Summary of REEDS INC - Yahoo! Finance

Item 2. Management's Discussion and Analysis or Plan of Operation

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes appearing elsewhere in this report. This discussion and analysis may contain forward-looking statements based on assumptions about our future business.

Overview

The results for the quarter ended September 30, 2009 reflect our continued reduction in operating costs, as compared to the prior year period. While sales have fallen during this adverse economic period affecting the grocery industry, we believe that our customer relationships are expanding and will result in increasing sales of our branded products in 2011. During the quarter ended September 30, 2009, we invested over $300,000 in capital improvements to our brewery and we are currently producing both branded and private label products in our upgraded brewery. Margins during the third fiscal quarter have remained consistent with earlier fiscal quarters, considering overall sales levels and fixed production costs. As we enter the 4th quarter, the Company is well positioned for an increasing backlog of private label business as well as strong sales increases of our branded product lines in 2010. Our strategic plan is to apply the gross margin revenues derived from our private label business to the increased promotion of our branded products in the marketplace.

Results of Operations

Three months ended September 30, 2009 Compared to Three months ended September 30, 2008

Sales of $4,027,000 for the three months ended September 30, 2009 represented a decrease of 5% or $206,000, as compared to the prior year same period amount of $4,233,000. The decrease in revenues is primarily due to lower volumes sold of our primary 12-ounce product lines, due to adverse economic conditions affecting the grocery industry as a whole. The decrease was partially offset by an increase in sales of new products, Virgil's Orange Cream Soda and Reed's Energy Elixir; as well as sales of the Sonoma Sparkler brand products starting in June 2009.

Cost of Goods Sold

Cost of goods sold consists primarily of the costs of our ingredients, packaging, production and freight. Cost of goods sold increased by 3% to $3,038,000 during the three months ended September 30, 2009 from $2,938,000 in 2008. The increases are primarily due to higher fixed productions costs and to increased freight costs. As our volume increases and our plant approaches capacity, the fixed production costs will be more fully absorbed into inventory production, reducing the average per-unit cost. We have not experienced significant increases in raw material and packaging costs, and we are also currently negotiating further reductions in glass costs, which will reduce our cost of goods sold in the future.

Gross Profit

Our gross profit decreased to $989,000 in the three months ended September 30, 2009, from $1,295,000 in 2008, a decrease of $306,000 or 24%. The gross profit as a percentage of sales decreased to 25% in 2009, from 31% in 2008. This gross profit margin decrease is primarily due to the increases in costs of goods sold described above.

Selling and marketing expenses

Selling and marketing expenses consist primarily of direct charges for staff compensation costs, advertising, sales promotion, marketing and trade shows. Selling and marketing costs decreased to $646,000 in the three months ended September 30, 2009 from $819,000 in 2008, a net decrease of $173,000 or 21%. The decrease is primarily due to decreases in compensation and travel costs of $184,000 and a decrease stock option expense of $37,000, partially offset by an increase in advertising promotion and trade shows of $44,000 and an increase in facilities-related costs of $4,000.

Our strategic direction in sales is to focus on our product placements in our estimated 10,500 supermarkets nationwide. This strategy replaces our strategy in 2008 that focused on both the supermarkets and a direct store delivery (DSD) effort. As a result, our sales organization has been reduced by 16 compared to the level we had in 2008. We have found that our most effective sales efforts are to grocery stores. We feel that the trend in grocery stores to offer their customers natural products can be served with our products. Our sales personnel are leveraging our success at natural food grocery stores to establish new relationships with mainstream grocery stores.

General and Administrative Expenses

We believe that our existing executive and administrative staffing levels are sufficient to allow for moderate growth without the need to add personnel and related costs for the foreseeable future.

Loss from Operations

Our loss from operations increased to $280,000 in the three months ended September 30, 2009 from $82,000 in the same period of 2008. The 2009 loss is primarily due to the lower sales and higher cost of goods sold in 2009.

Interest Expense

Interest expense increased to $122,000 in the three months ended September 30, 2009, compared to interest expense of $92,000 in the same period of 2008. The increase is due to the increase in long-term debt, as a result of our sale-leaseback; and increased borrowing under a line of credit agreement with First Capital LLC, secured primarily by our inventory and accounts receivable.

Nine months ended September 30, 2009 Compared to Nine months ended September 30, 2008

Sales of $11,658,000 for the nine months ended September 30, 2009 represented a decrease of 6% or $710,000, as compared to the 2008 same period amount of $12,368,000. The decrease in revenues is primarily due to a promotional program in 2008, covering our 5-liter "party kegs" of root beer, which did not recur in 2009; resulting in approximately $850,000 lower sales of that product. The volume of our primary 12-ounce products delivered in 2009 was approximately 3% higher than the same 2008 period.

Cost of Goods Sold

Cost of goods sold consists primarily of the costs of our ingredients, packaging, production and freight. Cost of goods sold decreased by 6% to $8,722,000 during the nine months ended September 30, 2009 from $9,283,000 in 2008. The 6% decrease in cost of goods sold is consistent with the 6% decrease in sales during the same periods.

Gross Profit

Our gross profit decreased to $2,936,000 in the nine months ended September 30, 2009, from $3,085,000 in 2008, a decrease of $149,000 or 5%. The gross profit as a percentage of sales was unchanged at 25% in 2009, as compared to 2008.

Selling and marketing expenses

Selling and marketing expenses consist primarily of direct charges for staff compensation costs, advertising, sales promotion, marketing and trade shows. Selling and marketing costs decreased to $1,853,000 in the nine months ended September 30, 2009 from $2,994,000 in 2008, a net decrease of $1,141,000 or 38%. The decrease is primarily due to decreases in compensation and travel costs of $1,131,000, decreases in advertising promotion and trade shows of $273,000, and decreases in facilities-related costs of $14,000; partially offset by an increase in stock option expense of $277,000.

General and Administrative Expenses

General and administrative expense consists primarily of the cost of executive, administrative, and finance personnel, as well as professional fees. General and administrative expenses decreased to $1,896,000 during the nine months ended September 30, 2009 from $2,548,000 in the same period of 2008, a net decrease of $652,000 or 26%. The decrease in 2009 is primarily due to a decrease in professional fees expense of $344,000 and a decrease in compensation costs of $349,000; partially offset by an increase in facilities-related costs of $14,000, and an increase in stock option expense of $27,000. In the 2008 period, we had a one-time non cash expense of approximately $300,000 for professional consulting services, for which we issued stock.

We believe that our existing executive and administrative staffing levels are sufficient to allow for moderate growth without the need to add personnel and related costs for the foreseeable future.

Impairment Loss

In connection with the sale of our buildings and brewery equipment in June 2009, and the concurrent lease-back of the same property and equipment, we recognized an impairment loss on the assets of $641,000. The loss recognized from impairment is a result of the lower net carrying values of the assets at the time of sale in relation to the market value of the property.

Loss from Operations

Our loss from operations decreased to $1,454,000 in the nine months ended September 30, 2009 from $2,457,000 in the same period of 2008. The reduced loss in 2009 is substantially a result of the lower operating costs in 2009.

Interest Expense

Interest expense increased to $319,000 in the nine months ended September 30, 2009, compared to interest expense of $199,000 in the same period of 2008. The increase is due to the increase in long-term debt, as a result of our sale-leaseback; and increased borrowing under a line of credit agreement with First Capital LLC, secured primarily by our inventory and accounts receivable.

Liquidity and Capital Resources

As of September 30, 2009, we had shareholders equity of $3,598,000 and we had working capital of $1,467,000, compared to shareholders equity of $3,961,000 and working capital of $636,000 at December 31, 2008. Cash and cash equivalents were $76,000 as of September 30, 2009, as compared to $229,000 at December 31, 2008. This increase in our working capital was primarily attributable to the proceeds from the financing transaction relating to our buildings and equipment, net of the repayment of long-term debt. In addition to our cash position on September 30, 2009, we had availability under our line of credit of approximately $78,000.

Our decrease in cash and cash equivalents to $76,000 at September 30, 2009 compared to $229,000 at December 31, 2008 was the result of $1,322,000 used in operating activities; $240,000 used in investing activities; and $1,409,000 provided by financing activities.

We believe that the Company currently has the necessary working capital to support existing operations through 2010; however, we foresee an additional requirement for capital needed to fund our seasonality, product launches and other growth plans. Our primary capital source will be cash flow from operations, as we gain profitability in 2010. During October 2009, we raised net proceeds of approximately $563,000 from an offering of our shares. In November 2009, we have entered an agreement to replace our revolving line of credit, which will more fully value our assets for collateral and enable increased borrowing for working capital purposes. We are currently involved in a rights offering to our existing shareholders that will provide additional working capital, if successful. We believe that the Company can become leaner if our sales goals do not materialize, and that our costs can be managed to produce profitable operations. Historically, we have financed our operations primarily through private sales of common stock, preferred stock, convertible debt, a line of credit from a financial institution, and cash generated from operations.

Net cash used in operations during 2009 was $1,322,000 compared with $2,650,000 used in operations during the same period in 2008. Cash used in operations during 2009 was primarily due to the net loss in period and to an increase in accounts receivable, prepaid costs and inventory; and to a decrease in accounts payable.

Net cash used in investing activities of $240,000 during 2009 compared with $186,000 during 2008 is primarily the result of equipment purchases.

Net cash provided by financing activities of $1,409,000 during 2009 was primarily due to proceeds from the sale of our buildings and equipment of $3,056,000 and the sale of common stock of $150,000 offset by principal payments on long-term debt of $1,763,000 and principal payments on the line of credit of $93,000. During the same period in 2008, we derived net proceeds from the refinancing of our land and buildings of $1,770,000, offset by principal payments on debt of $796,000. Our line of credit lender is a privately held, Senior Secured Commercial Lender.

On June 15, 2009, we closed escrow on the sale of our two buildings and its brewery equipment and concurrently entered into a long-term lease agreement for the same property and equipment. In connection with the lease we have the option to repurchase the buildings and brewery equipment from 12 months after the commencement date to the end of the lease term at the greater of the fair market value or an agreed upon amount. Since the lease contains a buyback provision and other related terms, we determined that we had continuing involvement that did not warrant the recognition of a sale; therefore, the transaction has been accounted for as a long-term financing. The proceeds from the sale, net of transaction costs, have been recorded as a financing obligation in the amount of $3,056,000. Monthly payments under the financing agreement are recorded as interest expense and a reduction in the financing obligation at an implicit rate of 9.9%. The financing obligation is personally guaranteed by the principal shareholder and chief executive officer.

On October 8, 2009, we sold an aggregate of 364,189 units ("Units") consisting of one share of our common stock ("Share") and warrants to purchase shares of our common stock ("Warrants")at a price of $1.80 per Unit pursuant to a public shelf registration on Form S-3. . The Warrants consist of (i) Series A Warrants, for the purchase of a number of shares of common stock equal to 40% of a purchaser's Shares, which have an initial exercise price of $2.25 per share and are exercisable for a period of five years commencing 183 days from the date of issuance, (ii) Series B Warrants, for the purchase of a number of shares of common stock equal to 50% of a purchaser's Shares, which have an exercise price equal to $1.80 and are exercisable for 60 trading days commencing immediately, and (iii) Series C Warrants, for the purchase of a number of a shares of common stock equal to 20% of a purchaser's Shares, which have an exercise price of $2.25 and are exercisable for five years commencing 183 days from the date of issuance. The Series B Warrants and Series C Warrants were only issued to purchasers who purchased Units for an aggregate purchase price of at least $125,000. The Company paid an 8% placement agent fee. The net proceeds to the Company from the shelf take-down, after deducting placement agent fees and estimated offering expenses, were approximately $563,000. At the closing, the Company issued 364,189 shares of common stock, Series A Warrants to purchase 145,676 shares of common stock, Series B Warrants to purchase 69,445 shares of common stock, and Series C Warrants to purchase 27,778 shares of common stock.

On November 4, 2009, we executed a binding revolver line commitment with GemCap Lending I, LLC to replace our existing line of credit. The senior revolver facility is for $3,000,000, based on 80% of eligible accounts receivable and 50% of eligible inventory, with a maximum inventory advance of $1,500,000. The line of credit bears interest of 18% per annum. The transaction is anticipated to close on or before November 18, 2009.

On November 5, 2009, our registration statement became effective for the distribution of transferable rights to our shareholders. We will distribute to the holders of our common stock transferable rights to purchase up to an aggregate of 225,000 shares of Series B Convertible Preferred Stock ("Series B Preferred") convertible into 1,125,000 shares of common stock. Each four (4) rights will entitle the holder to purchase one share of Series B Preferred at the subscription price of $10.00 per share. Each share of Series B Preferred carries a five percent (5%) annual dividend for a term of three (3) years, will have an initial stated value of $10.00 per share, and may be convertible into shares of common stock at a conversion ratio of five (5) shares of common stock for each share of Series B Preferred held at the time of conversion, representing an initial conversion price of $2.00 per share, which is subject to adjustment. We do not know whether this offering will be successful or completed; however, we have reasonable assurance that it will result in additional working capital provided to the Company.

Our operating losses have negatively impacted our liquidity and we are continuing to work on decreasing operating losses, while focusing on increasing net sales. We are currently borrowing near the maximum on our line of credit. We believe that our current cash position and lines of credit will be sufficient to enable us to meet our cash needs throughout 2010. We believe that if the need arises we can raise money through the equity markets.

We may not generate sufficient revenues from product sales in the future to achieve profitable operations. If we are not able to achieve profitable operations at some point in the future, we eventually may have insufficient working capital to maintain our operations as we presently intend to conduct them or to fund our expansion and marketing and product development plans. In addition, our losses may increase in the future as we expand our manufacturing capabilities and fund our marketing plans and product development. These losses, among other things, have had and will continue to have an adverse effect on our working capital, total assets and stockholders' equity. If we are unable to achieve profitability, the market value of our common stock will decline and there would be a material adverse effect on our financial condition.

If we continue to suffer losses from operations, our working capital may be insufficient to support our ability to expand our business operations as rapidly as we would deem necessary at any time, unless we are able to obtain additional financing. There can be no assurance that we will be able to obtain such financing on acceptable terms, or at all. If adequate funds are not available or are not available on acceptable terms, we may not be able to pursue our business objectives and would be required to reduce our level of operations, including reducing infrastructure, promotions, personnel and other operating expenses. These events could adversely affect our business, results of operations and financial condition. We cannot assure you that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or if they are not available on acceptable terms, our ability to fund the growth of our operations, take advantage of opportunities, develop products or services or otherwise respond to competitive pressures, could be significantly limited.

Critical Accounting Policies and Estimates

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. GAAP requires us to make estimates and assumptions that affect the reported amounts in our financial statements including various allowances and reserves for accounts receivable and inventories, the estimated lives of long-lived assets and trademarks and trademark licenses, as well as claims and contingencies arising out of litigation or other transactions that occur in the normal course of business. The following summarize our most significant accounting and reporting policies and practices:

Revenue Recognition. Revenue is recognized on the sale of a product when the product is shipped, which is when the risk of loss transfers to our customers, and collection of the receivable is reasonably assured. A product is not shipped without an order from the customer and credit acceptance procedures performed. The allowance for returns is regularly reviewed and adjusted by management based on historical trends of returned items. Amounts paid by customers for shipping and handling costs are included in sales. The Company reimburses its wholesalers and retailers for promotional discounts, samples and certain advertising and promotional activities used in the promotion of the Company's products. The accounting treatment for the reimbursements for samples and discounts to wholesalers results in a reduction in the net revenue line item. Reimbursements to wholesalers and retailers for certain advertising and promotional activities are included in the advertising, promotional and selling expenses line item.

Trademark License and Trademarks. We own trademarks that we consider material to our business. Three of our material trademarks are registered trademarks in the U.S. Patent and Trademark Office: Virgil's �, Reed's Original Ginger Brew All-Natural Jamaican Style Ginger Ale � and Tianfu China Natural Soda �. Registrations for trademarks in the United States will last indefinitely as long as we continue to use and police the trademarks and renew filings with the applicable governmental offices. We have not been challenged in our right to use any of our material trademarks in the United States. We intend to obtain international registration of certain trademarks in foreign jurisdictions.

We account for these items in accordance with FASB guidance, we do not amortize indefinite-lived trademark licenses and trademarks.

In accordance with FASB guidance, we evaluate our non-amortizing trademark license and trademarks quarterly for impairment. We measure impairment by the amount that the carrying value exceeds the estimated fair value of the trademark license and trademarks. The fair value is calculated by reviewing net sales of the various beverages and applying industry multiples. Based on our quarterly impairment analysis the estimated fair values of trademark license and trademarks exceeded the carrying value and no impairments were identified during the nine months ended September 30, 2009 or September 30, 2008.

Long-Lived Assets. Our management regularly reviews property, equipment and other long-lived assets, including identifiable amortizing intangibles, for possible impairment. This review occurs quarterly or more frequently if events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. If there is indication of impairment of property and equipment or amortizable intangible assets, then management prepares an estimate of future cash flows (undiscounted and without interest charges) expected to result from the use of the asset and its eventual disposition. If these cash flows are less than the carrying amount of the asset, an impairment loss is recognized to write down the asset to its estimated fair value. The fair value is estimated at the present value of the future cash flows discounted at a rate commensurate with management's estimates of the business risks. Quarterly, or earlier, if there is indication of impairment of identified intangible assets not subject to amortization, management compares the estimated fair value with the carrying amount of the asset. An impairment loss is recognized to write down the intangible asset to its fair value if it is less than the carrying amount. Preparation of estimated expected future cash flows is inherently subjective and is based on management's best estimate of assumptions concerning expected future conditions. No impairments were identified during the nine months ended September 30, 2009 or September 30, 2008.

Management believes that the accounting estimate related to impairment of our long lived assets, including our trademark license and trademarks, is a "critical accounting estimate" because: (1) it is highly susceptible to change from period to period because it requires management to estimate fair value, which is based on assumptions about cash flows and discount rates; and (2) the impact that recognizing an impairment would have on the assets reported on our balance sheet, as well as net income, could be material. Management's assumptions about cash flows and discount rates require significant judgment because actual revenues and expenses have fluctuated in the past and we expect they will continue to do so.

In estimating future revenues, we use internal budgets. Internal budgets are developed based on recent revenue data for existing product lines and planned timing of future introductions of new products and their impact on our future cash flows.

Accounts Receivable. We evaluate the collectability of our trade accounts receivable based on a number of factors. In circumstances where we become aware of a specific customer's inability to meet its financial obligations to us, a specific reserve for bad debts is estimated and recorded which reduces the recognized receivable to the estimated amount our management believes will ultimately be collected. In addition to specific customer identification of potential bad debts, bad debt charges are recorded based on our historical losses and an overall assessment of past due trade accounts receivable outstanding.

Inventories. Inventories are stated at the lower of cost to purchase and/or manufacture the inventory or the current estimated market value of the inventory. We regularly review our inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimated forecast of product demand and/or our ability to sell the product(s) concerned and production requirements. Demand for our products can fluctuate significantly. Factors that could affect demand for our products include unanticipated changes in consumer preferences, general market conditions or other factors, which may result in cancellations of advance orders or a reduction in the rate of reorders placed by customers. Additionally, our management's estimates of future product demand may be inaccurate, which could result in an understated or overstated provision required for excess and obsolete inventory.

Stock-Based Compensation. We periodically issue stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. We adopted FASB guidance effective January 1, 2006, and are using the modified prospective method in which compensation cost is recognized beginning with the effective date (a) for all share-based payments granted after the effective date and (b) for all awards granted to employees prior to the effective date that remain unvested on the effective date. We account for stock option and warrant grants issued and vesting to non-employees in accordance with accounting guidance whereby the fair value of the stock compensation is based on the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instrument is complete.

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