increase in our optics sales mix.

General and administrative expenses increased $25.6 million to $93.6 million for the nine months ended September 30, 2007 from $68.0 million for the nine months ended September 30, 2006. As a percentage of net sales, general

and administrative expenses were 12.9% of net sales for the nine months ended September 30, 2007 compared to 12.0% of net sales for the nine months ended September 30, 2006. General and administrative expenses of our retail operations increased $4.3 million, principally reflecting the increase in the number of retail stores we operate, including OSA and Bright Eyes. Additional increases in general and administrative expenses included a $4.2 million increase in amortization of intangible assets related to the businesses we acquired in 2007 and 2006, a $4.3 million increase in non-retail personnel and related benefit costs, $4.1 million in transaction costs related to the Merger and a $2.1 million increase in sales tax expense for taxes undercollected in prior years.

Operating income

Our operating income increased to $87.9 million, or 12.1% of net sales, for the nine months ended September 30, 2007 from $57.0 million, or 10.1% of net sales for the nine months ended September 30, 2006, an increase of $31.0 million or 54.4%. The increase in operating income as a percentage of net sales principally reflects the strong sales growth we experienced and the unfavorable impact on our gross margin for the fiscal 2006 period of the footwear restructuring charges and changes in the fair value of foreign currency derivatives, as discussed above.

Interest expense and interest income

Interest expense, net of interest income, was $8.2 million for the nine months ended September 30, 2007 compared to $0.7 million for the nine months ended September 30, 2006. Interest expense totaled $9.5 million for the nine months ended September 30, 2007 compared to $2.0 million for the nine months ended September 30, 2006, principally due to higher outstanding borrowings under the Credit Agreement during the 2007 period. Interest income was $1.4 million for the nine months ended September 30, 2007 compared to $1.2 million for the nine months ended September 30, 2006.

Income taxes

The provision for income taxes was $28.9 million for the nine months ended September 30, 2007, compared to $19.1 million for the nine months ended September 30, 2006. Our effective tax rate for the nine months ended September 30, 2007 was 36.2%, compared to 34.0% for the nine months ended September 30, 2006. We expect that our effective tax rate for fiscal 2007 will be approximately 36.1% due to the unfavorable impact of non-deductible transaction costs related to the Merger. The provision for income taxes for the nine months ended September 30, 2007 also includes approximately $1.0 million of interest expense on income tax liabilities, partially offset by the recognition of a $1.1 million benefit resulting from the resolution of a state income tax matter.

Net income

Net income increased to $50.9 million for the nine months ended September 30, 2007 from $37.1 million for the nine months ended September 30, 2006, an increase of $13.8 million or 37.1%, due to the factors discussed above.

Liquidity and Capital Resources

Our cash and cash equivalents were $53.7 million at September 30, 2007 compared to $31.3 million at December 31, 2006. The increase in our cash and cash equivalents principally reflects borrowings under the Credit Agreement and cash provided by operations, largely offset by payments for the acquisition of ESS and Bright Eyes. Our principal sources of liquidity are cash flow generated from operations and borrowings under the Credit Agreement. As of September 30, 2007, available borrowings under the Credit Agreement totaled $47.3 million. We believe that our existing cash and cash equivalents, available borrowings under the Credit Agreement and anticipated cash flows from operations will be sufficient to fund our operations and anticipated capital expenditures for at least the next 12 months. We may consider other acquisition opportunities or increases in our capital spending to extend our product lines or expand our retail operations. In order to fund any such capital expenditures or acquisitions, we may seek to obtain additional debt financing or issue additional shares of our common stock. There can be no assurance that additional financing, if necessary, will be available on terms acceptable to us or at all.

Cash provided by operating activities totaled $39.6 million for the nine months ended September 30, 2007 compared to cash provided by operating activities of $54.0 million for the comparable 2006 period. Operating cash flow for the nine months ended September 30, 2007 reflects our net income of $50.9 million and net non-cash charges (depreciation and amortization, stock-based compensation, changes in the fair value of derivative instruments and other) of $42.2 million, partially offset by net working capital increases of $53.5 million. The working capital

increases principally consisted of a $45.7 million increase in inventories and a $23.1 million increase in accounts receivable, partially offset by a $16.0 million increase in accounts payable, accrued expenses and other current liabilities.

At September 30, 2007, our working capital decreased to $116.3 million compared to $179.7 million at December 31, 2006, principally due to our use of short-term borrowings under the Credit Agreement to finance our acquisition of ESS and Bright Eyes. Working capital may vary from time to time as a result of seasonality, new product introductions, changes in accounts receivable and inventory levels and other factors. Accounts receivable, less allowances for doubtful accounts, were $140.8 million at September 30, 2007 compared to $109.2 million at December 31, 2006 and $115.8 million at September 30, 2006. Accounts receivable days outstanding, based on wholesale net sales, were 65 at September 30, 2007 compared to 68 at December 31, 2006 and 65 at September 30, 2006. Inventories increased to $208.1 million at September 30, 2007 compared to $155.4 million at December 31, 2006 and $154.1 million at September 30, 2006. The increased inventory reflects higher inventories of optics products to support our increased sales volume, seasonally higher AFA inventories in advance of the shipment of our Fall 2007 line, the expansion of our retail operations and the inventories of acquired businesses.

Cash used in investing activities of $187.4 million for the nine months ended September 30, 2007 principally consisted of payments of $131.7 million for acquisitions of businesses (principally ESS and Bright Eyes) and payments for capital expenditures of $55.7 million. Cash used in investing activities of $115.4 million for the nine months ended September 30, 2006 principally consisted of payments of $83.2 million for the acquisitions of businesses and payments for capital expenditures of $33.0 million. Capital expenditures for the nine months ended September 30, 2007 included $20.8 million for our retail operations. As of September 30, 2007, we had commitments of approximately $1.5 million for future capital expenditures, which we expect to fund with cash flows from operations or available borrowings under the Credit Agreement.

Cash provided by financing activities of $168.4 million for the nine months ended September 30, 2007 principally consisted of net borrowings under credit facilities of $157.7 million and proceeds from the exercise of stock options of $7.8 million. For the nine months ended September 30, 2006, cash provided by financing activities of $9.8 million principally consisted of net borrowings under credit facilities of $17.4 million and proceeds from the exercise of stock options of $2.3 million, partially offset by payments of $10.4 million to repurchase shares of our common stock.

During the nine months ended September 30, 2007, we repurchased no shares of our common stock under our previously announced share repurchase programs. As of September 30, 2007, the approximate dollar value of shares that may yet be repurchased under the share repurchase programs we announced on March 15, 2005 and September 25, 2006 was $3.3 million and $20.0 million, respectively.

Credit Agreement

The Credit Agreement provides for borrowings in multiple currencies by us and certain of our subsidiaries and for the issuance of letters of credit. The Credit Agreement expires in September 2011. Borrowings under the Credit Agreement bear interest at variable rates based upon the bank’s prime lending rate or LIBOR, plus specified margins. The weighted-average interest rate on borrowings outstanding under the Credit Agreement as of September 30, 2007 was 6.0%. We are required to pay a commitment fee on the daily unused amount of the commitments under the Credit Agreement and other fees as specified in the agreement. As of September 30, 2007, outstanding borrowings under the Credit Agreement were $197.1 million.

The Credit Agreement contains various restrictive covenants that require that we maintain certain financial ratios and that may limit our ability, among other things, to: incur or guarantee indebtedness, incur liens, pay dividends or repurchase stock, enter into transactions with affiliates, consummate asset sales, acquisitions or mergers, or make investments. As of September 30, 2007, we were in compliance with all restrictive covenants and financial ratio requirements of the Credit Agreement. Our obligations under the Credit Agreement are unsecured.

Certain of our subsidiaries also have lines of credit to provide working capital financing. These lines of credit bear interest at rates ranging from 1.4% to 7.1%. Some of our subsidiaries have bank overdraft accounts that renew annually and bear interest at rates ranging from 4.7% to 13.0%. The aggregate borrowing limit on the subsidiaries’ lines of credit and overdraft accounts is $26.9 million, of which $7.9 million was outstanding at September 30, 2007.

Contractual Obligations

The following table summarizes the future payments we are required to make under contractual obligations as of September 30, 2007 (in thousands):


			Oct. - Dec.
	Total		2007		2008		2009		2010		2011		Thereafter
Lines of credit	$	205,013	$	205,013	$	—	$	—	$	—	$	—	$	—
Long-term debt		25		25		—		—		—		—		—
Letters of credit		1,957		1,957		—		—		—		—		—
Operating leases		230,952		10,487		37,920		37,010		33,699		29,439		82,397
Endorsement contracts (1)		5,555		1,732		2,847		462		256		258		—
Product purchase commitments (2)		110,000		56,106		27,594		8,800		8,750		8,750		—
Capital purchase commitments		1,507		1,507		—		—		—		—		—
Additional consideration for
business acquired		2,000		—		1,000		1,000		—		—		—

	$	557,009	$	276,827	$	69,361	$	47,272	$	42,705	$	38,447	$	82,397


(1)		We have entered into endorsement contracts with selected athletes and others who endorse our products. Under these contracts, we have agreed to pay certain incentives based on specific achievements in addition to minimum annual payments. The amounts listed above for endorsement contracts represent approximate amounts of minimum payments required under these contracts. Actual amounts paid under these contracts may differ from the amounts listed as a result of the conditional components of these obligations.

(2)		Amounts listed for purchase obligations represent contractual agreements, letters of credit and open purchase orders for products or services to be incurred in the ordinary course of business, which are enforceable and legally binding and specify all significant terms.

Seasonality

Historically, our sales have been highest in the period from March to September, the period during which sunglass purchases and usage are typically highest in the northern hemisphere. As a result, our net sales and operating margins are typically higher in the second and third quarters and lower in the first and fourth quarters, as fixed operating costs are spread over the differing levels of sales volume. In anticipation of seasonal increases in demand, we typically build sunglass inventories in the fourth quarter and first quarter, when net sales have historically been lower. Sales of our AFA products, which generate relatively lower gross profits compared to our optics products, are generally lowest in the second quarter. This seasonal trend contributes to our gross profit in the second quarter, which historically has been the highest of the year. Although we expect these trends to continue, the impact of seasonality on our business may be partially mitigated by changes in our product mix and the impact of acquisitions. The future effects of seasonality may also be affected by the expansion of our retail operations, where sales and operating margins are typically highest in the fourth quarter.

Inflation

We do not believe inflation has had a material impact on our results of operations in the past. However, we cannot assure you that this will be the case in the future.

Non-GAAP Financial Measures

This report includes a discussion of “non-GAAP gross margin,” which is a non-GAAP financial measure. We provide this non-GAAP measure as a supplement to financial results based on GAAP. Non-GAAP gross margin differs from the most comparable GAAP measure, gross profit as a percentage of net sales, by excluding footwear restructuring charges and the impact of changes in the fair value of foreign currency derivatives not designated as cash flow hedges. A detailed reconciliation of non-GAAP gross margin to gross profit as a percentage of net sales is set forth in the table below. We encourage readers to review this reconciliation.

The footwear restructuring charges include provisions for estimated sales returns and markdown allowances (included in net sales) and write-downs of inventories and footwear-specific tooling, displays and equipment (included in cost of goods sold). Changes in the fair value of foreign currency derivatives not designated as cash flow hedges are included in cost of goods sold. Such changes (gains or losses) are recorded based upon the impact of changes in foreign currency exchange rates on the value of the foreign currency derivatives that we have purchased as part of our program to mitigate risks due to fluctuations in currency exchange rates.

We present non-GAAP gross margin to provide additional insight into our underlying operating results. We believe that excluding the non-cash gains and losses from changes in the fair value of these foreign currency derivatives, and the impact of the footwear restructuring charges, provides meaningful and useful information regarding the underlying trends in product margins based on actual production costs. Non-GAAP gross margin also enhances comparisons of our results of operations with historical periods. We use non-GAAP gross margin in reviewing product margins, making product pricing decisions, and analyzing product category profitability.

Non-GAAP gross margin has certain limitations because it does not reflect all of the costs associated with the operation of our business as determined in accordance with GAAP. Moreover, our non-GAAP gross margin may be different from similarly titled non-GAAP measures used by other companies, which may not provide investors a comparable view of our performance in relation to other companies in the same industry. Readers should consider non-GAAP gross margin in addition to, and not as a substitute for, or superior to, gross profit as a percentage of net sales determined in accordance with GAAP. We seek to compensate for the limitations of non-GAAP gross margin by providing descriptions of the reconciling items and a reconciliation of non-GAAP gross margin to the most directly comparable GAAP measure so that investors can appropriately incorporate non-GAAP gross margin and its limitations into their analyses. Additional information on the changes in the fair value of foreign currency derivatives not designated as cash flow hedges is included in Note 8 of Notes to Condensed Consolidated Financial Statements. A reconciliation of non-GAAP gross margin to the most directly comparable GAAP financial measure, gross profit as a percentage of net sales, is as follows (in thousands):


							Change in fair
				Footwear			value of foreign			Calculation of
	Reported			restructuring			currency			non-GAAP gross
	under GAAP			charges			derivatives			margin (1)
Three months ended September 30, 2007
Net sales	$	263,789		$	—		$	—		$	263,789
Cost of goods sold		117,284			—			—			117,284

Gross profit	$	146,505		$	—		$	—		$	146,505
Gross profit as a % of net sales		55.5	%
Non-GAAP gross margin											55.5	%

Three months ended September 30, 2006
Net sales	$	210,219		$	(22	)	$	—		$	210,241
Cost of goods sold		97,120			157			295			96,668

Gross profit	$	113,099		$	(179	)	$	(295	)	$	113,573
Gross profit as a % of net sales		53.8	%
Non-GAAP gross margin											54.0	%

Nine months ended September 30, 2007
Net sales	$	726,115		$	—		$	—		$	726,115
Cost of goods sold		319,895			—			—			319,895

Gross profit	$	406,220		$	—		$	—		$	406,220
Gross profit as a % of net sales		55.9	%
Non-GAAP gross margin											55.9	%

Nine months ended September 30, 2006
Net sales	$	565,501		$	(1,847	)	$	—		$	567,348
Cost of goods sold		257,164			1,490			3,702			251,972

Gross profit	$	308,337		$	(3,337	)	$	(3,702	)	$	315,376
Gross profit as a % of net sales		54.5	%
Non-GAAP gross margin											55.6	%


(1)		We do not use non-GAAP net sales or non-GAAP cost of goods sold separately as non-GAAP financial measures. Non-GAAP net sales and non-GAAP cost of goods sold are presented herein solely for the purpose of illustrating the computation of non-GAAP gross margin.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Foreign Currency Exchange Rate Risk

We have direct operations in Australia, Brazil, Canada, France, Germany, Italy, Japan, Mexico, New Zealand, South Africa, Switzerland and the United Kingdom, which collect receivables at future dates in the customers’ local currencies and purchase finished goods primarily in U.S. dollars. Accordingly, we are exposed to gains and losses that result from the effect of changes in foreign currency exchange rates on foreign currency denominated transactions and transactions of our international subsidiaries. As part of our overall strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, we use foreign exchange contracts in the form of forward and option contracts.

The following is a summary of all foreign exchange contracts (to purchase U.S. dollars for the respective foreign currencies) we held at September 30, 2007 (in thousands):


			Weighted-average
	U.S. Dollar		rate per			Fair Value
Currency	Equivalent		US $1.00		Maturity Dates	Gain (Loss)
British pound	$	17,671		0.5090	Oct. 2007 – Oct. 2008	$	(625	)
Canadian dollar		15,651		1.0310	Oct. 2007 – Jun. 2008		(588	)
Euro		17,296		0.7450	Oct. 2007 – Dec. 2008		(1,115	)
Japanese yen		18,105		112.1250	Oct. 2007 – Mar. 2009		(15	)

	$	68,723				$	(2,343	)

We use, and plan to continue to use, foreign exchange contracts as part of our strategy to manage our exposure to foreign currency exchange rate fluctuations. These foreign exchange contracts have various terms and maturity dates. Consequently, the total amount of exchange contracts held may change from one period to another. Also, we may, for various reasons, decide to either expand or reduce the level of foreign exchange contracts we hold. Based upon the foreign exchange contracts we held at September 30, 2007, if the value of the U.S. dollar were to hypothetically decrease by 10% relative to the foreign currencies which we have hedged with foreign exchange contracts, our gross profit and our pre-tax income would decrease by approximately $7.9 million. This change in gross profit and pre-tax income could be offset, to a greater or lesser extent, by a gain from translating foreign currency income and expenses into U.S dollars at the same hypothetical rate.

We have exposure to credit losses in the event of nonperformance by counterparties to foreign exchange contracts but we have no off-balance sheet credit risk of accounting loss. To mitigate such credit risks, we enter into derivative financial instruments with counterparties who are leading global financial institutions. We anticipate that the counterparties will be able to fully satisfy their obligations under the contracts. We do not obtain collateral or other security to support the forward exchange contracts subject to credit risk but monitor the credit standing of the counterparties.

Interest Rate Risk

The majority of our outstanding borrowings, including borrowings under the Credit Agreement and the credit facilities available to certain of our subsidiaries, bear interest at variable rates and subject us to interest rate risk related to fluctuations in the rates of interest we pay on these obligations. We generally do not enter into derivative contracts or other arrangements to manage our exposure to interest rate risk. Outstanding borrowings under these arrangements totaled $205.0 million at September 30, 2007. Based on the weighted-average interest rate of 6.0% applicable to borrowings outstanding under the Credit Agreement, if interest rates were to hypothetically increase by 10%, and to the extent that borrowings remain outstanding, for every $1.0 million of borrowings outstanding our interest expense would increase by approximately $6,000 per year.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2007. Disclosure controls and procedures are defined under SEC rules as controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within required time periods. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of September 30, 2007.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended September 30, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II. OTHER INFORMATION

Item 1. Legal Proceedings

On July 30 and July 31, 2007, Defendants filed demurrers to the complaint. On August 30, 2007, the Court sustained Defendants’ demurrers and granted plaintiff 15 days’ leave to amend. On September 14, 2007, the plaintiff filed an amended complaint, seeking the same relief as the original complaint. The amended complaint contains similar allegations as the original complaint and also adds allegations for breach of fiduciary duty based on a purported failure to disclose certain information in the Company’s preliminary proxy statement filed with the SEC on September 7, 2007 in connection with the Merger. On October 9, 2007, Defendants filed a demurrer to the amended complaint, which is currently scheduled to be heard by the Superior Court on December 13, 2007. We believe that the allegations are without merit and intend to vigorously defend this action.

We are a party to various claims, complaints and other legal actions that arise from time to time in the normal course of business. The outcome of such matters cannot be predicted with certainty and some claims, complaints and other legal actions may be disposed of unfavorably to us. Based on an evaluation of matters that are pending or asserted, we believe the disposition of such matters will not have a material adverse effect on our financial condition or results of operations.

Item 1A. Risk Factors

Information on risk factors is set forth in “Part I — Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2006. Except for the additional risk factor set forth below, during the period covered by this report, there were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2006.

If we do not complete the proposed Merger with Luxottica, our business could be adversely affected and the price of our common stock may decline significantly.

The Merger was approved by holders of two-thirds of the outstanding shares of our common stock at a special meeting held on November 7, 2007. Early termination of the applicable waiting period under the HSR Act was granted on August 24, 2007 and clearance under applicable antitrust, trade regulation or competition laws was obtained in Germany on August 28, 2007, in the United Kingdom on October 12, 2007 and in Australia on October 15, 2007. The Company filed for approval under Exon-Florio on August 16, 2007 and received approval from CFIUS on September 17, 2007. However, several additional conditions must be satisfied to complete the proposed Merger including, among others:

	•		the receipt of approvals under the antitrust or similar laws of South Africa;

	•		the absence of any order or injunction prohibiting the consummation of the Merger; and

	•		the filing of an articles of merger with the Secretary of State of the State of Washington.

These conditions are set forth in detail in the definitive proxy materials relating to a special meeting of our shareholders, which we filed with the SEC on October 17, 2007. We cannot assure you that that all of the conditions to the completion of the Merger will be satisfied.

In connection with the Merger we are subject to several risks, including the following:

	•		The price of our common stock has increased significantly since we announced the Merger. The Merger Price represents a premium of approximately 16% over $25.23, which was the closing share price of our common stock on the New York Stock Exchange on June 20, 2007, the date on which the Merger was first announced. The closing share price of our common stock was $28.45 on June 21, 2007 and $29.27 on November 6, 2007. If the conditions to the Merger set forth in the Merger Agreement are not met, the Merger may not occur, and the price of our common stock may decline significantly.

	•		In the event the proposed Merger is terminated by Luxottica, our remedies against Luxottica with respect to certain breaches of the Merger Agreement, if any, may not be adequate to cover our damages.

	•		We have incurred substantial transaction costs, and expect to incur additional transaction costs, that will not be recovered if the Merger is not completed.

	•		We cannot predict the outcome of any legal proceedings that have been or may be instituted against us, members of our Board of Directors, management and others relating to the Merger, including any settlement of such proceedings that may be subject to court approval. The resolution of any litigation or other legal process, regardless of its merit, could be costly and divert the efforts and attention of our management.

	•		Our management’s and employees’ attention may be diverted from the day-to-day operations of our business, which could disrupt our relationships with suppliers or customers.

	•		We may experience difficulty in attracting new employees or in retaining current employees.

Item 2 . Unregistered Sales of Equity Securities and Use of Proceeds

We made no unregistered sales of equity securities during the quarter ended September 30, 2007.

Issuer Purchases of Equity Securities

During the quarter ended September 30, 2007, we purchased no shares of our equity securities under our previously announced share repurchase programs. As of September 30, 2007, the approximate dollar value of shares that may yet be repurchased under the share repurchase programs we announced on March 15, 2005 and September 25, 2006 was $3.3 million and $20.0 million, respectively.

The following table sets forth the purchases of our equity securities made by us and affiliated purchasers for the quarter ended September 30, 2007:


	(a)			(b)		(c)		(d)
						Total number of shares		Approximate dollar
						purchased as part of		value of shares that may
	Total number of			Average price		publicly announced		yet be purchased under
Period	shares purchased			paid per share		program		the program

July 1 — 31, 2007		—			—		—	$	23,299,000
August 1 — 31, 2007		—			—		—		23,299,000
September 1 — 30, 2007		5,363	(1)	$	28.92		—		23,299,000

Total		5,363		$	28.92		—


(1)		Represents all of the shares of our common stock withheld from, or delivered by, employees in order to satisfy applicable tax withholding obligations in connection with the vesting of restricted stock. These repurchases were not made pursuant to any publicly announced plan or program.

Item 6. Exhibits


	2.1			Agreement and Plan of Merger, dated June 20, 2007, by and among Luxottica Group S.p.A., Norma Acquisition Corp. and Oakley, Inc., previously filed as Exhibit 2.1 to the Registrant’s Current Report on Form 8-K dated June 21, 2007, is incorporated herein by reference.
	3.1			Articles of Incorporation of the Company, previously filed with the Registration Statement on Form S-1 of Oakley, Inc. (Registration No. 33-93080), is incorporated herein by reference.
	3.2			Amendment No. 1 to the Articles of Incorporation, as filed with the Secretary of State of the State of Washington on September 26, 1996, previously filed with the Form 10-K of Oakley, Inc. for the year ended December 31, 1996, is incorporated herein by reference.
	3.3			Amended and Restated Bylaws of the Company (includes complete text of Bylaws; amends Section 1 and Sections 3a through 3f of Article IV of the Bylaws of the Company), previously filed with the Form 10-K of Oakley, Inc. for the year ended December 31, 1998, is incorporated herein by reference.
	10.1			Amendment to Employment Agreement, dated as of September 19, 2007, by and between Oakley, Inc. and D. Scott Olivet, filed as Exhibit 10.1 to the Registrant’s Current Report on Form 8-K/A dated September 20, 2007, is incorporated herein by reference.
	10.2			Shared Services Agreement, made as of September 20, 2007, by and between Oakley, Inc. and Red.com, Inc. dba Red Digital Cinema Camera Company, filed as Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated September 20, 2007, is incorporated herein by reference.
	31.1			Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31.2			Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32.1			Certification of CEO and CFO pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned duly authorized officers.


		Oakley, Inc.


November 7, 2007		/s/ D. Scott Olivet

		D. Scott Olivet
		Chief Executive Officer


November 7, 2007		/s/ Richard Shields

		Richard Shields
		Chief Financial Officer

EXHIBIT INDEX


	2.1			Agreement and Plan of Merger, dated June 20, 2007, by and among Luxottica Group S.p.A., Norma Acquisition Corp. and Oakley, Inc., previously filed as Exhibit 2.1 to the Registrant’s Current Report on Form 8-K dated June 21, 2007, is incorporated herein by reference.
	3.1			Articles of Incorporation of the Company, previously filed with the Registration Statement on Form S-1 of Oakley, Inc. (Registration No. 33-93080), is incorporated herein by reference.
	3.2			Amendment No. 1 to the Articles of Incorporation, as filed with the Secretary of State of the State of Washington on September 26, 1996, previously filed with the Form 10-K of Oakley, Inc. for the year ended December 31, 1996, is incorporated herein by reference.
	3.3			Amended and Restated Bylaws of the Company (includes complete text of Bylaws; amends Section 1 and Sections 3a through 3f of Article IV of the Bylaws of the Company), previously filed with the Form 10-K of Oakley, Inc. for the year ended December 31, 1998, is incorporated herein by reference.
	10.1			Amendment to Employment Agreement, dated as of September 19, 2007, by and between Oakley, Inc. and D. Scott Olivet, filed as Exhibit 10.1 to the Registrant’s Current Report on Form 8-K/A dated September 20, 2007, is incorporated herein by reference.
	10.2			Shared Services Agreement, made as of September 20, 2007, by and between Oakley, Inc. and Red.com, Inc. dba Red Digital Cinema Camera Company, filed as Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated September 20, 2007, is incorporated herein by reference.
	31.1			Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31.2			Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32.1			Certification of CEO and CFO pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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