Cost U Less (CULS) 10-Q 2006 Q2 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED JULY 2, 2006

OR

oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM _________          TO___________

COMMISSION FILE NUMBER           0-24543

COST-U-LESS, INC.

(Exact name of registrant as specified in its charter)

Washington	91-1615590
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

3633 136^th Place SE, Suite 110
Bellevue, Washington 98006
(Address of principal executive office) (Zip Code)

(425) 945-0213

(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 and 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. xYESoNO.

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

Large accelerated filero Accelerated filero Non-accelerated filerx

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
oYESxNO.

The registrant had 4,021,998 common shares, par value $0.001, outstanding at August 4, 2006.

COST-U-LESS, INC.

INDEX TO FORM 10-Q

PART I.	FINANCIAL INFORMATION
	Item 1.	Financial Statements (Unaudited)
		Condensed Consolidated Statements of Operations.	3
		Condensed Consolidated Balance Sheets.	4
		Condensed Consolidated Statements of Shareholders’ Equity.	5
		Condensed Consolidated Statements of Cash Flows.	6
		Notes to Condensed Consolidated Financial Statements.	7
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	17
	Item 4.	Controls and Procedures	17
PART II.	OTHER INFORMATION
	Item 1A.	Risk Factors.	18
	Item 4.	Submission of Matters to a Vote of Security Holders.	22
	Item 6.	Exhibits.	22
SIGNATURES			23

2

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)

COST-U-LESS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)

(Unaudited)

	13 WeeksEnded						26 WeeksEnded
	July 2, 2006			June 26, 2005			July 2, 2006			June 26, 2005
Net sales	$	53,568		$	52,295		$	108,260		$	105,534
Merchandise costs		43,515			42,597			88,008			86,262
Gross profit		10,053			9,698			20,252			19,272
Operating expenses:
Store		7,319			6,978			14,535			13,705
General and administrative		1,680			1,513			3,343			3,210
Store openings		139			233			153			264
Store closings		0			59			0			59
Total operating expenses		9,138			8,783			18,031			17,238
Operating income		915			915			2,221			2,034
Other income (expense):
Interest expense, net		(107	)		(59	)		(213	)		(110	)
Other		(3	)		(34	)		(15	)		82
Income before income taxes		805			822			1,993			2,006
Income tax provision		330			310			760			760
Net income	$	475		$	512		$	1,233		$	1,246
Earnings per common share:
Basic	$	0.12		$	0.13		$	0.31		$	0.32
Diluted	$	0.11		$	0.12		$	0.29		$	0.30
Weighted average common shares outstanding, basic		4,021,173			3,981,856			4,009,506			3,886,453
Weighted average common shares outstanding, diluted		4,244,038			4,228,017			4,232,807			4,134,133

The accompanying Notes to the Condensed Consolidated Financial Statements are an integral part of these statements.

3

COST-U-LESS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)

(Unaudited)

	July 2, 2006		January 1, 2006
ASSETS
Current assets:
Cash and cash equivalents	$	4,031	$	5,304
Accounts receivable, net		842		843
Inventories, net		24,565		23,027
Other current assets		1,615		1,136
Total current assets		31,053		30,310
Buildings and equipment, net		19,858		18,550
Deposits and other assets		713		772
Total assets	$	51,624	$	49,632
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	15,164	$	15,062
Accrued expenses and other liabilities		5,680		5,422
Line of credit		389		80
Current portion of long-term debt		267		267
Current portion of capital lease		234		226
Total current liabilities		21,734		21,057
Other long-term liabilities		1,341		1,192
Long-term debt, less current portion		1,877		2,011
Capital lease, less current portion		1,210		1,329
Total liabilities		26,162		25,589
Commitments and contingencies		—		—
Shareholders’ equity		25,462		24,043
Total liabilities and shareholders’ equity	$	51,624	$	49,632

The accompanying Notes to the Condensed Consolidated Financial Statements are an integral part of these statements.

4

COST-U-LESS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands, except share data)

(Unaudited)

	Common Stock— Shares		Common Stock— Amount		Retained Earnings		Accumulated Other Comprehensive Loss			Total
Balance at December 26, 2004		3,751,306	$	12,795	$	7,911	$	(773	)	$	19,933
Net income		—		—		1,246		—			1,246
Foreign currency translation adjustments		—		—		—		(18	)		(18	)
Comprehensive income											1,228
Exercise of common stock options including income tax benefit		238,570		1,111		—		—			1,111
Balance at June 26, 2005		3,989,876	$	13,906	$	9,157	$	(791	)	$	22,272
Balance at January 1, 2006		3,990,171	$	13,931	$	10,926	$	(814	)	$	24,043
Net income		—		—		1,233		—			1,233
Foreign currency translation adjustments		—		—		—		(8	)		(8	)
Comprehensive income											1,225
Stock based compensation		—		20		—		—			20
Exercise of common stock options including income tax benefit		31,827		174		—		—			174
Balance at July 2, 2006		4,021,998	$	14,125	$	12,159	$	(822	)	$	25,462

The accompanying Notes to the Condensed Consolidated Financial Statements are an integral part of these statements.

5

COST-U-LESS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

(Unaudited)

	26 Weeks Ended
	July 2, 2006			June 26, 2005
OPERATING ACTIVITIES:
Net income	$	1,233		$	1,246
Adjustments to reconcile net income to net cash provided/(used) by operating activities:
Depreciation and amortization		1,141			883
Stock Option Expense		20			—
Deferred tax provision		94			146
Loss on buildings and equipment		22			35
Tax benefit from exercise of stock options		—			684
Cash provided by/(used in) changes in operating assets and liabilities:
Accounts receivable		121			(887	)
Inventories		(1,538	)		(605	)
Other current assets		(482	)		(532	)
Deposits and other assets		59			6
Accounts payable		470			(1,199	)
Accrued expenses and other liabilities		(550	)		(1,220	)
Other long-term liabilities		58			(2	)
Net cash provided/(used) by operating activities		648			(1,445	)
INVESTING ACTIVITY:
Cash used to purchase property and equipment		(2,482	)		(4,813	)
Proceeds from sale of buildings and equipment		8			68
Net cash used by investing activities		(2,474	)		(4,745	)
FINANCING ACTIVITIES:
Proceeds from exercise of common stock options		128			427
Tax benefit from exercise of stock options		46			—
Proceeds from short term note payable		688			—
Proceeds from capital lease obligations		—			500
Proceeds from line of credit, net		309			2,873
Increase/(decrease) in bank checks outstanding		(368	)		645
Principal payments on capital lease obligations		(111	)		(50	)
Principal payments on long-term debt		(134	)		(133	)
Net cash provided by financing activities		558			4,262
Foreign currency translation adjustments		(5	)		(9	)
Net decrease in cash and cash equivalents		(1,273	)		(1,937	)
Cash and cash equivalents:
Beginning of period		5,304			6,081
End of period	$	4,031		$	4,144
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest	$	219		$	230
Income taxes	$	546		$	465
Cash received during the period for:
Income taxes	$	45		$	14

The accompanying Notes to the Condensed Consolidated Financial Statements are an integral part of these statements.

6

COST-U-LESS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Nature of Business and Summary of Significant Accounting Policies

     Nature of Business

          Cost-U-Less, Inc. (the “Company”) operates mid-sized warehouse club-style stores in various United States Territories (“U.S. Territories”), foreign island countries in the Pacific and the Caribbean, the Hawaiian Islands and Sonora, California. As of July 2, 2006, the Company operated eleven retail stores as follows: two stores in each of Hawaii and Guam, and one store in each of St. Thomas, St. Croix, American Samoa, Fiji, Curacao, St. Maarten and Sonora, California.

          On July 8, 2005, the Company announced that it had been granted approval from the Cayman Islands Trade and Business Licensing Board to operate a retail and wholesale business through a controlled subsidiary organized in the Cayman Islands. And on April 25, 2006, the Company announced that it had entered into a long-term lease with the developer of Governor’s Square in Grand Cayman to lease land on which to construct and operate a store under the Cost-U-Less name. The signing of the lease is one in a number of steps that must be undertaken before a store operating under the Cost-U-Less name can be opened in the Cayman Islands. Although there are still a number of steps that have to be taken before the store can be opened, the Company expects to open the store during the first half of 2007.

     Basis of Presentation

          The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). In the opinion of management, the financial information includes all adjustments that the Company considers necessary for a fair presentation of the financial position at such dates and the operations and cash flows for the periods then ended. The condensed consolidated balance sheet at January 1, 2006, has been derived from the audited financial statements at that date. Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to SEC rules and regulations on quarterly reporting. Operating results for the 13 and 26 week periods ended July 2, 2006, are not necessarily indicative of results that may be expected for the entire year. All quarterly periods reported consist of 13 weeks. For further information, refer to the financial statements and footnotes included in the Company’s annual report on Form 10-K filed with the SEC on March 29, 2006.

     Fiscal Year

          The Company reports on a 52/53-week fiscal year, consisting of four thirteen-week periods and ending on the Sunday nearest to the end of December. Fiscal 2006, ending on December 31, 2006, is a 52-week year. Fiscal 2005, which ended on January 1, 2006, was a 53-week fiscal year.

     Principles of Consolidation

          The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries in the U.S. Virgin Islands, Netherlands Antilles, Guam, American Samoa, Cayman Islands, Nevada, Fiji and New Zealand. All significant inter-company accounts and transactions have been eliminated in consolidation.

7

COST-U-LESS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)

(Unaudited)

     Foreign Currency Translations and Comprehensive Income

          The U.S. dollar is the functional currency for all locations, except for Fiji, Netherlands Antilles and the Cayman Islands, where the local currency is the functional currency. Assets and liabilities denominated in foreign currencies are translated at the applicable exchange rate on the balance sheet date. Net sales, costs and expenses are translated at the average rates of exchange prevailing during the period. Adjustments resulting from this process are reported, net of taxes, as Accumulated Other Comprehensive Income (Loss), a component of Shareholders’ Equity. Realized and unrealized gains on foreign currency transactions are included in Other Income (Expense). The cumulative translation adjustment resulting from a net investment in a country is recognized as income or expense in the period the Company has substantially liquidated operations in that country.

     Use of Estimates

          The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates are used for, but not limited to: allowance for doubtful accounts; depreciable lives of assets; reserves for inventory; and deferred tax valuation allowances. Future events and their effects cannot be determined with certainty. Accordingly, the accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of the consolidated financial statements may change as new events occur, as more experience is acquired, as additional information is obtained and as the Company’s operating environment changes. Actual results could differ from those estimates.

     Stock-Based Compensation

          The Company maintains a stock incentive compensation plan that provides for the granting of various stock awards, including stock options and restricted stock, with a maximum of 1,000,000 shares of common stock available for issuance. Options issued under the plan vest at various terms ranging from immediately to five years and generally expire ten years from the date of grant. The options are generally granted at prices equal to the fair value on the date of grant. There were 357 shares available for future grant under the plan at July 2, 2006.

           Prior to the adoption of Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payments,” which revises SFAS 123, “Accounting for Stock-Based Compensation” in the first quarter of fiscal 2006, the Company accounted for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for stock options. Because the Company generally grants stock options to employees at exercise prices equal to fair market value on the date of grant, no significant compensation cost has been recognized for option grants in periods prior to fiscal 2006. As permitted by SFAS 123, stock-based compensation was included as a pro forma disclosure in the notes to the consolidated financial statements.

          Effective with the first fiscal quarter of fiscal 2006, the Company adopted the fair value recognition provisions of SFAS 123R, using the modified-prospective transition method. Under this transition method, stock-based compensation expense will be recognized in the consolidated financial statements for stock options granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Results for prior periods have not been restated, as provided for under the modified-prospective method.

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

8

COST-U-LESS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)

(Unaudited)

          Had stock option compensation expense for the Company’s stock option plans been recognized based on the estimated fair value on the grant date under the fair value methodology allowed by FAS 123, as amended by FAS 148, the Company’s net income and earnings per share amounts would have been as follows:

	13 Weeks Ended June 26, 2005			26 Weeks Ended June 26, 2005
Net income as reported		$	512		$	1,246
Less: Total stock-based employee compensation expense determined under fair value method for all awards, net of tax			12			14
Net income pro forma		$	500		$	1,232
Earnings per common share, basic as reported		$	0.13		$	0.32
Earnings per common share, basic pro forma		$	0.13		$	0.32
Earnings per common share, diluted as reported		$	0.12		$	0.30
Earnings per common share, diluted pro forma		$	0.12		$	0.30

          Disclosures for the 13 and 26 week periods ended July 2, 2006, are not presented because the amounts are recognized in the consolidated financial statements.

          The following table summarizes the stock option transactions during the 26 weeks ended July 2, 2006:

	Options			Weighted Average Exercise Price			Weighted Average Contractual Life		Aggregate Intrinsic Value (a)
Outstanding at January 1, 2006		613,324			$	3.39		—		—
Granted at fair value		4,000				8.09		—		—
Forfeited		(1,475	)			4.75		—		—
Exercised		(31,827	)			4.06		—		—
Outstanding at July 2, 2006		584,022				3.38		5.65	$	2,742,935
Exercisable at July 2, 2006		583,432				3.39		5.65	$	2,739,153

(a) The intrinsic value of a stock option is the amount by which the market value of the underlying stock exceeds the exercise price of the option.

          The Company recognized stock compensation costs of $20,000 and a related tax benefit of $8,000 during both the 13 and 26 weeks ended July 2, 2006. The expense recorded for the portion vesting in the current period for the 2,090 options granted prior to, but not vested as of, January 1, 2006, is less than $1,000. The remaining unrecognized compensation cost related to these unvested options, as of January 1, 2006, is also less than $1,000. These options will be fully vested as of August 2006.

9

COST-U-LESS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)

(Unaudited)

          Cash proceeds, tax benefits and intrinsic value related to total stock options exercised during the first 26 weeks of fiscal 2006 and fiscal 2005 were as follows (in thousands):

	26 Weeks Ended
	July 2, 2006		June 26, 2005
Proceeds from stock options exercised	$	128	$	427
Tax benefit related to stock options exercised		46		684
Intrinsic value of stock options exercised		134		2,013

Reclassifications

          Certain reclassifications of prior period balances have been made for consistent presentation with the current period.

New Accounting Pronouncements

          In October 2005, the FASB issued Staff Position No. FAS 13-1, “Accounting for Rental Costs Incurred During a Construction Period” (FSP 13-1). FSP 13-1 requires that rental costs associated with ground or building operating leases that are incurred during a construction period be recognized as rental expense. FSP 13-1 is effective for the first reporting period beginning after December 15, 2005. The adoption of FSP 13-1 did not impact the Company’s financial statements for the first quarter of fiscal 2006, as the Company did not have a lease for a site under construction. However, on April 25, 2006, the Company announced that it had entered into a twenty-year lease with the developer of Governor’s Square in Grand Cayman to lease land on which to construct and operate a store under the Cost-U-Less name. Rental payments under this lease commenced on April 1, 2006. In accordance with FSP 13-1 and other applicable lease accounting guidance, the Company will expense rental costs over the lease term, which includes the construction period.

2. Earnings Per Share

          Basic earnings per share is computed using the weighted average number of common shares outstanding during the period and excludes any dilutive effects of stock options and warrants. Diluted earnings per share are computed using the weighted average number of common shares and potentially dilutive shares outstanding during the period. Potentially dilutive shares are excluded from the computation if their effect is anti-dilutive.

          The following table sets forth the computation of basic and diluted earnings per common share:

	13 Weeks Ended				26 Weeks Ended
	July 2, 2006		June 26, 2005		July 2, 2006		June 26, 2005
Numerator:
Net income	$	475	$	512	$	1,233	$	1,246
Denominator:
Denominator for basic earnings per share—weighted average shares		4,021,173		3,981,856		4,009,506		3,886,453
Effect of dilutive common equivalent shares:
Stock options.		222,865		246,161		223,301		247,680
Denominator for diluted earnings per share—adjusted weighted average shares and assumed conversion of stock options		4,244,038		4,228,017		4,232,807		4,134,133
Basic earnings per common share	$	0.12	$	0.13	$	0.31	$	0.32
Diluted earnings per common share	$	0.11	$	0.12	$	0.29	$	0.30

10

COST-U-LESS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)

(Unaudited)

          The diluted share calculation for the 13 and 26 weeks ended July 2, 2006, excludes 8,000 stock options outstanding. These options are excluded due to their anti-dilutive effect.

3. Line of Credit

          The Company has maintained a line of credit with Wells Fargo Business Credit since April 9, 2003. On May 26, 2005, the Company entered into the Fourth Amendment to the Credit and Security Agreement (the Fourth Amendment) as it relates to the line of credit. The Fourth Amendment extended the maturity date of the line of credit from April 9, 2006, to May 18, 2007. Additionally, the Fourth Amendment (1) reduced the interest rate to an annual interest rate equal to the “prime rate” as defined by Wells Fargo Bank National Association, (2) reduced the minimum interest charge to not less than $25,000 per calendar year, (3) increased the unused line fee to a rate of three-eighths of one percent (0.375%) per annum on the average daily unused line and (4) eliminated the one day interest charge on all payments received on the line of credit. The line of credit was further amended on April 20, 2006, to update specific financial covenants contained in the credit agreement, including minimum book net worth, minimum net income and capital expenditures.

          The line of credit consists of a $6.0 million committed, secured revolving credit line with a sublimit for letters of credit and bankers acceptances in an amount up to $0.7 million. At July 2, 2006, there was $0.4 million outstanding on the line of credit and $0.2 million in letters of credit outstanding. At July 2, 2006, the rate charged by Wells Fargo was 8.25%.

          Borrowings continue to be limited to the lesser of $6.0 million or the amount calculated under the borrowing base. The borrowing base is equal to the lesser of (a) $6.0 million or (b) the sum of 70% of eligible inventory in the United States of America, plus 60% of eligible inventory in the U.S. Virgin Islands and Guam, less specified reserves.

          The line of credit contains various covenants, all of which the Company believes it was in compliance with as of July 2, 2006.

4. Commitments and Contingencies

          Legal Proceedings

          We may be subject to legal proceedings or claims, either asserted or unasserted, that arise in the ordinary course of business. While the outcome of these potential claims cannot be predicted with certainty, we do not believe that any pending legal matters will have a material adverse effect on us. However, any adverse outcome to future lawsuits against us may result in a material adverse affect on our financial condition.

11

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

Certain Factors That May Affect Future Results of Operations

          This discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto appearing in Item 1 of this report. In addition to historical information, this quarterly report on Form 10-Q contains, and may incorporate by reference, statements which may constitute forward-looking statements which involve known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements may be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “estimate,” “anticipate,” “continue,” or similar terms, variations of such terms or the negative of those terms, but the absence of such terms does not mean that a statement is not forward-looking. Forward-looking statements reflect the expectations of our management at the time that they are made and do not represent an opinion about what may happen in the future. More information about factors that could affect our financial results is included in Item 1A. of Part II of this report and in the “Risk Factors That May Affect Future Results” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” sections of our annual report on Form 10-K for the fiscal year ended January 1, 2006, which was filed on March 29, 2006, with the Securities and Exchange Commission.

          The following management’s discussion and analysis of financial condition and results of operations should be read in conjunction with management’s discussion and analysis of financial condition and results of operations included in our annual report on Form 10-K for the fiscal year ended January 1, 2006.

          As used in this quarterly report on Form 10-Q, unless the context otherwise requires, the terms “we,” “us,” “our,” “the Company,” and “Cost-U-Less” refer to Cost-U-Less, Inc., a Washington corporation, and its subsidiaries.

Overview

          We operate mid-sized warehouse club-style stores in the United States Territories, foreign island countries in the Pacific and the Caribbean, the Hawaiian Islands and Sonora, California. Our primary strategy is to operate in island markets, offering predominately U.S. branded goods. We currently operate eleven retail stores as follows: two stores in each of Hawaii and Guam, and one store in each of St. Thomas, St. Croix, American Samoa, Fiji, Curacao, St. Maarten and Sonora, California.

          Our stores are patterned after the warehouse club concept, except our stores (i) are smaller (averaging approximately 32,000 square feet vs. large format warehouse clubs of approximately 130,000 square feet), (ii) generally target niche markets, mainly U.S. Territories, U.S. island states and foreign island countries, (iii) carry a wide assortment of local and ethnic food items, and (iv) do not charge a membership fee. Although we do not have large seasonal fluctuations in sales, the fourth quarter is typically the highest sales quarter due to additional holiday sales.

          During fiscal 2005, we built a new St. Croix store on a parcel of land located closer to the main trade area in the center of the island than our existing store. This new building expanded the size of our St. Croix store by about 45% to approximately 38,000 square feet. The new store opened on May 26, 2005.

          On April 25, 2006, we announced that we had entered into a long-term lease with the developer of Governor’s Square in Grand Cayman to lease land on which to construct and operate a store under the Cost-U-Less name through a controlled subsidiary organized in the Cayman Islands. The signing of the lease is one in a number of steps that we must undertake before we can open a store operating under the Cost-U-Less name in the Cayman Islands. Although there are still a number of steps that we have to take before the store can be opened, we expect to open the store during the first half of 2007.

          On August 10, 2006, we completed the remodel and expansion of our store in St. Thomas. In addition to increasing the size of our store by approximately 6,400 square feet (an increase of approximately 18%), we also upgraded and replaced much of the store’s equipment, added a new produce format and a rotisserie department. Additionally, we recently completed a remodel of our Kauai store to add retail enhancements such as fresh produce by the pound. Furthermore, we continue to explore expansion opportunities in selected markets and additional relocation opportunities for stores in existing markets. We currently have no plans to open stores in new markets during fiscal 2006.

12

Results of Operations

          During the 13 and 26 weeks ended July 2, 2006, we continued to experience improvements in comparable-store sales. Additionally, the strong margins we experienced in the second half of fiscal 2005 continued during 2006. These increases were offset by higher store expenses primarily attributable to higher utility expenses. Although, increasing energy costs have impacted our cost of doing business in the form of higher freight charges and store utility costs, we were able to maintain operating margins by passing these costs on in the form of higher pricing. However, if higher energy costs persist, we may not be able to continue to offset these increases in the future.

Comparison of the 13 and 26 Weeks Ended July 2, 2006, to the 13and 26 Weeks Ended June 26, 2005:

          Net Sales: Net sales of $53.6 million for the 13 weeks ended July 2, 2006, increased 2.4% compared to net sales of $52.3 million for the same period in the prior year. Net sales of $108.3 million for the 26 weeks ended July 2, 2006, increased 2.6% compared to net sales of $105.5 million for the same period in the prior year. The increase in net sales in the 13 and 26 weeks ended July 2, 2006, as compared to the same periods in the prior year, was due to comparable-store sales increases partially offset by a decline in business-to-business sales as compared to the same period in the prior year. We expect the level of business-to-business activity for fiscal 2006 to be similar to or slightly less than the levels in 2005.

          Comparable-store sales (stores open for a full 13 months) increased 2.8% and 3.2% for the 13 and 26 weeks ended July 2, 2006, respectively, as compared to the same periods in the prior year. Nine of our eleven stores experienced increased sales in both the 13 and 26 weeks ended July 2, 2006, as compared to the same periods in the prior year, primarily due to general inflationary trends and related price increases, improvements in our assortment of goods and operating improvements including better in-stock inventory levels. The improvement in our comparable-store sales during the 13 weeks ended July 2, 2006, occurred despite the negative impact of the Easter holiday, during which all of our stores are closed for a least one day. The Easter holiday fell in the second quarter of fiscal 2006 as compared to the first quarter of fiscal 2005. This shift in the holiday weekend negatively impacted sales for the 13 weeks ended July 2, 2006, by approximately 1%.

          Gross Profit:Gross profit of $10.1 million, or 18.8% of sales, for the 13 weeks ended July 2, 2006, increased as compared to gross profit of $9.7 million, or 18.5% of sales, in the same period in the prior year. Gross profit of $20.3 million, or 18.7% of sales, for the 26 weeks ended July 2, 2006, increased as compared to gross profit of $19.3 million, or 18.3% of sales, in the same period in the prior year. The improvement in gross profit dollars in both the 13 and 26 weeks ended July 2, 2006, was primarily due to improvements in merchandising, including enhanced sourcing and pricing strategies to maintain operating margins.

          Store expenses:Store expenses increased to $7.3 million and $14.5 million for the 13 and 26 weeks ended July 2, 2006, respectively, as compared to $7.0 million and $13.7 million for the same periods in the prior year. As a percentage of sales, store expenses were 13.7% and 13.4% of sales for the 13 and 26 weeks ended July 2, 2006, respectively, as compared to 13.3% and 13.0% for the same periods in the prior year. For the 13 weeks ended July 2, 2006, approximately 59% of the dollar increase in store expenses was attributable to higher energy (utility) expenses, which were 20% higher than the same period in the prior year. Another 39% of the dollar increase was due to increased depreciation expense, primarily due to our new store in St. Croix. For the 26 weeks ended July 2, 2006, approximately 46% of the dollar increase in store expenses, was attributable to higher energy (utility) expenses, which were 21% higher than the same period in the prior year. Another 32% of the dollar increase was due to increased depreciation expense, primarily due to our new store in St. Croix. An additional 13% of the dollar increase was attributable to payroll and related costs such as health care, which were 2% higher than the same period in the prior year. Payroll and related costs, although higher due to volume, remained comparable as a percent of store sales at 5.2% of store sales for both 2006 and 2005.

          General and administrative expenses:General and administrative expenses increased to $1.7 million and $3.3 million for the 13 and 26 weeks ended July 2, 2006, respectively, as compared to $1.5 million and $3.2 million for the same periods in the prior year. As a percentage of sales, store expenses were 3.1% of sales for both the 13 and 26 weeks ended July 2, 2006, respectively, as compared to 2.9% and 3.0% for the same periods in the prior year. The increase in both the 13 and 26 week periods was primarily attributable to an increase in health benefits paid. Approximately 40% of our employees, including all of our corporate employees, are in a health plan that is self-insured with a stop-loss provision. We experienced a higher volume of claims during the 13 and 26 weeks ended July 2, 2006, than we experienced in the same periods in the prior year.

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          Store opening expenses:Store opening expenses decreased to $0.1 million and $0.2 million for the 13 and 26 weeks ended July 2, 2006, respectively, as compared to $0.2 million and $0.3 million for the same periods in the prior year. Store opening expenses in 2006 include costs associated with our initial work on our store in the Cayman Islands, including rent expense associated with our land lease for that location. Store opening expenses in fiscal 2005 primarily relate to costs associated with the relocation of our St. Croix store and the evaluation of potential new store locations. We expect store opening expenses in fiscal 2006 to be higher than those incurred in fiscal 2005 as we continue to develop our new store in the Cayman Islands.

          Store closing expenses:Store closing expenses of $59,000 in both the 13 and 26 weeks ended June 26, 2005, represent the costs incurred with closing our former St. Croix location after we relocated our store on May 26, 2005.

          Interest expense, net: Interest expense, net increased to $0.1 million and $0.2 million for the 13 and 26 weeks ended July 2, 2006, respectively, as compared to $59,000 and $0.1 million for the same periods in the prior year. The increase was primarily attributable to the capitalization of approximately $40,000 and $0.1 million of interest related to the construction of our new store in St. Croix during the 13 and 26 weeks ended June 26, 2005, respectively.

          Other income/(expense): Other income/(expense) was ($3,000) for the 13 weeks ended July 2, 2006, as compared to ($34,000) for the same period in the prior year. Other income/(expense) was ($15,000) for the 26 weeks ended July 2, 2006, as compared to $82,000 for the same period in the prior year. The decrease in the 26 weeks ended July 2, 2006 was primarily due to the receipt of a $0.1 million non-recurring insurance reimbursement in 2005. All other amounts included in other income/(expense) are attributable to gains on foreign currency transactions and translation of intercompany balances for transactions that exceed the permanent investments in those countries.

          Income tax provision: Our income tax provision for the 13 weeks ended July 2, 2006, increased to $330,000, or 41.0% of pre-tax income, as compared to $310,000, or 37.7% of pre-tax income, for the same period in the prior year. Our income tax provision for the 26 weeks ended July 2, 2006, increased to $760,000, or 38.1% of pre-tax income, as compared to $760,000, or 37.8% of pre-tax income, for the same period in the prior year. The increase in effective tax rate in fiscal 2006 was primarily due to expenses incurred in the Cayman Islands that are not tax deductible as there are no corporate taxes in the Cayman Islands. This increase was partially offset by the implementation of tax planning strategies in the latter half of fiscal 2005, which enabled us to offset a portion of our other foreign subsidiary losses against foreign subsidiary income.

          Net income: Net income was $0.5 million, or $0.11 per fully diluted share, for the 13 weeks ended July 2, 2006, as compared to a net income of $0.5 million, or $0.12 per fully diluted share, in the same period in the prior year. Net income was $1.2 million, or $0.29 per fully diluted share, for the 26 weeks ended July 2, 2006, as compared to $1.2 million, or $0.30 per fully diluted share for the same period in the prior year.

Liquidity and Capital Resources

          We currently finance our operations with proceeds from various credit facilities and internally generated funds. Although we utilized existing working capital to finance the $5.6 million used to purchase the land and construct our new St. Croix store during fiscal 2005, we hope to re-finance our St. Croix store, and any future relocations and new stores, either through an operating lease, a sale-leaseback arrangement or long-term funding from a financial institution. We intend to continue leasing as many of our store locations as feasible. In those instances where a lease is not available on acceptable terms, we intend to finance our stores utilizing long-term funding from a financial institution (as we currently do for our St. Thomas and St. Maarten buildings).

          We generated $0.6 million of net cash from operations during the 26 weeks ended July 2, 2006, as compared to the utilization of $1.4 million of net cash from operations during the same period in the prior year. The increase in cash provided by operations during the 26 weeks ended July 2, 2006, as compared to the same period in the prior year, was primarily due to a decrease in cash used to pay down accounts payable and accrued expenses, partially offset by an increase in cash used to acquire inventory during the 26 weeks ended July 2, 2006.

          Net cash used in investing activities was $2.5 million for the 26 weeks ended July 2, 2006, as compared to $4.7 million in the same period in the prior year. The cash used in investing activities during the 26 weeks ended July 2, 2006, was primarily due to costs associated with renovating and expanding the size of our store in St. Thomas by approximately 6,400 square feet (an increase of approximately 18%) and the replacement of our current point of sale system with a new and improved version. We anticipate that the cost associated with building construction and updating equipment associated with our St. Thomas store will be approximately $1.5 to $1.9 million, of which approximately $1.0 million was spent during the 26 weeks ended July 2, 2006. We anticipate that the cost of replacing our current point of sale system will be approximately $1.0 million when complete, most of which will be financed with a capital lease. Additionally, we spent approximately $0.2 million on the remodel of our Kauai

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store in order to add retail enhancements such as fresh produce by the pound. The cash used in investing activities in the 26 weeks ended June 26, 2005, was primarily due to costs associated with the construction of the new building in St. Croix where we relocated our St. Croix store on May 26, 2005.

          We currently have no plans to open stores in new markets during fiscal 2006. However, we are currently in the process of working with local architects and engineers to define the type of building we could construct in the Cayman Islands, which we expect to open during the first half of 2007. We anticipate spending approximately $3.5 to $4.5 million dollars during fiscal 2006 on our proposed new store in the Cayman Islands. In addition, we are continuing to explore expansion opportunities in selected markets and additional relocation opportunities for stores in existing markets.

          We generated $0.5 million of cash from financing activities in the 26 weeks ended July 2, 2006, as compared to $4.3 million generated in the same period in the prior year. The $3.7 million decrease was primarily due to a decrease in borrowings on our line of credit and a decrease in bank checks outstanding during the 26 weeks ended July 2, 2006, as compared to the same period in the prior year. This was partially offset by $0.7 million obtained from a short term note payable that is being utilized to finance the replacement of our point of sale system. The short term note payable will be converted into a capital lease once all of our stores are converted over to the new system, which we expect to occur in the third quarter of 2006.

          We maintain a line of credit with Wells Fargo Business Credit. The line of credit expires on May 18, 2007, has an annual interest rate equal to the “prime rate” as defined by Wells Fargo Bank National Association, and has an unused line fee of three-eighths of one percent (0.375%) per annum on the average daily unused line. The line of credit contains various financial covenants, including minimum book net worth, minimum net income and capital expenditures.

          The line of credit consists of a $6.0 million committed, secured revolving credit line with a sublimit for letters of credit and bankers acceptances in an amount up to $0.7 million. At July 2, 2006, there was $0.4 million outstanding on the line of credit and $0.2 million in letters of credit outstanding. At July 2, 2006, the rate charged by Wells Fargo was 8.25%.

          Borrowings continue to be limited to the lesser of $6.0 million or the amount calculated under the borrowing base. The borrowing base is equal to the lesser of (a) $6.0 million or (b) the sum of 70% of eligible inventory in the United States of America, plus 60% of eligible inventory in the U.S. Virgin Islands and Guam, less specified reserves.

          A significant portion of our cash flow is generated by our operations. If our operating results deteriorate as a result of a decrease in customer demand, declining economic conditions in the markets in which we have stores, energy related cost increases, or pricing pressures from our customers or our competitors, our ability to generate positive cash flow from operations may be jeopardized. We believe that amounts available under our various credit facilities, existing cash available for working capital purposes, and cash flow from operations will most likely be sufficient to fund our operations through the next twelve months. However, if such sources of liquidity are unavailable or insufficient to satisfy our liquidity requirements, we may need to issue equity or debt securities, obtain additional credit facilities or consider alternative financing arrangements. There can be no assurance that we will be able to obtain additional financing when needed, or that any available financing will be on terms acceptable to us.

Contractual Obligations

          As of July 2, 2006, our commitments to make future payments under long-term contractual obligations were as follows (in thousands):

	Payments Due by Period
Contractual Obligations	Total		Less than 1 year		1 to 3 years		4 to 5 years		After 5 years
Long-term debt	$	2,144	$	267	$	534	$	534	$	809
Operating Leases (1)		35,684		4,959		8,936		4,999		16,790
Capital Lease		1,723		321		642		572		188
Total	$	39,551	$	5,547	$	10,112	$	6,105	$	17,787

(1) Adjusted to reflect a new agreement to lease land entered into in April 2006 for a potential store location in the Cayman Islands. The agreement commenced on April 1, 2006 and provides for a lease term of 20 years from the date on which the building is completed and ready for occupancy. Initial payments under the agreement are $15,000 per month until the building is completed and ready for occupancy, after which the base rent under the lease agreement will increase pursuant to its terms.

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Critical Accounting Policies

          We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. The significant accounting policies are summarized in Note 1 to the consolidated financial statements included in our annual report on Form 10-K for the fiscal year ended January 1, 2006.

          The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience and other factors believed 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. Actual results could differ from those estimates.

          We believe that the following accounting policies are the most critical in the preparation of our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain.

Inventories

          Inventories are carried at the lower of average cost or market. We provide for estimated inventory losses between physical inventory counts on the basis of a percentage of sales. The provision is adjusted periodically to reflect the trend of actual physical inventory count results.

Long Lived Assets

          When facts and circumstances indicate that the carrying values of long-lived assets, including intangibles, may be impaired, an evaluation of the recoverability is performed by comparing the carrying value of the assets to projected future cash flows. Upon indication that the carrying value of such assets may not be recoverable, we recognize an impairment loss by a charge against current operations.

Foreign Currency Translation

          The U.S. dollar is the functional currency for all our locations, except for Fiji, Netherlands Antilles and the Cayman Islands, where the local currency is the functional currency. Assets and liabilities denominated in foreign currencies are translated at the applicable exchange rate on the balance sheet date. Net sales costs and expenses are translated at the average rates of exchange prevailing during the period. Adjustments resulting from this process are reported, net of taxes, as Accumulated Other Comprehensive Income (Loss), a component of Shareholders’ Equity. Realized and unrealized gains on foreign currency transactions are included in Other Income (Expense). The cumulative translation adjustment resulting from a net investment in a country is recognized as income or expense in the period we substantially liquidated operations in that country.

Income Taxes

          Income tax expense includes U.S. and foreign income taxes. We account for income taxes under the liability method. Under the liability method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. We apply judgment in determining whether it is more likely than not that the deferred tax assets will be realized, and valuation allowances are established when necessary. Our effective tax rate is currently higher than the expected federal statutory rate because valuation allowances have been established against the tax benefits of foreign losses, as we have no assurance that we will be able to generate an adequate amount of taxable income in the future to utilize such benefits. We are developing and implementing certain tax planning strategies which may affect our ability to recognize some of the deferred tax assets that are currently allowed for and may ultimately change our estimate of the valuation allowance.

Accounting Pronouncements

          In October 2005, the FASB issued Staff Position No. FAS 13-1, “Accounting for Rental Costs Incurred During a Construction Period” (FSP 13-1). FSP 13-1 requires that rental costs associated with ground or building operating leases that are incurred during a construction period be recognized as rental expense. FSP 13-1 is effective for the first reporting period beginning after December 15, 2005. The adoption of FSP 13-1 did not impact our financial statements for the first quarter of fiscal 2006, as we did not have a lease for a site under construction. However, on April 25, 2006, we announced that we had entered into a twenty-year lease with the developer of Governor’s Square in Grand Cayman to lease land on which to

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construct and operate a store under the Cost-U-Less name. Rental payments under this lease commenced on April 1, 2006. In accordance with FSP 13-1 and other applicable lease accounting guidance, we will expense rental costs over the lease term, which includes the construction period.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

          We operate stores in foreign countries and have market risks associated with foreign currencies. However, sales are primarily made in U.S. dollars or foreign currencies with minimal trade credit extended and no borrowings exist in foreign currencies. Cash deposited from sales are remitted back to the U.S. bank account routinely.

          We record gains and losses on foreign currency transactions, and translation of intercompany balances for transactions that exceed the permanent investments in those countries in Other Income (Expense). Gains and losses are primarily attributable to appreciation and (depreciation) in the Fijian dollar as compared to the U.S. dollar.

          We operate in three foreign countries that function under currencies other than the US dollar. Two of the these foreign countries operate under the Netherlands Antilles Guilder that has historically had an exchange rate fixed to the U.S. dollar but there can be no assurance that this will continue. If the Netherlands Antilles Guilder is allowed to float this would lead to an increase in foreign exchange volatility and risk which could have a materially adverse effect on our business, financial condition and operating results. There is also the possibility these three foreign countries that function under currencies other than the U.S. dollar could devalue their currency against the U.S. dollar at any time and if this was to occur there could be a materially adverse effect on our business, financial condition and operating results.

          We have also assessed our vulnerability to interest rate risk associated with our financial instruments, including, cash and cash equivalents, lines of credit and long term debt. Due to the nature of these financial instruments, we believe that the risk associated with interest rate fluctuations does not pose a material risk. Our line of credit and long-term debt can be expected to vary in the future as a result of future business requirements, market conditions and other factors.

          We did not have any derivative financial instruments as of July 2, 2006.

ITEM 4. CONTROLS AND PROCEDURES

          Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of July 2, 2006. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of such date.

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PART II – OTHER INFORMATION

ITEM 1A. RISK FACTORS

          You should carefully consider the following factors that may affect future results and other information included in this annual report. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that are currently deemed immaterial also may impair our business operations or could cause actual results to differ from historical results or those anticipated. If any of the following risks actually occur, our business, financial condition and operating results could be materially adversely affected.

Because we have a small store base, adverse store performance or increased expenses will have a more significant adverse impact on our operating and financial results than if we had a larger store base.

          We opened our first store in 1989 and opened a total of 21 stores through June 2006 and presently operate eleven stores. Our closure of the ten other stores prior to March 2001 adversely affected our operating results. Should any existing store experience a significant decline in profitability or any new store be unprofitable, the negative effect on our business would be more significant than would be the case if we had a larger store base, and could have a material adverse effect on our business, financial condition and results of operations. In addition, if our general and administrative expenses increase, the negative effect on our business and results of operations would be more significant than if we had a larger store base. Although we intend to carefully plan for the implementation of additional stores, there can be no assurance that such plans can be executed as envisioned or that the implementation of those plans will not have a material adverse effect on our business, financial condition and results of operations. In addition, our ability to acquire products at a lower cost than competitors or obtain volume-based pricing can be adversely affected because of our small store base.

Our ability to operate profitably in existing markets and to expand into new markets may be adversely affected by competing warehouse clubs or discount retailers.

          The warehouse club and discount retail businesses are highly competitive. If we fail to successfully respond to competitive pressures in this industry, or to effectively implement our strategies to respond to these pressures, our operating results may be negatively affected. Many of our competitors have substantially greater resources, buying power and name recognition than we have. The cost of doing business in island markets is typically higher than on the U.S. mainland because of ocean freight and duty costs and higher facility costs. In addition, our gross margin and operating income are generally lower for stores in markets where traditional warehouse clubs and discount retailers also operate stores, due to increased price competition and reduced market share. We may be required to implement price reductions and other actions in order to remain competitive in our markets. For example, Costco is expected to open a new store in Kauai in late 2006, which would likely cause our gross margin and operating income for our Kauai store to be lower in fiscal 2006 due to the increased competition and reduced market share and the actions we may be required to take to remain competitive in Kauai. Furthermore, our ability to expand into and operate profitably in new markets may be adversely affected by the existence or entry of competing warehouse clubs or discount retailers. These factors could result in reduced sales and margins or loss of market share, any of which could negatively affect our results of operations.

One or more of our stores may be damaged or destroyed by volatile weather conditions or natural disasters, which would severely harm our business and financial results.

          Our stores are primarily located on islands subject to volatile weather conditions and natural disasters, such as tsunamis, hurricanes, floods, typhoons and earthquakes. If the islands on which any of our stores is located experienced any of these or other severe weather conditions or natural disasters, one or more of our stores could be damaged significantly or destroyed. For example, on December 8, 2002, our two stores on the island of Guam suffered damage from Supertyphoon Pongsona, resulting in the immediate closure of both stores. Our Tamuning store lost its generator in the storm and our Dededo store had to be closed for reconstruction. Additionally, we have four stores in the Caribbean, which has experienced increased activity from hurricanes and tropical storms in the past few years. The damage or destruction of one or more of our stores would materially harm our business, operating results and financial condition. We could also experience business interruptions, delays in shipping, delays in construction or loss of life as a result of severe weather conditions, any of which could materially affect our business.

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If we were to experience a catastrophic loss as a result of severe weather conditions or otherwise, we may exceed our insurance policy limits and we may have difficulty obtaining similar insurance coverage in the future.

          We maintain property, casualty and business interruption insurance coverage in amounts we consider customary in our industry for these types of events. However, insurance payments generally do not fully reimburse us for all of the damages and lost profits caused by adverse weather events. If any insurance reimbursement we receive does not fully cover the losses and business interruption caused by severe weather events or natural disasters, or if our insurance coverage is not adequate to cover such losses or we exceed our insurance policy limits, we may be required to pay substantial amounts and our financial condition and liquidity would suffer.

          Additionally, we utilize a combination of insurance policies and self-insurance mechanisms to provide for the potential liabilities for property insurance, general liability, director and officers’ liability, workers’ compensation and employee health care insurance. The costs related to obtaining our current insurance coverage have been increasing. If the costs of maintaining this insurance coverage continue to increase significantly, we would experience an associated increase in our store and administrative expenses that may negatively impact our results of operations. In addition, there is no assurance as to how casualty insurance carriers may react to increasing weather related damages in areas where are stores are located. If we are unable to maintain our current or similar insurance coverage, or if an event were to occur that was not covered by our current insurance policy coverage levels (including acts of terrorism, war and actions such as government nationalizations), our business and results of operations could suffer.

If energy costs and fuel surcharges continue to rise, the profitability of our stores may decline and our business and financial condition could suffer.

          We have experienced increasing energy and fuel surcharge costs over the last few years and have largely been able to pass these additional costs on to our customers with higher prices. For example, during the 26 weeks ended July 2, 2006, our energy (utility) expenses were approximately 20% higher than the same period in fiscal 2005. If these costs continue to rise, we may not be able to continue the practice of passing on these additional costs to our customers. Our inability to effectively pass on these costs to our customers could have a significant adverse effect on our business, results of operations and financial condition.

If we fail to effectively manage the logistical and local operating challenges we face because our business primarily consists of island and international operations, our business and results of operations would suffer.

          Our net sales from island operations represented approximately 94.5% of our total net sales for fiscal 2005. We expect that our island and international operations together will continue to account for nearly all of our total net sales. The distance, as well as the time-zone differences, involved with island locations impose significant challenges to our ability to manage our operations. Logistical challenges are presented by operating individual store units in remote locations, whether in terms of information flow or transportation of goods. In addition, island operations involve uncertainties arising from items such as:

§	Changes in local labor markets, including unionization and inadequate labor pools;
§	Local business practices, language and cultural considerations, including the capacity or willingness of local business and government officials to provide necessary services;
§	Ability to acquire, install and maintain modern capabilities such as dependable and affordable electricity, telephone, computer, Internet and satellite connections often in undeveloped regions;
§	Political, military and trade tensions;
§	Currency exchange rate fluctuations and repatriation restrictions;
§	Local economic conditions;
§	Difficulty enforcing agreements or protecting intellectual property;
§	Collection of debts and other obligations in foreign countries; and
§	Volatile island operating expenses, including utilities.

          Our inability to effectively manage these logistical challenges and local uncertainties inherent in our island and international operations could have a significant adverse effect on our business, results of operations and financial condition.

We do not have operating experience in many of the markets in which we may consider opening new stores. If we are unable to adapt our operations to support any future expansion plans or if any new stores we open are not profitable, our business and financial condition could suffer.

          We have not opened stores in foreign island markets at a rapid pace. Although we have no plans to open stores in new markets during 2006, we continue to explore expansion opportunities in selected markets and additional relocation opportunities for stores in existing markets. For example, in May 2005 we moved our St. Croix store into a newly constructed building on a

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parcel of land located closer to the main trade area in the center of the island than our former store. Additionally, on April 25, 2006, we announced that we had entered into a long-term lease with the developer of Governor’s Square in Grand Cayman to lease land on which to construct and operate a store under the Cost-U-Less name through a controlled subsidiary organized in the Cayman Islands. The signing of the lease is one in a number of steps that we must undertake before we can open a store operating under the Cost-U-Less name in the Cayman Islands. Although there are still a number of steps that we have to take before the store can be opened, we expect to open the store during the first half of 2007. New markets such as the Cayman Islands and others we may enter may present operational, competitive, regulatory and merchandising challenges that are different from those we currently encounter. We do not have operating experience in many of the markets in which we may consider opening new stores. In fact, in June 2000, we closed the two stores that we had opened in New Zealand in 1999, as they had performed below expectations, due in part to competitive and merchandising challenges that are different from our other stores. Additionally, in February 2001, we closed one of our two Fiji stores, due primarily to the impact that political turmoil and the resulting economic downturn in Fiji were having on the tourist industry. We have encountered, and may continue to encounter, substantial delays, increased expenses or loss of potential store sites due to the complexities, cultural differences, and local political issues associated with the regulatory and permitting processes in the island markets in which we may locate our stores. There can be no assurance that we will be able to adapt our operations to support our future expansion plans or that any new stores will be profitable. Any failure on our part to manage our growth could have a material adverse effect on our business, financial condition and results of operations.

A decline in the general economic condition in the United States or in island markets in which we operate could have a significant impact on our financial performance.

          The success of our operations depends to a significant extent on a number of factors relating to discretionary consumer spending, including employment rates, business conditions, interest rates, inflation, population and gross domestic product levels in each of our island markets, taxation, consumer spending patterns and customer preferences. We cannot fully foresee the changes in business and economic conditions that may result from domestic or foreign factors. There can be no assurance that consumer spending in our markets will not be adversely affected by these factors, thereby affecting our growth, net sales and profitability. A downturn in tourism or a decline in the national or regional economies of the United States and the U.S. Territories or any foreign countries in which we currently or will operate, could have a material adverse effect on our business, financial condition and results of operations.

A prolonged decrease in tourism and air travel could have an indirect but significant impact on our financial performance, operations and liquidity.

          Because our operations are primarily located in U.S. Territories and foreign island countries throughout the Pacific and Caribbean, the success of our operations depends to a significant extent on tourism and the travel industry. Prolonged adverse occurrences affecting tourism or air travel, particularly to non-U.S. destinations, including political instability, armed hostilities, terrorism, weather conditions, or other activity that involves or affects air travel or the tourism industry generally, could have an indirect but adverse and significant impact on our financial performance, operations, liquidity or capital resources.

The loss of key personnel or our inability to successfully hire skilled store managers could harm our business and results of operations.

          Our success depends in large part on the abilities and continued service of our executive officers and other key employees. Additionally, we rely significantly on the skill and expertise of our on-site store managers, particularly in island markets where language, education and cultural factors may impose additional challenges. We do not carry key-man life insurance on any of our personnel. There can be no assurance that we will be able to hire, train and retain skilled managers and personnel to support our existing business and any growth, or that we will be able to retain the services of our executive officers and other key employees, the loss of any of whom could have a material adverse effect on our business, financial condition and results of operations.

If our information systems are disrupted, our business and results of operations could suffer.

          Our business is highly dependent on communications and information systems, primarily systems provided by third-party vendors. Any failure or interruption of our systems or systems provided by third-party vendors could cause delays or other problems in our operations, which could have a material adverse effect on our business, financial condition and results of operations.

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If ourstore employees decided to become unionized, we may experience increased operating costs or other operation problems.

          None of our employees are currently covered by a collective bargaining agreement. However, several of our hourly employees in our St. Maarten store have joined the local union. Unionization of any of our stores could result in higher employee compensation and restrictive working condition demands that could increase our operating costs and have a material adverse effect on our business, financial condition and results of operations.

We are subject to various governmental regulations and licensing requirements, which may have an adverse effecton our business.

          Governmental regulations and licensing requirements in foreign countries where we plan to expand our operations might prevent or delay entry into the market or prevent or delay the introduction, or require modification, of certain of our operations. For example, in July 2005 the Cayman Islands Trade and Business Licensing Board granted approval for us to operate a retail and wholesale business in the Cayman Islands through a controlled subsidiary. However, this is the first in a series of steps that we must take before we can open a store operating under the Cost-U-Less name in the Cayman Islands. Additionally, our ability to compete may be adversely affected by foreign governmental regulations and licensing requirements that encourage or mandate the employment of citizens of, or purchase of supplies from vendors, in a particular jurisdiction. We may also be subject to taxation in these foreign jurisdictions, and the final determination of our tax liabilities may involve the interpretation of the statutes and requirements of the various domestic and foreign taxing authorities. We may also be subject to currency repatriation restrictions. If governmental regulations or licensing requirements prevent or delay our entry into market, require modification of our existing operations, or subject us to taxation or currency repatriation issues, our business, financial condition and results of operations could suffer.

If we are unable to overcome challenges resulting from the isolation of store operations from our corporate management and our increased dependence on local managers, we may experience decreased productivity or other operational problems.

          Our headquarters and administrative offices are located in Washington State; however, ten of our eleven stores and a majority of our employees are located on islands. Although we invest resources to hire and train our on-site managers, the inability of our executives to be physically present at our current and planned store sites on a regular basis may result in the following:

§	Isolation of store operations from corporate management and an increased dependence on store managers;
§	Diminished ability to oversee employees, which may lead to decreased productivity or other operational problems;
§	Construction delays or difficulties caused by inadequate supervision of the construction process; and
§	Communication challenges.

          We may need to invest significant resources to update and expand our communications systems and information networks and to devote a substantial amount of time, effort and expense to national and international travel in order to overcome these challenges; failure to do so could have a material adverse effect on our business, financial condition and results of operations.

We may encounter disruption in the transportation of our products, which would significantly harm our business.

          Our island locales require the transportation of products over great distances on water, which results in the following:

§	Substantial lags between the procurement and delivery of product, thus complicating merchandising and inventory control methods;
§	Possible loss of product due to potential damage to, or destruction of, ships or containers delivering our goods;
§	Tariff, customs and shipping regulation issues;
§	Substantial ocean freight and duty costs;
§	Port and container security issues; and
§	Interruption in the delivery of product due to labor disruption or weather related issues.

          Moreover, only a limited number of transportation companies service our regions, none of which has entered into a long-term contract with us. The inability or failure of one or more key transportation companies to provide transportation services to us, changes in the regulations that govern shipping tariffs or any other disruption in our ability to transport our merchandise could have a material adverse effect on our business, financial condition and results of operations.

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Our failure to adequately address barriers and challenges associated with expansion outside of the United States or its territories could cause our business to suffer.

          Three of our stores are located outside the United States or its territories. Our future expansion plans may involve entry into additional foreign countries, which may involve additional or heightened barriers and challenges that are different from those we currently encounter, including risks associated with being further removed from the political and economic systems in the United States and anti-American sentiment as a result of political or military action. We do not currently engage in currency hedging activities. The failure to adequately address the additional challenges involved with international operations could have a material adverse effect on our business, financial condition and results of operations.

Certain provisions in our charter documents and elsewhere may discourage third parties from attempting to acquire control of our Company, which may have an adverse effect on the price of our stock.

          Our board of directors has the authority, without obtaining shareholder approval, to issue up to 2,000,000 shares of preferred stock and to fix the rights, preferences, privileges and restrictions of such shares without any further vote or action by our shareholders. Our articles of incorporation and bylaws also provide for a classified board and special advance notice provisions for proposed business at annual meetings. In addition, Washington law contains certain provisions that may have the effect of delaying, deferring or preventing a hostile takeover of our company. Further, we have a shareholder rights plan that is designed to cause substantial dilution to a person or group that attempts to acquire our company without approval of our board of directors, and thereby make a hostile takeover attempt prohibitively expensive for a potential acquirer. These provisions, among others, may have the effect of making it more difficult for a third party to acquire, or discouraging a third party from attempting to acquire, control of our company, even if shareholders may consider such a change in control to be in their best interests, which may cause the price of our common stock to suffer.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

          The annual meeting of our shareholders was held on May 17, 2006. The following proposals were submitted to a vote:

          The election of one director, to hold office until our annual meeting of shareholders in 2009 and until his successor is duly elected and qualified. The terms of the other members of our board of directors, Robert C. Donegan, J. Jeffrey Meder, David A. Enger and Gary W. Nettles, continued after the annual meeting of shareholders.

          This proposal received the following number of votes:

	Affirmative	Withheld
George C. Textor	3,367,975	480,279

          The ratification of the appointment of Grant Thornton LLP as our independent auditors for fiscal year 2006. This proposal was approved with 3,806,409 shares voting for approval, 41,515 shares voting against approval, and 330 shares abstaining.

ITEM 6. EXHIBITS

Exhibit No.			Description
10.1		Lease Agreement between Governor’s Square Limited and Cayman Cost U Less Limited dated April 19, 2006 *
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	*	This exhibit (or portions thereof) has been filed separately with the Commission pursuant to an application for confidential treatment. The confidential portions of this Exhibit have been omitted and are marked by an asterisk.

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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 thereunto duly authorized.

	COST-U-LESS, INC.
Date: August 11, 2006	/s/ J. Jeffrey Meder
	J. Jeffrey Meder President and Chief Executive Officer
Date: August 11, 2006	/s/ Martin P. Moore
	Martin P. Moore Chief Financial Officer

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