UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Commission file number 0-21577

WILD OATS MARKETS, INC.

(Exact name of registrant as specified in its charter)

Boulder, Colorado 80301

(Address of principal executive offices, including zip code)

(303) 440-5220

(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.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12-b of the Exchange Act).  

As of July 28, 2006, there were 29,462,616 shares outstanding of the registrant's common stock (par value $0.001 per share).

Consolidated Balance Sheets

Consolidated Statements of Operations

Consolidated Statements of Comprehensive Income (Loss)

Consolidated Statements of Cash Flows

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

Notes to Consolidated Financial Statements

(unaudited)

The accompanying unaudited consolidated financial statements have been prepared by the Company in accordance with United States generally accepted accounting principles for interim financial information and pursuant to instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with United States generally accepted accounting principles have been condensed or omitted pursuant to Securities and Exchange Commission’s ("SEC") rules and regulations. In the opinion of the Company, all adjustments necessary to present fairly the financial position at July 1, 2006 and results of operations and cash flows for all periods presented have been made. The consolidated balance sheet at December 31, 2005 has been derived from the audited financial statements at that date.

These consolidated financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto included in the Company's 2005 Annual Report on Form 10-K as filed with the SEC. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures of contingent assets and liabilities. Examples include accounting for self-insurance reserves, stock-based compensation, restructuring charges and store closing costs, asset impairment charges, goodwill, inventory valuation, and contingencies. Actual results may differ from these estimates. The results of operations for the three and six months ended July 1, 2006 are not necessarily indicative of the operating results to be expected for any subsequent quarter or for the entire fiscal year ending December 30, 2006.

The unaudited information included in the consolidated financial statements for the three and six months ended July 1, 2006 and July 2, 2005 includes the results of operations of the Company for the 13 and 26 weeks then ended.

Principles of consolidation. The Company’s consolidated financial statements include the amounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Inventories. Store inventories are valued principally at the lower of cost or market, with cost primarily determined under the retail method on a first in first out ("FIFO") basis. FIFO cost is determined using the retail inventory method for approximately 80% of inventories and using the item cost method for highly perishable products representing approximately 20% of inventories. Under the retail inventory method, the valuation of inventories at cost and the resulting gross margins are determined by applying a cost-to-retail ratio for various categories of similar items to the retail value of inventories. Inherent in the retail inventory method calculations are certain management judgments and estimates, including shrinkage, which could impact the ending inventory valuation at cost as well as the resulting gross margins. Certain other highly perishable inventories are valued primarily at the lower of cost or market on a specific item basis, with cost determined on a FIFO basis.

Reclassifications. Certain prior period information has been reclassified to conform to the current year presentation. This includes a reclassification of the Company’s 2005 results of operations to more accurately reflect Selling, General and Administrative expenses and Direct Store expenses. For the three and six months ended July 2, 2005, approximately $5.8 million and $10.8 million, respectively, was reclassified from Selling, General and Administrative expenses to Direct Store expenses in order to reflect regional store support services more appropriately.

The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity computed under the effective interest method. Such amortization and accretion is included in interest income. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in interest income. The cost of securities sold is based on the specific identification method. Realized income and dividends on securities classified as available-for-sale are included in interest income. Investments classified as available-for-sale are marked to market each reporting period with the unrealized gain or loss reflected as a component of other comprehensive income (loss).

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS No. 123R") and related interpretations, using the Black-Scholes valuation model and the modified prospective application. Accordingly, the financial statements for periods prior to January 1, 2006, will not include compensation cost calculated under the fair value method of SFAS No. 123R. SFAS No. 123R requires companies to recognize the cost of employee services received in exchange for awards of equity instruments based upon the grant-date fair value of those awards.

Stock-based compensation expense recognized under SFAS No. 123R in the Consolidated Statement of Operations for the three and six months ended July 1, 2006 was $511,000 and $1.3 million, respectively. The stock-based compensation expense for the three and six months ended July 1, 2006 included $97,000 and $200,000, respectively, related to restricted stock units ("RSUs") that were issued as Board of Directors’ compensation that would have been included in the Company’s Consolidated Statements of Operations under the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25"), and related interpretations. For the three and six month periods ended July 1, 2006, there were no income tax benefits recognized in the Consolidated Statement of Operations for stock-based compensation arrangements. Basic and diluted earnings per share for the three and six month periods ended July 1, 2006 are $0.01 and $0.02, and $0.03 and $0.04 lower, respectively, than if the Company had continued to account for stock-based compensation under APB No. 25. The estimated fair value of the Company’s stock-based awards, less estimated forfeitures, is amortized over the awards’ expected life on a straight-line basis.

The Employee Stock Purchase Plan ("ESPP") was modified in response to the adoption of SFAS No. 123R. Beginning in the first quarter of 2006, the discount on the price of the shares was reduced to 5% and will be applied to the price of shares on the date in which the buy period closes each quarter.

The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123R to its stock option plans for the three and six months ended July 2, 2005:

* Amounts are net of a pro-forma tax rate which is not necessarily indicative of our effective tax rate for the respective periods.

At July 1, 2006, the Company had six stock-based compensation plans: the 1996 Equity Incentive Plan ("1996 Plan"), the 2001 Non-Officer/Non-Director Equity Incentive Plan ("2001 Plan"), the 2006 Equity Incentive Plan ("2006 Plan"), and three individual nonqualified stock option plans. The 1996 Plan provides for grant of incentive stock options to employees (including officers and employee-directors) and nonqualified stock options, restricted stock and restricted stock units ("RSUs") and stock bonuses to employees, directors and consultants. The 1996 Plan expired in May of 2006, however, there are still outstanding nonvested options that will continue to affect the Company’s stock-based compensation expense. The 2001 Plan provides for the grant of nonqualified stock options to employees of the Company who are not officers or directors. The 2006 Plan provides for the grant of stock options, restricted stock, RSUs, stock appreciation rights ("SARs"), stock-based and cash-based performance awards and stock bonuses to employees, directors and consultants. The individual stock option plans were created during 2001, 2005 and 2006 as inducements to certain executives to accept offers of employment with the Company. For all six stock-based compensation plans, the exercise price of the options is determined by the Board of Directors, provided that the exercise price for an incentive stock option cannot be less than 100% of the fair market value of the common stock on the grant date and the exercise price for a nonqualified stock option cannot be less than 85% of the fair market value of the common stock on the grant date. The outstanding options for all six plans generally vest over a period of four years and generally expire 10 years from the grant date.

For all of the Company’s stock-based compensation plans, the fair value of each grant was estimated at the date of grant using the Black-Scholes option pricing model. Black-Scholes utilizes assumptions related to volatility, the risk-free interest rate, the dividend yield and expected life. Expected volatilities utilized in the model are based on the historical volatility of the Company’s stock price. The risk-free interest rate is derived from the U.S. Treasury yield curve in effect at the time of grant. The model incorporates exercise and post-vesting forfeiture assumptions based on an analysis of historical data. The expected life of the fiscal 2006 grants is derived from historical information and other factors. The following summary presents the weighted-average assumptions used for grants issued in fiscal 2006 and fiscal 2005:

The following summary presents information regarding outstanding stock options as of July 1, 2006 and changes during the six months then ended with regard to options under the Plans:

As of July 1, 2006, the total unrecorded deferred stock-based compensation balance for nonvested shares, net of expected forfeitures, was $1.5 million which is expected to be amortized over a weighted-average period of 1.3 years.

Cash received from option exercises was $4.7 million and $8.6 million for the three and six months ended July 1, 2006, respectively, and $914,000 and $1.1 million for the three and six months ended July 2, 2005. For periods subsequent to the adoption of SFAS No. 123R, the Company presents excess tax benefits from the exercise of stock options, if any, in the Consolidated Statement of Cash Flows as a financing cash inflow and as a corresponding reduction in operating cash flow.

Property, plant and equipment are recorded at cost and consist of the following (in thousands):

Depreciation expense was $6.3 million for the three months ended July 1, 2006 and July 2, 2005, and $12.9 million for the three and six months ended July 1, 2006 and July 2, 2005, respectively.

Contingent convertible senior debentures. In June 2004, the Company issued $115.0 million aggregate principal amount of its 3.25% Convertible Senior Debentures due May 15, 2034 in a private placement. The debentures bear regular interest at the annual rate of 3.25%, payable semiannually on May 15 and November 15 of each year until May 15, 2011, after which date, no regular interest will be due. Commencing May 20, 2011 and ending November 14, 2011, and for any six-month period thereafter, contingent interest will be due and payable in the amount of 0.25% of the average trading price of the debentures during a specified period, if the average trading price of the debentures equals or exceeds 125% of the principal amount of the debentures. Refer to Note 7 – Earnings per Share for the potentially dilutive impact of the convertible debentures on future periods.

During the second quarter of 2005, the Company made an irrevocable election to pay the principal amount of debentures in cash upon conversion, however, the Company retains the ability to satisfy the remainder of any conversion payment, exceeding the debenture defined principal, in cash or any combination of cash and common stock. According to their terms, the debentures are callable and convertible into the Company's common stock prior to maturity at the option of the holders under the following circumstances: (1) during any calendar quarter commencing after June 30, 2004 and before March 31, 2029, if the last reported sale price of the Company’s common stock is greater than or equal to 130% of the conversion price of $17.70 per share for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the proceeding calendar quarter; (2) at any time on or after April 1, 2029 if the last reported sale price of the Company’s common stock on any date on or after March 31, 2029 is greater than or equal to 130% of the conversion price; (3) subject to certain limitations, during the five business-day period after any five consecutive trading-day period in which the trading price per debenture for each day of that period was less than 98% of the product of the conversion rate and the last reported sale price of the Company's common stock; (4) if the Company calls the debentures for redemption; (5) upon the occurrence of certain corporate transactions; or (6) if the Company requests a credit rating for the debentures, at any time when the credit ratings assigned to the debentures are below specified levels. While a credit rating has been issued for the debentures, the rating was not requested by the Company, but initiated by the rating agency. Therefore, a change in the current rating will not trigger a call provision. The debentures are initially convertible into 56.5099 shares of the Company's common stock per $1,000 principal amount, which is equivalent to approximately $17.70 per share, for total initial underlying shares of 6,498,639. The conversion rate will be subject to adjustment upon the occurrence of specified events. Pursuant to the underwriting agreement and within 90 days of issuance, the Company filed a shelf registration statement covering resales of the debentures and the common stock issuable upon conversion thereof. The registration statement was declared effective August 26, 2005.

On or after May 20, 2011, the Company may redeem for cash some or all of the debentures at any time and from time to time, for a price equal to 100% of the principal amount of the debentures plus accrued and unpaid contingent interest, if any. Holders have the right to require the Company to repurchase any or all debentures for cash, at a repurchase price equal to 100% of the principal amount of the debentures, plus accrued and unpaid interest on: (1) May 15, 2011, May 15, 2014, and May 15, 2024; and (2) upon the occurrence of a fundamental change (as defined in the debenture indenture). In the case of a fundamental change in which all of the consideration for the common stock in the transaction or transactions constituting the fundamental change consists of cash, the Company also will pay to the holders a make-whole premium (as defined in the debenture indenture), the amount of which could be significant but would not be determinable unless and until there were to be a public announcement of such a fundamental change. Any make-whole premium would be payable to all holders regardless of whether the holder elects to require the Company to repurchase the debentures or elects to surrender the debentures for conversion.

The debentures are unsecured and unsubordinated obligations, and rank equal in priority with all of the Company's existing and future unsecured and unsubordinated indebtedness and senior in right of payment to all of its subordinated indebtedness. The debentures will effectively rank junior to any of the Company's secured indebtedness and any of its indebtedness that is guaranteed by its subsidiaries. Payment of principal and interest on the debentures will be structurally subordinated to the liabilities of the Company's subsidiaries.

There are no financial covenants within the debenture indenture, however, the Company paid penalty interest of 0.25% for the first 90 days of 2005 and paid 0.50% thereafter until the debentures were publicly registered on August 26, 2005. In 2005, the Company paid $305,102 in additional interest to debenture holders due to not having an effective registration statement within the specified timeframe.

In 2004, total proceeds from the issuance of the debentures were $115.2 million. The Company used $25.0 million of the net proceeds to repurchase 1,977,800 outstanding shares of its common stock, $31.2 million to pay the outstanding balance on its credit facility, and approximately $3.7 million to pay related debt issuance costs.

Credit facility. On March 31, 2005, the Company entered into a five-year revolving secured credit facility with Bank of America, N.A. (the "B of A Facility"). Concurrent with the execution of the B of A Facility, the Company terminated its existing $95.0 million credit facility (the "Wells Facility") with Wells Fargo Bank N.A. as administrative agent. The B of A Facility allows borrowings and letters of credit up to a maximum of $40.0 million, with an option to increase borrowings up to $100.0 million, subject to a borrowing base determined by the value of certain inventory, credit card receivables, invested cash and, at the Company’s discretion, mortgaged leaseholds. The B of A Facility is secured by certain assets including, but not limited to, cash, inventory and fixed assets. Borrowings under the B of A Facility bear interest, at the Company’s election, at the prime rate or at London Interbank Offering Rate ("LIBOR") plus a margin ranging from 1.00% to 1.50%, depending on the excess borrowing availability over amounts borrowed. Interest rates are determined quarterly. The Company is charged a commitment fee on the unused portion of the B of A Facility. There are no financial covenants, other than the obligation to maintain a certain percentage of minimum excess availability (as defined in the agreement) at all times. The B of A Facility requires compliance on a monthly basis with certain non-financial covenants, including limitations on incurring additional indebtedness and making investments, the use and disposition of collateral, changes of control, as well as cash management provisions. In conjunction with the debt refinancing, the Company wrote off approximately $559,000 related to the remaining unamortized debt issuance cost from the Wells Facility and capitalized debt issuance costs of approximately $331,000 through December 31, 2005 to be amortized over the life of the agreement using the effective interest method. As of July 1, 2006, the Company had letters of credit outstanding totaling $14.5 million which reduce our availability to approximately $25.5 million.

The Company does not have any derivative financial instruments as of July 1, 2006 that meet the criteria of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.

Earnings per share are calculated in accordance with the provisions of SFAS No. 128, Earnings Per Share ("SFAS No. 128"). SFAS No. 128 requires the Company to report both basic earnings per share, which is based on the weighted-average number of common shares outstanding, and diluted earnings per share, which is based on the weighted-average number of common shares outstanding and all dilutive potential common shares outstanding, except where the effect of their inclusion would be anti-dilutive. Anti-dilutive stock options of 154,479 and 994,948 for the three months ended July 1, 2006 and July 2, 2005, respectively, and 202,406 and 1,728,802 for the six months ended July 1, 2006 and July 2, 2005, respectively, were not included in the diluted earnings per share calculations.

The Emerging Issues Task Force ("the Task Force") of the Financial Accounting Standards Board ("FASB") concluded in Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share that contingently convertible debt should be included in diluted earnings per share computations using the if-converted method regardless of whether any of the conversion contingencies have been met. During the second quarter of 2005, the Company irrevocably elected to satisfy 100% of the principal amount of the debentures in cash to be converted on or after July 1, 2005. The Company maintains the right to satisfy the remainder of the conversion obligation to the extent it exceeds the principal amount in cash or common stock or any combination of cash and common stock. In calculating diluted earnings per share for the six months ending July 1, 2006, no shares related to the debentures conversion have been included as the effect would have been anti-dilutive.

During the first and second quarters of fiscal 2006, no goodwill was recorded as a result of acquisitions, the Company concluded goodwill was not impaired and no other changes in the carrying amount of goodwill occurred. During the first quarter of fiscal 2005, the Company closed its remaining store in Eugene, Oregon and exited the market area. Associated goodwill of $960,000, net of accumulated amortization recorded prior to the adoption of FASB No. 142, Goodwill and Other Intangible Assets, was written off resulting in an ending net balance of $105.1 million.

Other intangible assets consist of the following (in thousands):

Amortization expense related to finite lived intangible assets was $89,000 and $93,000 for the three months ended July 1, 2006 and July 2, 2005, respectively, and $179,000 and $196,000 for the six months ended July 1, 2006 and July 2, 2005, respectively. The estimated amortization of finite lived intangible assets for the remainder of 2006 and each of the fiscal years through 2011 is as follows (in thousands):

During the second quarter of fiscal 2006, the Company recorded restructuring and asset impairment charges of $295,000 consisting of the following components (in thousands):

Details of the significant components are as follows:

• Changes in estimate related to lease-related liabilities for sites previously identified for closure ($70,000 of restructuring expense) - During the second quarter of fiscal 2006, the Company accrued additional amounts for its closed store located in Florida. Based on changes in facts and circumstances and the related change in estimate, the Company adjusted remaining lease-related liabilities previously recorded for this location and recognized the additional restructuring expense during the second quarter of fiscal 2006.

• Severance for employees notified of termination in the second quarter of fiscal 2006 ($5,000 of restructuring expense) - During the second quarter of 2006, five employees were notified of their involuntary termination in connection with one store designated to be closed. As of July 1, 2006, no benefits had been paid to these terminated employees.

• Accretion expense on lease-related liabilties ($184,000 of restructuring expense) - During the second quarter, the Company accrued accretion expense on reserves for lease-related liabilities that were calculated using the net present value of the minimum lease payments (net of sublease income).

• Asset impairment charges ($36,000 of restructuring expense) – During the second quarter, management identified asset impairment charges of $36,000 for the net book value of assets to be disposed of from one store location designated to be closed.

During the second quarter of 2006, there were no asset impairment charges in accordance with the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. In determining whether an impairment exists, the Company estimates the store’s future cash flows on an undiscounted basis, and if the cash flows are not sufficient to recover the carrying value, then the Company uses a discounted cash flow based on a risk-adjusted discount rate, to adjust its carrying value of the assets, and records a provision for impairment as appropriate. The Company continually re-evaluates its stores’ performance to monitor the carrying value of its long-lived assets in comparison to projected cash flows.

For the six months ended July 1, 2006, the Company recorded net restructuring and asset impairment charges of $2.0 million consisting of the following components (in thousands):

Details of the significant components are as follows:

• Changes in estimate related to lease-related liabilities for sites previously identified for closure ($136,000 of restructuring expense) – For the six months ended July 1, 2006, the Company accrued additional amounts for closed locations in Florida, Tennessee, and California. Based on changes in facts and circumstances and the related change in estimate, the Company adjusted remaining lease-related liabilities previously recorded for these locations and recognized the additional restructuring expense during the first six months of fiscal 2006.

• Lease-related liability for sites closed year to date through July 1, 2006 ($1.4 million of restructuring expense) – For the six months ended July 1, 2006, the Company closed stores in Portland, Oregon, and Fort Lauderdale, Florida.

• Severance for employees notified of termination ($119,000 of restructuring expense) – For the six months ended July 1, 2006, 75 employees were notified of their involuntary termination in connection with the closure of two stores; one store in Portland, Oregon, one store in Fort Lauderdale, Florida, and a third store designated to be closed in Aurora, Colorado. As of July 1, 2006, $105,000 in benefits had been paid to terminated employees.

• Accretion expense on lease-related liabilties ($312,000 of restructuring expense) – During the first six months of 2006, the Company accrued accretion expense on reserves for lease-related liabilities that were calculated using the net present value of the minimum lease payments (net of sublease income).

• Asset impairment charges ($36,000 of restructuring expense) – During the first six months ended July 1, 2006, management identified asset impairment charges of $36,000 for the net book value of assets to be disposed of from one store location designated to be closed.

The Company incurred charges for accelerated depreciation related to planned store closures of $34,000 and $55,000 for the three months ended July 1, 2006 and July 2, 2005, respectively, and $86,000 and $448,000 for the six months ended July 1, 2006 and July 2, 2005, respectively. These costs are included in the "Cost of goods sold and occupancy costs" line of the Consolidated Statements of Operations.

As of July 1, 2006, the Company’s restructuring balances consist of $2.5 million in accrued liabilities and other long-term obligations of $5.5 million.

For the six months ended July 1, 2006, the Company recorded $452,000 of income tax expense, as a result of income before income taxes of $8.2 million during the period. The tax expense relates to income generated by the Company’s Canadian operations. The Company has a $67,000 net deferred tax asset, which was generated primarily as a result of temporary differences related to its Canadian operations. The Company performs assessments of the realization of its net deferred tax assets according to SFAS No. 109 ("SFAS No. 109"), Accounting for Income Taxes. As a result of these assessments, the Company concluded at January 1, 2005, that it should place a full valuation allowance against its US net deferred tax asset. The Company has assessed its valuation allowance during the current quarter and continues to record a full valuation allowance against its US net deferred tax asset.

In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109 ("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. FIN No. 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN No. 48 are effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the possible impact implementing FIN No. 48 may have on its financial position and results of operations.

Perry D. Odak. In May 2002, the Company’s Board of Directors amended the employment agreement of Perry D. Odak, the Company’s CEO and President. The amendment extended through December 2002, the period during which the issuance by the Company of additional securities as part of an equity financing would entitle Mr. Odak to receive up to 300,000 stock options exercisable for the Company’s common stock. In March 2002, Mr. Odak was issued options to purchase 5,856 shares of common stock under a provision of his employment agreement that provided for the maintenance of his 5% equity position in the event of a capital-raising transaction, based upon the issuance of 111,269 shares of common stock, the resale of which was registered on Form S-3, filed in April 2002. In August 2002, the Company’s Board of Directors approved a third amendment to Mr. Odak’s employment agreement, pursuant to which up to 70,000 of the stock options to which Mr. Odak would be entitled under his employment agreement as a result of the closing of a capital-raising transaction could be granted to other employees of the Company designated by Mr. Odak. The options would only be granted upon the closing of the capital-raising transaction, have a 10-year term, vest over four years and have an exercise price equal to the closing price of the Company’s stock on the date the capital-raising transaction was concluded. An equal number of options would be granted simultaneously to Mr. Odak, provided that the options granted to Mr. Odak would only be exercisable as the options granted to other employees terminated (as opposed to expired) without exercise.

As a result of the completion of an equity offering of 4.45 million shares of the Company’s common stock in September 2002, the Company issued options exercisable for 164,211 shares of the Company’s stock to Mr. Odak pursuant to the terms of his employment agreement. An additional 70,000 options, to which Mr. Odak would have been entitled under his employment agreement, were issued to executives of the Company designated by Mr. Odak. The Company also issued an additional 70,000 options to Mr. Odak, provided that the options granted to Mr. Odak are only exercisable as the options granted to the designated executives under the third amendment to Mr. Odak’s employment agreement terminate (as opposed to expire) without exercise. The Company also made a matching grant of 70,000 additional options from the Company’s 1996 Equity Incentive Plan to the same executives. The Company may incur quarterly compensation expense, based on any increase in the then-current stock price over the exercise price, as a result of the issuance of the initial 70,000 options (as opposed to the Company’s matching grant of 70,000 additional options) to the designated executives and Mr. Odak.

The Odak Employment Agreement, as amended, provides for the payment of the existing $9.2 million supplemental bonus in the event of Mr. Odak's death or disability, as defined in the Odak Employment Agreement, while employed by the Company, and for payment of a bonus of approximately $1.6 million: (i) in the event Mr. Odak terminates his employment for "good reason", as defined in the Odak Employment Agreement, or (ii) in the event Mr. Odak is terminated without "Cause", as defined in the Odak Employment Agreement. The Company has acquired an insurance policy for the benefit of the Company to cover Mr. Odak's death or disability in the approximate amount of the supplemental bonus.

In March 2001, Mr. Odak purchased 1,332,649 shares of Common Stock for $6.969 per share for an aggregate purchase price of $9.3 million. Mr. Odak paid $13,326 in cash and executed a full recourse, five-year promissory note for the balance of $9,273,905 to the Company, with interest accruing at 5.5% per annum, compounding semiannually. On February 19, 2006, pursuant to the termination of the five-year promissory note, Mr. Odak sold 678,530 shares of Common Stock for $17.89 per share to the Company. The Company repurchased the shares for $12,138,902, effectively relieving all debt owed by Mr. Odak and reducing the number of shares outstanding by 678,530. The repurchased shares are reflected as treasury shares in the Company’s consolidated balance sheet.

On June 16, 2006, the Company and Mr. Odak entered into the Fifth Amendment to the Employment Agreement to extend the period during which a notice of non-renewal could be given under the Odak Employment Agreement, which continued on a year-to-year basis after expiration of the initial five year term in March 2006. With respect to the existing one-year term, the Company must provide to Mr. Odak notice of non-renewal of the Employment Agreement not later than August 15, 2006 (the period between June 19, 2006 and August 15, 2006 being referred to as the "Extended Notice Period"). The deadline for notice of non-renewal of the Employment Agreement for all years after March 19, 2007 remains unchanged. The Fifth Amendment also provides that Mr. Odak may terminate his employment with the Company for Good Reason (as defined in the Employment Agreement) if (a) the Company, in bad faith, fails to engage in negotiations regarding a new employment agreement or modifications to the Employment Agreement during the Extended Notice Period or (b) during the Extended Notice Period, the Company provides Mr. Odak with a notice of non-renewal of the Employment Agreement prior to August 14, 2006.

Tim Auchterlonie, individually and on behalf of all others similarly situated and the general public, and Roes 1 to 1000 vs. Wild Oats Markets, Inc. and Does 1 through 100, is a suit brought in August 2004 in the Superior Court, County of Los Angeles, for payment of overtime and damages relating to alleged violations of the California Business and Professions Code by a former store director claiming that he should have been classified as an employee paid on an hourly basis, together with other related claims. In mid-2005, five additional named plaintiffs were added to the suit, and the trials of the original plaintiff and the new plaintiffs were bifurcated. The Company believes that all of the named plaintiffs were correctly classified as exempt employees based upon their job duties. The Company has settled with the original plaintiff, and the trial date has been vacated. A trial for the remaining plaintiffs has been set for third quarter 2006.

Ana Marie Hoeppner et al. v. Wild Oats Markets, Inc., Superior Court, County of Los Angeles, is a case filed by seven California plaintiffs involving parties and claims found in the Auchterlonie lawsuit disclosed above. The Company believes that it will prevail on the issue of improper classification as managerial employees. The lawsuit is in the initial discovery phase.

In June 2002 an administrative law judge ("ALJ") found against the Company in Wild Oats Markets, Inc. and Local 371, United Food & Commercial Workers, in certain unfair labor practice charges brought in connection with the opening of the Company’s store in Westport, Connecticut. In May 2005, the NLRB issued a Decision and Order, setting forth certain equitable, injunctive and monetary remedies to be undertaken by the Company, including payment of backpay less interim earnings, and offers of employment to certain former employees of a store that the Company sold in 2000 (the "Sold Store"). The Company agreed to reinstate one former employee and paid an immaterial amount to settle all claims related to the Sold Store.

The Company also is named as defendant in various actions and proceedings arising in the normal course of business. In all of these cases, the Company is denying the allegations and is vigorously defending against them and, in some cases, has filed counterclaims. Although the eventual outcome of the various lawsuits cannot be predicted, it is management’s opinion that these lawsuits will not result in liabilities that would materially affect the Company’s consolidated results of operations, financial position, or cash flows.

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

This Executive Summary section of Management’s Discussion and Analysis of Financial Condition and Results of Operations provides a broad summary of the more specific and detailed information disclosed in other sections of this report. The context that it provides should be viewed as a supplement to, and read in conjunction with, the details contained elsewhere in this report.

In 2006, we continued to improve our gross margins over last year, which is the result of strengthening of our marketing and merchandising initiatives and improvements in supply chain efficiencies. Through the date of this report in 2006, all three of our new store openings this year set records for the highest grand opening sales in the Company’s history by their respective format. To date, we have also closed three smaller, older, under-performing stores.

As of the end of the second quarter of fiscal 2006, we had 113 stores located in 24 states and Canada, as compared to 111 stores located in 24 states and Canada at the end of the second quarter of fiscal 2005.

Results of Operations

Our net income for the three and six months ended July 1, 2006 was $4.9 million or $0.16 per diluted share and $7.8 million or $0.26 per diluted share, respectively, compared with net income of $922,000 or $0.03 per diluted

share and a net loss of $229,000 or $0.01 per diluted share, in the same periods in fiscal 2005. The following tables set forth, for the periods indicated, certain selected income statement data expressed as a percentage of sales and in dollars (in thousands – percentages may not add due to rounding):

Sales for the three and six months ended July 1, 2006 increased 4.2% and 5.7%, respectively, as compared to the same periods in fiscal 2005. These increases were primarily driven by positive comparable sales and a greater number of stores in our store base compared to 2005. Total square feet of open stores increased 2.8% over the second quarter of 2005, as the second fiscal quarter 2006 ended with 2.60 million total square feet as compared to 2.53 million total square feet in the second fiscal quarter of 2005. Comparable store sales increased 1.3% for the second quarter of 2006 and 2.7% for the year to date period ended July 1, 2006 as compared to an increase of 5.4% and 2.5% in the same periods last year. Reduced comparable store sales in the second quarter of 2006 relative to last year is attributed to the short-term impact of new competition and a shift in timing for major promotional activity.

Gross profit consists of sales less cost of goods sold and store occupancy costs. Occupancy costs include store related depreciation, rent and utilities. As a percentage of sales, gross profit increased to 30.2% in the second quarter of fiscal 2006 and 30.4% for the year to date period ended July 1, 2006 from 29.0% and 28.9% for the same periods in fiscal 2005, respectively. The improvement in gross margin relative to last year can be attributed to continued strength in higher margin product categories, improvements in supply chain efficiencies, as well as having fewer new stores open in this year’s second quarter relative to 2005. Traditionally, the gross margins of new stores are lower due to higher shrink and heavy promotional activity.

Direct store expenses include payroll, payroll taxes and benefits, marketing and advertising, regional store support services, store supplies and maintenance, and other store-specific costs. As a percentage of sales, direct store expenses remained relatively constant in the three and six months ended July 1, 2006, from the same periods last year.

Selling, general and administrative ("SG&A") expenses include corporate administrative support services and purchasing. SG&A expenses for the quarter ended July 1, 2006 increased 0.2% as a percentage of sales compared to the same period in fiscal 2005. For the six months ended July 1, 2006, SG&A expenses increased 0.6% as a percentage of sales as compared to the same period in fiscal 2005. SG&A expenses in the second quarter and year to date period ended July 1, 2006 were higher as a percentage of sales compared to the same periods in 2005 primarily due to an increase in accrued bonuses, professional fees, and the impact of expensing stock compensation resulting from the implementation of Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS No. 123R").

Pre-opening expenses include labor, rent, advertising, utilities, training, supplies and certain other costs incurred prior to a store’s opening. Pre-opening expenses for the second quarter of fiscal 2006 increased to $792,000 compared to $780,000 during the same period in fiscal 2005, due to the timing of the opening of new stores, in addition to the costs related to future planned store openings. Furthermore, as we move into denser market areas causing the number of our non-turnkey leases to increase, we are experiencing additional rent expense earlier in the opening process due to longer construction periods.

The number of stores opened is as follows:

In the second quarter of fiscal 2006, we opened one new Wild Oats Natural Marketplace store in Tampa, Florida. As of the date of this report, we have also opened a new Capers Community Market in Vancouver, British Columbia.

Restructuring and asset impairment charges, net

Restructuring and asset impairment charges consist of the following components (in thousands):