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REED > SEC Filings for REED > Form 10-Q on 14-Nov-2012All Recent SEC Filings

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Form 10-Q for REEDS INC


14-Nov-2012

Quarterly Report


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

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

Our third quarter results reflect our continued sales growth in all products and regions. We have begun the rollout of our new kombucha line, which we feel will become a significant component of our 2013 revenues. Our kombucha rollout has included promotional discounts and, more importantly, higher plant production costs as we refine our methods of producing this high quality product. Such discounts and costs will continue in the fourth quarter 2012, however, we believe that the kombucha product line will ultimately produce higher margins than our other branded products in 2013. We consider this investment to be economical when compared to the costs that another company would incur to either acquire or develop a similar product.

Overall, we are investing in promotions at a higher rate than last year and we feel that this has helped lift our sales volumes without margin erosion. Our promotions have generally been at the grocer level, along with incentives for our dealers to favor our products in their sales efforts.

We are currently into our "busy season" with our private label production and sales, and we have several new significant private label products about to roll-out. Our Los Angeles plant capacity is increasing dramatically as we continue to add key equipment and implement new processes.

We believe that our fourth quarter will show favorable trends in all areas of our business and that our fiscal 2012 year will prove to be a turning point for the Company, as we focus on profitable operations along with investments in revenue enhancement activities that will accelerate our growth at the same time.

Results of Operations

Three months ended September 30, 2012 Compared to Three months ended September 30, 2011

Sales

Sales of $7,888,000 for the three months ended September 30, 2012 represented an increase of 23% from $6,400,000 in the prior year same period. Sales growth was driven primarily by continued increases in sales volume in our branded products as we expand our distribution networks. We have been steadily adding distributors and expanding our product offerings to existing customers. Increases in private label sales also contributed to our overall sales increases, with private label revenues contributing approximately 15% of overall sales in the quarter ended September 30, 2012, as compared to approximately 9% in 2011.

Cost of Tangible Goods Sold

Cost of tangible goods sold consists of the costs of raw materials utilized in the manufacture of products, co-packing fees, repacking fees, in-bound freight charges, as well as certain internal transfer costs. Our costs of tangible goods sold of $4,810,000 for the three months ended September 30, 2012 represents a slight decrease in per unit costs, as compared to the 2011 same period. We have reduced certain copack related fees and have negotiated decreases in certain raw ingredients pricing, resulting in an overall decrease in our per-unit costs of our core 12-ounce beverages of approximately 1% in 2012, as compared to 2011.

Cost of Goods Sold - Idle Capacity

Cost of goods sold - idle capacity consists of direct production costs of our Los Angeles plant in excess of charges allocated to our finished goods in production. Plant costs include labor costs, production supplies, repairs and maintenance, and inventory write-off. Our charges for labor and overhead allocated to our finished goods are determined on a market cost basis, which is lower than our actual costs incurred. Plant costs in excess of production allocations are expensed in the period incurred rather than added to the cost of finished goods produced. Idle capacity expenses increased to $621,000 in the three months ended September 30, 2012, from $405,000 in 2011. The increase is primarily due to unabsorbed startup costs relating to our kombucha roll-out production in our Los Angeles plant. As we refine our production methods, we feel that these costs will reduce in the future. Our Los Angeles plant production has increased by over 20% in the third quarter, as compared to 2011.

Gross Profit

Our gross profit of $2,457,000 in the three months ended September 30, 2012 represents an increase of $432,000, or 21% from 2011. As a percentage of sales, our gross profit decreased to 31% in 2012 as compared to 32% in 2011. The decrease is primarily due to the negative impact of our plant idle capacity on our gross profit percentage, mitigated by lower costs of tangible goods sold and sales volume increases.

Delivery and Handling Expenses

Delivery and handling expenses consist of delivery costs to customers and warehouse costs incurred for handling our finished goods after production. Delivery costs increased by 30% in the three months ended September 30, 2012 to $763,000 from $587,000 in 2011. The increase is generally consistent with our increase in sales volume, along with higher shipping costs for cold storage products sold in 2012, namely kombucha.

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 increased overall to $818,000 in the three months ended September 30, 2012 from $570,000 in 2011. The $248,000 increase is primarily due to increased trade show and advertising costs of $145,000, increased compensation and travel costs of $119,000; offset by a decrease in delivery and facilities related costs of $27,000. We have provided new promotional incentives to several of our distributors and have experienced positive results. We are increasing our sales staff in a conservative manner as our sales territories continue to grow.

General and Administrative Expenses

General and administrative expenses consist primarily of the cost of executive, administrative, and finance personnel, as well as professional fees. General and administrative expenses decreased to $693,000 during the three months ended September 30, 2012 from $867,000 in the same period of 2011. In the 2011 third quarter, we incurred legal costs of approximately $200,000 that did not recur in the 2012 third quarter. Compensation costs decreased in the 2012 three month period by $58,000. Professional and consulting costs increased by $29,000 in the 2012 third quarter, facilities costs increased by $45,000, and depreciation costs increased by $9,000.

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.

Income/Loss from Operations

Our income from operations of $183,000 in the three months ended September 30, 2012 represents an improvement of $182,000 from the income of $1,000 in the same period of 2011.

Interest Expense

Interest expense decreased to $161,000 in the three months ended September 30, 2012, compared to interest expense of $175,000 in the same period of 2011. The decrease is primarily due to a lower rate of interest charged on our revolving line of credit than in 2011.

Modified EBITDA

The Company defines modified EBITDA (a non-GAAP measurement) as net loss before interest, taxes, depreciation and amortization, and non-cash expense for securities. Other companies may calculate modified EBITDA differently. Management believes that the presentation of modified EBITDA provides a measure of performance that approximates cash flow before interest expense, and is meaningful to investors.

                            MODIFIED EBITDA SCHEDULE



                                                      Three Months Ended
                                                        September 30,
                                                     2012           2011
          Net income (loss)                        $  22,000     $ (174,000 )

          Modified EBITDA adjustments:
          Depreciation and amortization              184,000        164,000
          Interest expense                           161,000        175,000
          Stock option compensation                   26,000         59,000
          Other stock compensation for services        2,000         45,000
          Total EBITDA adjustments                   373,000        443,000

          Modified EBITDA income from operations   $ 395,000     $  269,000

Nine months ended September 30, 2012 Compared to Nine months ended September 30, 2011

Sales

Sales of $22,258,000 for the nine months ended September 30, 2012 represented an increase of 26% from $17,731,000 in the prior year same period. Sales growth was driven primarily by continued increases in sales volume in our branded products as we expand our distribution networks. We have been steadily adding distributors and expanding our product offerings to existing customers. Increases in private label sales also contributed to our overall sales increases, with private label revenues contributing approximately 14% of overall sales in the quarter ended September 30, 2012, as compared to approximately 9% in 2011.

Cost of Tangible Goods Sold

Cost of tangible goods sold consists of the costs of raw materials utilized in the manufacture of products, co-packing fees, repacking fees, in-bound freight charges, as well as certain internal transfer costs. Our costs of tangible goods sold of $13,691,000 for the nine months ended September 30, 2012 represents approximately the same average cost per unit as compared to the 2011 same period.

Cost of Goods Sold - Idle Capacity

Cost of goods sold - idle capacity consists of direct production costs of our Los Angeles plant in excess of charges allocated to our finished goods in production. Plant costs include labor costs, production supplies, repairs and maintenance, and inventory write-off. Our charges for labor and overhead allocated to our finished goods are determined on a market cost basis, which is lower than our actual costs incurred. Plant costs in excess of production allocations are expensed in the period incurred rather than added to the cost of finished goods produced. Idle capacity expenses increased to $1,428,000 in the nine months ended September 30, 2012, from $1,300,000 in 2011. The increase is primarily due to unabsorbed startup costs relating to our kombucha roll-out production during the quarter ended September 30, 2012 in our Los Angeles plant. As we refine our production methods, we feel that these costs will reduce in the future.

Gross Profit

Our gross profit of $7,139,000 in the nine months ended September 30, 2012 represents an increase of 33% from 2011. As a percentage of sales, our gross profit increased to 32% in 2012 as compared to 30% in 2011. The improved gross profit percentage is primarily due to lower costs of goods sold, as described above, along with selected price increases. Additionally, the negative impact of our plant idle capacity on our gross profit percentage is lower as our sales volume increases.

Delivery and Handling Expenses

Delivery and handling expenses consist of delivery costs to customers and warehouse costs incurred for handling our finished goods after production. Delivery costs increased by 20% in the nine months ended September 30, 2012 to $1,827,000 from $1,519,000 in 2011. The increase is generally consistent with our increase in sales volume.

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 increased overall to $2,239,000 in the nine months ended September 30, 2012 from $1,751,000 in 2011. The $488,000 increase is primarily due to increased trade show and advertising costs of $297,000, increased compensation and travel costs of $138,000, and an increase in delivery and facilities related costs of $53,000.

General and Administrative Expenses

General and administrative expenses consist primarily of the cost of executive, administrative, and finance personnel, as well as professional fees. General and administrative expenses increased to $2,238,000 during the nine months ended September 30, 2012 from $2,198,000 in the same period of 2011. In the 2011 nine month period, we incurred legal costs of approximately $245,000 that did not recur in the 2012 period. Compensation costs decreased in the 2012 nine month period by $118,000. Professional and consulting costs increased by $116,000 in the 2012 nine month period, facilities costs increased by $116,000, and depreciation costs increased by $45,000.

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.

Income/Loss from Operations

Our income from operations of $835,000 in the nine months ended September 30, 2012 represents an improvement of $925,000 from the loss of $90,000 in the same period of 2011.

Interest Expense

Interest expense decreased to $493,000 in the nine months ended September 30, 2012, compared to interest expense of $504,000 in the same period of 2011. The decrease is primarily due to lower rate of interest charged on our revolving line of credit in 2012 than in 2011, partially offset by interest charged on higher borrowings in 2012 than in 2011.

Modified EBITDA

The Company defines modified EBITDA (a non-GAAP measurement) as net loss before interest, taxes, depreciation and amortization, and non-cash expense for securities. Other companies may calculate modified EBITDA differently. Management believes that the presentation of modified EBITDA provides a measure of performance that approximates cash flow before interest expense, and is meaningful to investors

                            MODIFIED EBITDA SCHEDULE



                                                       Nine Months Ended
                                                         September 30,
                                                     2012            2011
         Net income (loss)                        $   342,000     $  (594,000 )

         Modified EBITDA adjustments:
         Depreciation and amortization                556,000         472,000
         Interest expense                             493,000         504,000
         Stock option compensation                     81,000         189,000
         Other stock compensation for services         23,000         123,000
         Total EBITDA adjustments                   1,153,000       1,288,000

         Modified EBITDA income from operations   $ 1,495,000     $   694,000

Liquidity and Capital Resources

As of September 30, 2012, we had stockholders equity of $4,899,000 and we had working capital of $3,221,000, compared to stockholders equity of $4,305,000 and working capital of $2,655,000 at December 31, 2011. Cash and cash equivalents were $1,429,000 as of September 30, 2012, as compared to $713,000 at December 31, 2011.

Our increase in cash and cash equivalents to $1,429,000 at September 30, 2012 was primarily a result of profitable operations and decreases in inventory. During the nine months ended September 30, 2012, we invested $334,000 in plant improvements. We are upgrading the facilities as well as adding new equipment to our production line that will increase our flexibility in product offerings and increase our plant performance. We also received $135,000 from the exercise of stock options and warrants.

Our Loan and Security Agreement with PMC Financial Services Group, LLC provides a $4 million revolving line of credit and a $750,000 term loan. The revolving line of credit is based on 85% of eligible accounts receivable and 50% of eligible inventory. The interest rate on the revolving line of credit is at the prime rate plus 3.75% (7% at September 30, 2012). The term loan is for $750,000 and bears interest at the prime rate plus 11.6%, which shall not be below 14.85%, is secured by all of the unencumbered assets of the Company, and is to be repaid in 48 equal installments of principal and interest of $21,000. We feel that this loan facility is adequate for our current business plans.

We believe that the Company currently has the necessary working capital to support existing operations through 2012. Our primary capital source will be cash flow from operations. If our sales goals do not materialize as planned, we believe that the Company can become leaner and 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.

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 may 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 would decline and there would be a material adverse effect on our financial condition.

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. 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 activities are included in selling and marketing expenses.

Cost of Tangible Goods Sold - Cost of tangible goods sold consists of the costs of raw materials utilized in the manufacture of products, co-packing fees, repacking fees, in-bound freight charges, as well as certain internal transfer costs. Raw materials account for the largest portion of the cost of sales. Raw materials include cans, bottles, other containers, ingredients and packaging materials.

Cost of goods sold - Idle Capacity - Cost of goods sold - idle capacity consists of direct production costs in excess of charges allocated to finished goods. Our charges for labor and overhead allocated to our finished goods are determined on a cost basis. Plant costs include labor costs, production supplies, repairs and maintenance, and inventory write-off. Plant costs in excess of production allocations are expensed in the period incurred.

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 three months ended September 30, 2012.

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 could be 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. The Company accounts for stock option and warrant grants issued and vesting to employees based on FASB ASC Topic 718 "Compensation - Stock Compensation", whereas the award is measured at its fair value at the date of grant and is amortized ratably over the vesting period. We account for stock option and warrant grants issued and vesting to non-employees in accordance with FASB ASC Topic 505 "Equity" 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.

We estimate the fair value of stock options using the Black-Scholes option-pricing model, which was developed for use in estimating the fair value of options that have no vesting restrictions and are fully transferable. This model requires the input of subjective assumptions, including the expected price volatility of the underlying stock and the expected life of stock options. Projected data related to the expected volatility of stock options is based on the historical volatility of the trading prices of the Company's common stock and the expected life of stock options is based upon the average term and vesting schedules of the options. Changes in these subjective assumptions can materially affect the fair value of the estimate, and therefore the existing valuation models do not provide a precise measure of the fair value of our employee stock options.

We believe there have been no significant changes, during the three month period ended September 30, 2012, to the items disclosed as critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update (ASU) No. 2011-04, "Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs". ASU No. 2011-4 does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting. The ASU is effective for interim and annual periods beginning after December 15, 2011. The Company adopted ASU No. 2011-04 effective January 1, 2012 and it did not affect the Company's results of operations, financial condition or liquidity.

In June 2011, the FASB issued ASU No. 2011-05, "Presentation of Comprehensive Income". The ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders' . . .

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