UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

For the quarterly period ended September 29, 2006

Commission file number 0-26188

PALM HARBOR HOMES, INC.

(Exact name of registrant as specified in its charter)

972-991-2422

(Registrant’s telephone number, including area code)

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Shares of common stock $.01 par value, outstanding on November 3, 2006 – 22,831,240.

PALM HARBOR HOMES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

See accompanying notes.

1

PALM HARBOR HOMES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

See accompanying notes.

2

PALM HARBOR HOMES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

See accompanying notes.

3

PALM HARBOR HOMES, INC

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The condensed consolidated financial statements reflect all adjustments, which include only normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation in conformity with generally accepted accounting principles. Certain footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been omitted. The condensed consolidated financial statements should be read in conjunction with the audited financial statements for the year ended March 31, 2006 included in the Company’s Form 10-K. Results of operations for any interim period are not necessarily indicative of results to be expected for a full year.

The balance sheet at March 31, 2006 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

Inventories consist of the following (in thousands):

In June 2002, the Company invested $3.0 million to become the sole limited partner and 50% owner of an existing mortgage banking firm, BSM Financial L. P. (“BSM”) which was being accounted for using the equity method of accounting.

During the second quarter of fiscal year 2007, the Company filed a petition for the dissolution of its partnership with BSM. The investment in BSM of $4.4 million was written off effective September 29, 2006. Subsequent to September 29, 2006, the Company received a countersuit from BSM alleging, among other things, breach of contract and related claims. The Company intends to vigorously defend itself against these claims and pursue its own claims. The revenues and income (loss) of the limited partnership were as follows for the three and six month periods ended September 29, 2006 and September 23, 2005 (in thousands):

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PALM HARBOR HOMES, INC

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Consumer loans receivable, net of allowance for loan losses, consist of the following (in thousands):

The allowance for loan losses and related additions and deductions to the allowance during the six months ended September 29, 2006 and September 23, 2005 are as follows (in thousands):

The Company has an agreement with a financial institution for a $70.0 million floor plan facility, expiring March 30, 2009. The advance rate for the facility is 90% of manufacturer’s invoice. This facility is used to finance a portion of the new home inventory at the Company’s retail superstores and is secured by new home inventory and a portion of receivables from financial institutions. The interest rate on the facility is prime (8.25% at September 29, 2006) plus 0.6% or prime plus 1.0% to 3.0% for aged units, of which the Company has none as of September 29, 2006. The floor plan facility contains certain provisions requiring the Company to maintain minimum amounts of liquidity, profitability, inventory turns and tangible net worth in order to borrow against the facility. As of September 29, 2006, the Company was not in compliance with the minimum net profitability covenant. The Company is required to maintain a minimum net profitability of $7.5 million in total for the most recent four quarters. The Company obtained a waiver from the financial institution for the quarter ended September 29, 2006. The Company does not expect to be in compliance with the covenant in the third quarter and has also obtained a waiver for the third quarter ending December 29, 2006. In the event the Company is not in compliance with any of its floor plan facility requirements in the future, it would seek a waiver of any default from the lending institution and, if no such waiver was obtained, maturities of outstanding debt could be accelerated. The Company had $42.6 million and $37.9 million outstanding under its floor plan credit facility at September 29, 2006 and March 31, 2006, respectively.

On May 5, 2004, the Company issued $65.0 million aggregate principal amount of 3.25% Convertible Senior Notes due 2024 (the “Notes”) in a private, unregistered offering. Interest on the Notes is payable semi-annually in May and November. On June 8, 2004, the initial

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PALM HARBOR HOMES, INC

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

purchaser of the Notes exercised its option to purchase an additional $10.0 million aggregate principal amount of the Notes. On September 15, 2004, for the benefit of the Note holders, the Company filed a shelf registration statement covering resales of the Notes and the shares of the Company’s common stock issuable upon the conversion of the Notes. The Notes are senior, unsecured obligations and rank equal in right of payment to all of the Company’s existing and future unsecured and senior indebtedness. Each $1,000 in principal amount of the Notes is convertible, at the option of the holder, at a conversion price of $25.92, or 38.5803 shares of the Company’s common stock upon the satisfaction of certain conditions and contingencies. For the six-month periods ended September 29, 2006 and September 23, 2005, the effect of converting the senior notes to 2,894,000 shares of common stock was anti-dilutive, and was, therefore, not considered in determining diluted earnings per share.

On July 12, 2005, the Company, through its subsidiary CountryPlace, completed its initial securitization for approximately $141.0 million of loans, which was funded by issuing bonds totaling approximately $118.4 million. The bonds were issued in four different classes: Class A-1 totaling $36.3 million with a coupon rate of 4.23%; Class A-2 totaling $27.4 million with a coupon rate of 4.42%; Class A-3 totaling $27.3 million with a coupon rate of 4.80%; and Class A-4 totaling $27.4 million with a coupon rate of 5.20%. Maturity of the bonds is at varying dates beginning in 2006 through 2015 and were issued with a weighted average maturity of 4.66 years. The proceeds from the securitization were used to repay approximately $115.7 million of borrowings on the Company’s warehouse revolving debt with the remaining proceeds being used for general corporate purposes, including originating new loans. For accounting purposes, this transaction was structured as a securitized borrowing.

The Company, through its subsidiary CountryPlace, has an agreement with a financial institution for a $125.0 million warehouse borrowing facility to fund loans originated by CountryPlace. The facility is collateralized by specific consumer loans receivable pledged to the facility and bears interest at the rate of LIBOR (5.375% as of September 29, 2006) plus 1.25%. The facility terminates March 16, 2007; however, amounts outstanding under the facility are effectively settled and re-borrowed on a monthly basis. The facility provides for an advance of 88% against the outstanding principal balance of eligible consumer loan receivables and draws at an 80% advance rate against land-home loans in various stages of completion. CountryPlace had outstanding borrowings under the warehouse facility of $76.7 million as of September 29, 2006 and $37.4 million as of March 31, 2006. The facility contains certain requirements relating to the performance and composition of the consumer loans receivable pledged to the facility and financial covenants regarding maintenance of a certain loan delinquency ratio, minimum ratio of liabilities to stockholders’ equity for CountryPlace and a minimum capitalization for CountryPlace, which is customary in the industry. As of September 29, 2006, CountryPlace was in compliance with these requirements. As CountryPlace continues to expand and draw down on its warehouse facility, the Company will fund the difference between the amounts advanced under the warehouse borrowing facility and the balance of any additional loan originations. For CountryPlace to increase its borrowings under the facility to the maximum $125.0 million, CountryPlace would have to originate an additional $53.4 million of new loans, of which $7.1 million would have to be funded through the Company’s operations.

6

PALM HARBOR HOMES, INC

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The difference between net income (loss) and total comprehensive income (loss) for the three and six months ended September 29, 2006 and September 23, 2005 is as follows (in thousands):

The Company is contingently liable under the terms of repurchase agreements covering independent retailers’ floor plan financing. Under such agreements, the Company agrees to repurchase homes at declining prices over the term of the agreement, generally 12 to 18 months. At September 29, 2006, the Company estimates that its potential obligations under all repurchase agreements were approximately $27.5 million. It is management’s opinion that no material loss will occur from the repurchase agreements.

The Company is subject to various legal proceedings and claims that arise in the ordinary course of business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial position or results of operations or cash flows of the Company.

The Company provides the retail homebuyer a one-year limited warranty covering defects in material or workmanship in home structure, plumbing and electrical systems. The amount of warranty reserves recorded are estimated future warranty costs relating to homes sold, based upon the Company’s assessment of historical experience factors, such as actual number of warranty calls and the average cost per warranty call.

The accrued product warranty obligation is classified as accrued liabilities in the condensed consolidated balance sheets. The following table summarizes the accrued product warranty obligations at September 29, 2006 and September 23, 2005 (in thousands):

7

PALM HARBOR HOMES, INC

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

In December 2004, the FASB issued Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R requires that the compensation cost relating to share-based payment transactions, including grants of employee stock options, be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. SFAS 123R permits entities to use any option-pricing model that meets the fair value objective in the statement. The Company adopted SFAS 123R in the first quarter of fiscal 2007. The adoption of the standard did not have a material impact on the Company’s consolidated financial position or results of operations.

The Company operates principally in two segments: (1) factory-built housing, which includes manufactured housing, modular housing and retail operations and (2) financial services, which includes finance and insurance. The following table details net sales and income (loss) from operations by segment for the three and six months ended September 29, 2006 and September 23, 2005 (in thousands):

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PART I. Financial Information

Item 1. Financial Statements

See pages 1 through 8.

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

Executive Overview

We are one of the nation’s leading manufacturers and marketers of factory-built homes. We market nationwide through vertically integrated operations, encompassing manufactured and modular housing, chattel financing and insurance. As of September 29, 2006, we operated 16 manufacturing facilities that sell homes through 111 company-owned retail superstores and builder locations and approximately 350 independent retail dealers, builders and developers. Through our 80% owned subsidiary, CountryPlace, we offer chattel and non-conforming land/home loans to purchasers of factory built homes sold by Company-owned retail superstores and certain independent retail dealers, builders and developers. The loans originated through CountryPlace are held for our own investment portfolio and ultimately securitized. We also provide property and casualty insurance for owners of manufactured homes through our wholly-owned subsidiary, Standard Casualty.

During fiscal 2005, we began to serve as a general contractor with respect to virtually all aspects of the sale and construction process in certain regions of the country. This could include foundation work, driveways, landscape installations and other amenities the customer requests to complete the home. We anticipate expanding this role to additional geographic regions in future periods. During the second quarter of fiscal 2007, we completed 228 jobs for our company-owned retail superstores and builder locations and 82 for independent dealers, builders and developers.

The traditional HUD manufactured housing industry has continued to falter through the summer months and a meaningful recovery has yet to gain traction. We remain focused on managing the fundamental aspects of our business that we can control. Our modular business continues to thrive and we are pleased with the trends and growth for our modular products. However, at the beginning of the second fiscal quarter, we noted that the pace of growth in our traditional HUD business was slowing down as indicated by backlog levels and incoming order rates. As previously announced, in response to this trend, we have reduced our retail housing operations by eight stores and closed one less-than-efficient factory. We believe we have taken the right steps to more effectively balance our manufacturing and distribution capacity with the current needs of the market.

We continue to focus on cost management as well as opportunities surrounding our modular product. Our modular product line allows us to reach a high quality, credit worthy customer base and continue to grow our business in a declining manufactured housing industry. Revenues for modular products were up 63% through the first half of fiscal 2007 and now account for 30% of our recurring revenues.

CountryPlace originated $26.3 million in new chattel loans this quarter. We will continue to execute our strategy of expanding our consumer financing capabilities through CountryPlace. For the second quarter, 27% of our retail customers were financed by CountryPlace. We have filed a petition for the dissolution of our partnership with BSM Financial, L.P., a conventional real estate mortgage bank of which we are the 50% sole limited partner. During the second quarter, we wrote off our investment in BSM of $4.4 million. Subsequent to September 29, 2006, we received a countersuit from BSM alleging, among other things, breach of contract and related claims. We intend to vigorously defend ourselves against these claims and pursue our own claims.

9

The following table sets forth certain items of the Company’s condensed consolidated statements of operations as a percentage of net sales for the periods indicated.

The following table summarizes certain key sales statistics as of and for the three and six months ended September 29, 2006 and September 23, 2005.

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Three Months Ended September 29, 2006 Compared to Three Months Ended September 23, 2005

Net Sales. Net sales increased 4.9% to $179.4 million in the second quarter of fiscal 2007 from $171.0 million in the second quarter of fiscal 2006. Net sales for the factory-built housing segment increased $7.0 million primarily due to increases in the average selling prices of new modular and manufactured homes sold in the second quarter of fiscal 2007 as compared to the second quarter of fiscal 2006. The average retail selling price of a new manufactured home increased 6.5% from $77,000 in the second quarter of fiscal 2006 to $82,000 in the second quarter of fiscal 2007 and the average retail selling price of a new modular home increased 14.0% from $143,000 in the second quarter of fiscal 2006 to $163,000 in the second quarter of fiscal 2007. In addition, the average wholesale selling price of a new manufactured home increased 8.1% from $62,000 in the second quarter of fiscal 2006 to $67,000 in the second quarter of fiscal 2007. These increases in average selling price are the result of customers purchasing larger, more complex homes as well as the pass through of rising material prices. This increase in average selling prices is offset by a decrease of 9.6% in the number of homes sold. Sales to independent dealers, builders and developers comprise 40.0% of total factory-built homes sold for the second quarter of fiscal 2007 as compared to 45.5% in the second quarter of fiscal 2006. Financial services revenue increased $1.4 million reflecting an increase in interest income resulting from an increase in consumer loans receivable from $148.9 million at September 23, 2005 to $196.2 million at September 29, 2006.

Gross Profit. In the quarter ended September 29, 2006, gross profit decreased to $40.6 million, or 22.6% of net sales, from $43.3 million, or 25.3% of net sales, in the quarter ended September 23, 2005. Gross profit for the factory-built housing segment decreased from 23.3% of net sales in the second quarter of fiscal 2006 compared to 20.1% in the second quarter of fiscal 2007. Excluding the charges for closed retail stores and the one closed factory of $1.6 million, gross profit would have been 23.5% for the quarter. The internalization rate, which is the percentage of factory-built homes we manufactured and sold through our company-owned retail superstores and builder locations, declined from 60% in the second quarter of fiscal 2006 to 59% in the second quarter of fiscal 2007. Gross profit for the financial services segment increased $1.3 million due to the increase in financial services revenue as explained above.

Selling, General and Administrative Expenses. As a percentage of net sales, selling, general and administrative expenses remained essentially flat at 23.6% in the second quarter of fiscal 2007 compared to 23.3% in the second quarter of fiscal 2006. Selling, general and administrative expenses increased to $42.2 million in the quarter ended September 29, 2006 from $39.9 million for the quarter ended September 23, 2005. Selling, general and administrative expenses for factory built housing increased $1.8 million, general corporate purposes increased $0.4 million and financial services increased $0.2 million. The increase in factory-built housing expense is due to the one time charges for closing the eight retail stores and one factory of $2.4 million. Excluding the restructuring charges, selling, general and administrative expenses would have decreased from prior year and represented 22.2% of net sales for the second quarter of fiscal 2007.

Interest Expense. Interest expense increased 27.6% to $3.7 million in the second quarter of fiscal 2007 as compared to $2.9 million in the second quarter of fiscal 2006. This increase was due to the increase in floor plan payable and warehouse revolving debt principal balance during the second quarter of fiscal 2007 compared to second quarter of fiscal 2006. The increase in the prime rate to 8.25% versus 6.75% also contributed to the increase.

11

Equity in Earnings (Loss) of Limited Partnership. Loss in limited partnership was $0.2 million in the second quarter of fiscal 2007 as compared to earnings of $0.5 million in the second quarter of fiscal 2006.

Impairment of Limited Partnership. During the second quarter of fiscal year 2007, we filed a petition for dissolution of our partnership with BSM. The investment in BSM of $4.4 million as of September 2006 was written off effective September 29, 2006. Subsequent to September 29, 2006, we received a countersuit from BSM alleging, among other things, breach of contract and related claims. We intend to vigorously defend ourselves against these claims and pursue our own claims.

Interest Income and Other. Interest income and other increased $0.4 million to $1.1 million in the second quarter of fiscal 2007 as compared to $0.7 million in the second quarter of 2006. This increase resulted from higher interest rates.

Six Months Ended September 29, 2006 Compared to Six Months Ended September 23, 2005

Net Sales. Net sales increased 10.9% to $373.9 million in the first six months of fiscal 2007 from $337.2 million in the first six months of fiscal 2006. Net sales for the factory-built housing segment increased $34.1 million primarily due to increases in the average retail selling prices of new modular and manufactured homes as well as a shift in product mix to modular homes which have a higher average selling price. Modular homes comprised 25.9% of total factory-built home sales in the first six months of fiscal 2007 as compared to 17.3% in the first six months of fiscal 2006. The average wholesale selling price of a new manufactured home increased 6.6% from $61,000 in the first six months of fiscal 2006 to $65,000 in the first six months of fiscal 2007. The average retail selling price of a manufactured home increased 4.0% to $79,000 in the first six months of fiscal 2007 from $76,000 in the first six months of fiscal 2006. The increases in average selling price of new manufactured and modular homes resulted primarily from customers purchasing larger, more complex homes as well as the pass through of rising material prices. Sales to independent dealers, builders and developers decreased 8.8% and comprise 42.4% of total factory-built homes sold for the first six months of fiscal 2007 as compared to 44.9% in the first six months of fiscal 2006. Financial services revenue increased $2.6 million reflecting an increase in interest income resulting from an increase in consumer loans receivable from $148.9 million at September 23, 2005 to $196.2 million at September 29, 2006.

Gross Profit. For the six months ended September 29, 2006, gross profit as a percentage of net sales declined slightly to 24.6%, or $92.1 million, from 25.5%, or $85.9 million, in the six months ended September 23, 2005. Including the charges for the closed retail stores and the one closed factory of $1.6 million, gross profit for the factory-built housing segment declined slightly from 23.4% of net sales for the first six months of fiscal 2006 to 22.4% for the first six months of fiscal 2007. Gross profit for the financial services segment increased $2.1 million due to the increase in net sales as explained above and offset by losses incurred at Standard Casualty as a result of hurricane Rita, during 2005.

Selling, General and Administrative Expenses. As a percentage of net sales, selling, general and administrative expenses remained flat at 23.1% for the first six months of fiscal 2007 and the first six months of fiscal 2006. Selling, general and administrative expenses increased from $78.0 million in the six months ended September 23, 2005 to $86.3 million in the six months ended September 29, 2006. Selling, general and administrative expenses for factory-built housing increased $6.1 million, for general corporate purposes increased by $1.8 million and for financial services increased by $0.4 million. The increase in factory-built housing expense is primarily due to the charge of $2.4 million for closing of the eight retail stores and one factory. The increase in general corporate expenses is due primarily to increases in compensation-related costs. Without

12

the restructuring charges, selling, general and administrative expenses would have decreased to 22.4% as a percentage of net sales for the first six months of fiscal 2007, a decrease from the first six months of fiscal 2006.

Interest Expense. Interest expense increased 22.4% to $7.1 million for the six months ended September 29, 2006 from $5.8 million for the six months ended September 23, 2005. This increase is primarily the result of an increase in the interest expense relating to the securitized loans of $1.1 million. In May of fiscal 2006, we completed our initial securitization by issuing bonds totaling $118.4 million.

Equity in Earnings (Loss) of Limited Partnership. Equity in earnings (loss) in limited partnership was $0.3 million for the first six months of fiscal 2007 compared to earnings of $1.0 million in the first six months of fiscal 2006.

Impairment of Limited Partnership. During the second quarter of fiscal year 2007, we filed a petition for dissolution of our partnership with BSM. The investment in BSM of $4.4 million as of September 2006 was written off effective September 29, 2006. Subsequent to September 29, 2006, we received a countersuit from BSM, alleging among other things, breach of contract and related claims. We intend to vigorously defend ourselves against these claims and pursue our own claims.

Interest Income and Other. Interest income and other decreased $0.5 million to $2.3 million for the six months ended September 29, 2006 as compared to $2.8 million for the six months ended September 23, 2005. This decrease was primarily due to income earned on a real estate investment totaling $1.5 million in the first quarter of fiscal 2006 offset by the increase in interest income due to higher interest rates.

Liquidity and Capital Resources

Net cash used in operating activities was $60.0 million in the first six months of fiscal 2007 compared to $13.8 million provided by operating activities in the first six months of fiscal 2006. The $73.8 million increase in net cash used in operating activities is primarily the result of $9.3 million in restricted cash relating to customer deposits held in trust accounts and letters of credit supporting insurance policies, $11.0 million in our construction lending program, $22.7 million in consumer loans originated by CountryPlace, and $35.5 million decrease in accounts payable and accrued liabilities.

Net cash used in investing activities decreased to $3.6 million in the first six months of fiscal 2007 as compared to $4.1 million in the first six months of fiscal 2006. This decrease in cash used in investing was primarily due to the additional purchase of property, plant and equipment of $2.8 million offset by an increase in sales of available for sale investments.

Net cash provided by financing activities totaled $36.6 million in the first six months of fiscal 2007 compared to $15.9 million in the first six months of fiscal 2006. The $20.8 million increase in cash provided by financing activities is the result of an increase in proceeds from the floor plan of $9.0 million and an increase in the proceeds from the CountryPlace warehouse revolving debt and securitized debt of $11.8 million. In fiscal 2006, we completed our initial securitization by issuing bonds totaling $118.4 million and used a portion of the proceeds to reduce our warehouse debt.

We have an agreement with a financial institution for a $70.0 million floor plan facility expiring March 30, 2009. The advance rate for the facility is 90% of manufacturer’s invoice. This facility is used to finance a portion of the new home inventory at our retail superstores and is secured by new home inventory and a portion of receivables from financial institutions. The interest rate on the

13

facility is prime (8.25% at September 29, 2006) plus 0.6% or prime plus 1.0% to 3.0% for aged units, of which we had none as of September 29, 2006. The floor plan facility contains certain provisions requiring us to maintain minimum amounts of liquidity, profitability, inventory turns and tangible net worth in order to borrow against the facility. As of September 29, 2006, we were not in compliance with the minimum net profitability covenant. We are required to maintain a minimum net profitability of $7.5 million in total for the most recent four quarters. We obtained a waiver from the financial institution for the quarter ended September 29, 2006. We do not expect to be in compliance with this covenant in the third quarter and have also obtained a waiver for the third quarter ending December 29, 2006. In the event we are not in compliance with any of our floor plan facility requirements in future periods, we would seek a waiver of any default from the lending institution and, if no such waiver was obtained, maturities of outstanding debt could be accelerated. We had $42.6 million and $37.9 million outstanding under our floor plan credit facility at September 29, 2006 and March 31, 2006, respectively.

On May 5, 2004, Palm Harbor issued $65.0 million aggregate principal amount of 3.25% Convertible Senior Notes due 2024 (the “Notes”) in a private, unregistered offering. Interest on the Notes is payable semi-annually in May and November. On June 8, 2004, the initial purchaser of the Notes exercised its option to purchase an additional $10.0 million aggregate principal amount of the Notes. On September 15, 2004, for the benefit of the Note holders, we filed a shelf registration statement covering resales of the Notes and the shares of Palm Harbor’s common stock issuable upon the conversion of the Notes. The Notes are senior, unsecured obligations and rank equal in right of payment to all of our existing and future unsecured and senior indebtedness. Each $1,000 in principal amount of the Notes is convertible, at the option of the holder, at a conversion price of $25.92, or 38.5803 shares of Palm Harbor’s common stock upon the satisfaction of certain conditions and contingencies. For the six-month periods ended September 29, 2006 and September 23, 2005, the effect of converting the senior notes to 2,894,000 shares of common stock was anti-dilutive, and was, therefore, not considered in determining diluted earnings per share.

CountryPlace has an agreement with a financial institution for a $125.0 million warehouse borrowing facility to fund loans originated by CountryPlace. The facility is collateralized by specific consumer loans receivable pledged to the facility and bears interest at the rate of LIBOR (5.375% at September 29, 2006) plus 1.25%. The facility provides for an advance of 88% against the outstanding principle balance of eligible consumer loan receivables and draws at an 80% advance rate against land-home loans in various stages of completion. CountryPlace had outstanding borrowings under the warehouse facility of $76.7 million as of September 29, 2006 and $37.4 million as of March 31, 2006. The facility contains certain requirements relating to the performance and composition of the receivables pledged to the facility and financial covenants regarding the maintenance of a certain loan delinquency ratio, minimum ratio of liabilities to stockholder’s equity for CountryPlace and a minimum capitalization for CountryPlace, which are customary in the industry. As of September 29, 2006, CountryPlace was in compliance with these requirements. As CountryPlace continues to expand and draw down on its warehouse facility, the Company will fund the difference between the amounts advanced under the warehouse borrowing facility and the balance of any additional loan originations. For CountryPlace to increase its borrowings under the facility to the maximum $125.0 million, CountryPlace would have to originate an additional $53.4 million of new loans, of which $7.1 million would have to be funded through the Company’s operations.

On July 12, 2005, we, through our subsidiary CountryPlace, completed our initial securitization for approximately $141.0 million of loans, which was funded by issuing bonds totaling approximately $118.4 million. The bonds were issued in four different classes: Class A-1 totaling $36.3 million with a coupon rate of 4.23%; Class A-2 totaling $27.4 million with a coupon rate of 4.42%; Class A-3 totaling $27.3 million with a coupon rate of 4.80%; and Class A-4 totaling $27.4

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million with a coupon rate of 5.20%. Maturity of the bonds is at varying dates beginning in 2006 through 2015 and were issued with a weighted average maturity of 4.66 years. The proceeds from the securitization were used to repay approximately $115.7 million of borrowings on the Company’s warehouse revolving debt with the remaining proceeds being used for general corporate purposes, including origination of new loans. For accounting purposes, this transaction was structured as a securitized borrowing.

We believe that the proceeds from the securitization, the issuance of the convertible senior notes, floor plan financing, borrowings on the warehouse facility and any other available borrowing alternatives will be adequate to support our working capital needs, currently planned capital expenditure needs and expansion of CountryPlace for the foreseeable future. However, because future cash flows and the availability of financing will depend on a number of factors, including prevailing economic and financial conditions, business, the market for asset backed securitizations and other factors beyond our control, no assurances can be given in this regard.

Forward-Looking Information/Risk Factors

Certain statements contained in this report are forward-looking statements within the safe harbor provisions of the Securities Litigation Reform Act. Forward-looking statements give our current expectations or forecasts of future events and can be identified by the fact that they do not relate strictly to historical or current facts. Investors should be aware that all forward-looking statements are subject to risks and uncertainties and, as a result of certain factors, actual results could differ materially from these expressed in or implied by such statements. These risks include such assumptions, risks, uncertainties and factors associated with the following:

Financing for our retail customers may be limited, which could affect our sales volume.

Our retail customers, who do not use BSM or CPM, generally either pay cash or secure financing from third party lenders, which have been negatively affected by adverse loan experience. Several major lenders, which had provided financing for our customers, have withdrawn from the manufactured housing finance business. Reduced availability of such financing is currently having an adverse effect on the manufactured housing business and our home sales. Availability of financing is dependent on the lending practices of financial institutions, financial markets, governmental policies and economic conditions, all of which are largely beyond our control. Quasi-governmental agencies such as Fannie Mae and Freddie Mac, which are important purchasers of loans from financial institutions, have tightened standards relating to the manufactured housing loans that they will buy. Most states classify manufactured homes as personal property rather than real property for purposes of taxation and lien perfection, and interest rates for manufactured homes are generally higher and the terms of the loans shorter than for site-built homes. Financing for the purchase of manufactured homes is often more difficult to obtain than conventional home mortgages. There can be no assurance that affordable retail financing for manufactured homes will continue to be available on a widespread basis. If third party financing were to become unavailable or were to be further restricted, this could have a material adverse effect on our results of operations.

If CountryPlace is unable to adequately and timely service its loans, it may adversely affect its results of operations.

Although CountryPlace has originated loans since 1995, it has limited loan servicing and collections experience. In 2002, it implemented new systems to service and collect the portfolio of loans it originates. The management of CountryPlace has industry experience in managing,

15

PALM HARBOR HOMES, INC

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

servicing and collecting loan portfolios; however, many borrowers require notices and reminders to keep their loans current and to prevent delinquencies and foreclosures. If there is a substantial increase in the delinquency rate that results from improper servicing or loan performance, the profitability and cash flow from the loan portfolio in CountryPlace could adversely affect CountryPlace’s ability to continue to securitize its loans.

If CountryPlace’s customers are unable to repay their loans, CountryPlace may be adversely affected.

CountryPlace makes loans to borrowers that it believes are creditworthy based on its credit guidelines. However, the ability of these customers to repay their loans may be affected by a number of factors, including, but not limited to:

If customers do not repay their loans, the profitability and cash flow from the loan portfolio could adversely affect CountryPlace’s ability to continue to securitize its loans.

If CountryPlace is unable to continue to securitize its loans, it will be required to seek other sources of long-term funding, which funding may not be available.

The loans that are originated by CountryPlace are funded with proceeds from its warehouse borrowing facility and borrowings from us. On July 12, 2005, CountryPlace successfully completed its initial securitization for approximately $141.0 million of loans which were funded by issuing bonds totaling approximately $118.4 million. We anticipate CountryPlace will continue to securitize its loans as a primary source of funding. The proceeds from future securitizations will be used to repay any borrowings from the warehouse facility and from us, as well as to originate new loans. The securitization market is dependent upon a number of factors, including general economic conditions, conditions in the securities market generally and conditions in the asset-backed securities market specifically. Although the asset-backed securitization market for manufactured housing lenders has improved slightly in the past year in terms of access to the markets, as well as pricing and credit enhancement levels, poor performance of any loans we may securitize in the future could harm our future access to the securitization market. If CountryPlace is unable to continue to securitize its loans on terms that are economical, or if there is a decline in the securitization market for manufactured housing loans, and if CountryPlace is unable to obtain additional sources of long-term funding, it could have a material adverse effect on our results of operations, financial condition and business prospects.

Reduced availability of wholesale financing may adversely affect our inventory levels of new homes.

We finance a portion of our new inventory at our retail superstores through wholesale “floor plan” financing arrangements. Through these arrangements, financial institutions provide us with a loan for the purchase price of the home. Since the beginning of the industry downturn in 1999, several major floor plan lenders have exited the floor plan financing business. Although we currently have a floor plan facility with a financial institution totaling $70 million, there can be no assurance that we will continue to have access to such facility or that we will not be forced to reduce our new home inventory at our retail superstores.

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Our repurchase agreements with floor plan lenders could result in increased costs.

In accordance with customary practice in the manufactured housing industry, we enter into repurchase agreements with various financial institutions pursuant to which we agree, in the event of a default by an independent retailer in its obligation to these credit sources, to repurchase manufactured homes at declining prices over the term of the agreements, typically 12 to 18 months. The difference between the gross repurchase price and the price at which the repurchased manufactured homes can then be resold, which is typically at a discount to the original sale price, is an expense to us. Thus, if we were obligated to repurchase a large number of manufactured homes in the future, this would increase our costs, which could have a negative effect on our earnings. Tightened credit standards by lenders and more aggressive attempts to accelerate collection of outstanding accounts with retailers could result in defaults by retailers and consequently repurchase obligations on our part may be higher than has historically been the case. During the second quarter of fiscal 2007 and 2006, net losses incurred under these repurchase agreements totaled $0 and $1,000, respectively.

We are dependent on our principal executive officer and the loss of his service could adversely affect us.

We are dependent to a significant extent upon the efforts of our principal executive officer, Larry H. Keener, Chairman of the Board and Chief Executive Officer. The loss of the services of our principal executive officer could have a material adverse effect upon our business, financial condition and results of operations. Our continued growth is also dependent upon our ability to attract and retain additional skilled management personnel.

We are controlled by two shareholders, who may determine the outcome of all elections.

Approximately 52% of our outstanding common stock is beneficially owned or controlled by our Chairman Emeritus, Lee Posey and Capital Southwest Corporation and its affiliates. As a result, these shareholders, acting together, are able to determine the outcome of elections of our directors and thereby control the management of our business.

Increased prices and unavailability of raw materials could have a material adverse effect on us.

Our results of operations can be affected by the pricing and availability of raw materials. In fiscal 2006 and 2005, for example, we experienced an increase in prices of our raw materials of approximately 5% and 6%, respectively. Although we attempt to increase the sales prices of our homes in response to higher materials costs, such increases typically lag behind the escalation of materials costs. Although lumber costs are currently at a five year low, three of the most important raw materials used in our operations, lumber, gypsum wallboard and insulation, have experienced significant price fluctuations in the past several fiscal years. Although we have not experienced any shortage of such building materials today, there can be no assurance that sufficient supplies of lumber, gypsum wallboard and insulation, as well as other materials, will continue to be available to us on terms we regard as satisfactory.

If inflation increases, we may not be able to offset inflation through increased selling prices.

If there is a material increase in inflation in the future, it is unlikely that we will be able to increase our selling prices to completely offset the material increase in inflation and as a result, our operating results may be adversely affected.

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The manufactured housing industry is highly competitive and some of our competitors have stronger balance sheets and cash flow, as well as greater access to capital, then we do. As a result of these competitive conditions, we may not be able to sustain past levels of sales or profitability.

The manufactured housing industry is highly competitive, with relatively low barriers to entry. Manufactured and modular homes compete with new and existing site-built homes and to a lesser degree, with apartments, townhouses and condominiums. Competition exists at both the manufacturing and retail levels and is based primarily on price, product features, reputation for service and quality, retailer promotions, merchandising and terms of consumer financing. Some of our competitors have substantially greater financial, manufacturing, distribution and marketing resources than we do. As a result of these competitive conditions, we may not be able to sustain past levels of sales or profitability.

If our retail customers are unable to obtain insurance for factory-built homes, our sales volume and results of operations may be adversely affected.

We sell our factory-built homes to retail customers located throughout the United States including in coastal areas, such as Florida. In second quarter of fiscal 2007, 21.3% of our revenues were generated in Florida. Some of our retail customers in these areas have experienced difficulty obtaining insurance for our factory-built homes due to adverse weather-related events in these areas, primarily hurricanes. If our retail customers face continued and increased difficulty in obtaining insurance for the homes we build, our sales volume and results of operations may be adversely affected.

Our business is highly cyclical and there may be significant fluctuations in our quarterly results.

The factory-built housing industry is highly cyclical and seasonal and has experienced wide fluctuations in aggregate sales in the past. We are subject to volatility in operating results due to external factors beyond our control such as:

Sales in our industry are also seasonal in nature, with sales of homes traditionally being stronger in the spring, summer and fall months. The cyclical and seasonal nature of our business causes our revenues and operating results to fluctuate and makes it difficult for management to forecast sales and profits in uncertain times. As a result of seasonal and cyclical downturns, results from any quarter should not be relied upon as being indicative of performance in future quarters.

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We are concentrated geographically, which could harm our business.

In the second quarter of fiscal 2007, approximately 21.3% of our revenues were generated in Florida and approximately 23.1% of our revenues were generated in Texas. A decline in the demand for manufactured housing in these two states and/or a decline in the economies of these two states could have a material adverse effect on our results of operations.

We face increased competition from on site builders of residential housing, which may reduce our revenues.

Our homes compete with homes that are built on site. The sales of site built homes are declining, which is resulting in more site built homes being available at lower prices. The decreased price of site built homes could make them more competitive with our homes. As a result, the sales of our homes could decrease, which could negatively impact our results of operations.

Item 3. Quantitive and Qualitative Disclosure About Market Risk

We are exposed to market risks related to fluctuations in interest rates on our variable rate debt, which consists primarily of our liabilities under retail floor plan financing arrangements and warehouse revolving debt. For variable interest rate obligations, changes in interest rates generally do not impact fair market value, but do affect future earnings and cash flows. Assuming our and CountryPlace’s level of variable rate debt as of September 29, 2006 is held constant, each one percentage point increase in interest rates occurring on the first day of the year would result in an increase in interest expense for the coming year of approximately $1.2 million.

We are also exposed to market risks related to our fixed rate consumer loans receivable balances and our convertible senior notes. For fixed rate loans receivable, changes in interest rates do not change future earnings and cash flows from the receivables. However, changes in interest rates could affect the fair market value of the loan portfolio. Assuming CountryPlace’s level of loans held for investment as of September 29, 2006 is held constant, a 10% increase in average interest rates would decrease the fair value of CountryPlace’s portfolio by approximately $4.4 million. For our fixed rate convertible senior notes, changes in interest rates could affect the fair market value of the related debt. Assuming the amount of convertible senior notes as of September 29, 2006 is held constant, a 10% decrease in interest rates would increase the fair value of the notes by approximately $1.5 million.

CountryPlace is exposed to market risk related to the accessibility and terms of financing in the asset-backed securities market. On July 12, 2005, CountryPlace successfully completed its initial securitized financing of approximately $141.0 million of loans. CountryPlace intends to continue to securitize its loan originations as a means to obtain long-term fixed interest rate funding. The inability to continue to securitize its loans would require CountryPlace to seek other sources of funding or to reduce or eliminate its loan originations if other sources of funding are not available.

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Item 4. Controls and Procedures

Under the supervision and with the participation of our principal executive officer and principal financial officer, management has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange act of 1934) as of September 29, 2006. Based on that evaluation, our principal executive officer and out principal financial officer have concluded that our disclosure controls and procedures were effective as of September 29, 2006.

There has been no change to our internal control over financial reporting during the quarter ended September 29, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. Other Information

(a) The following exhibits are filed as part of this report:

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.

Date: November 3, 2006

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