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

Show all filings for SPY INC.

Form 10-Q for SPY INC.


14-Nov-2012

Quarterly Report


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

This Item 2 contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Although forward-looking statements reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. See "Special Note Regarding Forward-Looking Statements" at the beginning of this report.

The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and the related notes and other financial information appearing elsewhere in this Quarterly Report and in the audited Consolidated Financial Statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2011, previously filed with the Securities and Exchange Commission.

The terms "we," "us," "our," and the "Company" refer to SPY Inc. and its subsidiaries unless the context requires otherwise.

Overview

SPY Inc. designs, markets and distributes premium sunglasses, goggles and prescription frame eyewear. In 1994, we began as a grassroots brand in Southern California with the goal of creating innovative and aesthetically progressive eyewear, and, in doing so, we believe we captured the imagination of the action sports market with authentic, distinctive, performance-driven products under the SPY®brand. Today, we believe the SPY® brand, symbolized by the distinct "cross" logo, is a well recognized eyewear brand in its segment of the action sports industry, with a reputation for its high quality products, style and innovation.

We were incorporated as Sports Colors, Inc. in California in August 1992, but we had no operations until April 1994, when we changed our name to Spy Optic, Inc. In November 2004, we reincorporated in Delaware and changed our name to Orange 21 Inc. In February 2012, we changed our name from Orange 21 Inc. to SPY Inc. to better reflect the focus of our business going forward.

References in this report to "we," "our," "us," "SPY," and "SPY Inc." refer to SPY Inc. and its two operating subsidiaries - Spy Optic Inc. ("SPY North America") and Spy Optic Europe S.r.l. S.U. ("SPY Europe") - except where the context clearly indicates that the term refers only to SPY Inc. Effective December 31, 2010, we sold substantially all of our interest in LEM S.r.l. ("LEM"). See "LEM Purchase Commitments" in Note 12 to the Consolidated Financial Statements.

Our Products and Target Markets

SPY® Products

We design, market and distribute premium products for hard core participants in action sports, motorsports, snow sports, cycling and multi-sports markets, which embrace their attendant lifestyle subcultures, crossing over into more mainstream fashion, music and entertainment markets. We believe a principal strength is our ability to create distinctive products for active people within the youthful demographics of these subcultures. Our principal products - sunglasses, goggles and prescription frames - are marketed under the SPY ® brand.

We have built SPY® by developing innovative, proprietary, performance-based products with quality materials and lens technologies, style and value. We sell our products directly to numerous retail locations in North America, and to retail locations internationally supported by our international staff and distributors. We have developed collaborations with important multi-store action sports, sporting goods, sunglass specialty and lifestyle retailers in North America and other strategically-selected, individually owned-and-operated specialty retailers focusing on surfing, motocross, snowboarding, cycling, skateboarding, snow skiing, motorsports, wakeboarding, multi-sports and mountain biking.

We separate our eyewear products into three groups: (i) Sunglasses, which includes fashion, performance sport and women-specific sunglasses; (ii) Goggles, which includes snow sport and motocross goggles created for our core demographics, and a new goggle line extension for the SPY® brand that targets new distribution opportunities and customers; and (iii) Optical, which includes optical-quality frames and sunglasses for persons in a slightly older, but still youthful, demographic. In addition, we sell branded accessories for sunglasses and goggles.

SPY® is a creative, athlete-driven brand. We strive to ensure that our products are relevant in function and design. We do this, in part, through receiving feedback from the athletes who wear our products during competition and by knowing the lifestyles of our target customers. In doing so, we believe we are able to offer a stronger product offering to our target market.


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Previous Products

During 2011 and 2010, we designed, manufactured and sold eyewear under the O'Neill ®, Melodies by MJB® and Margaritaville®brands. During 2011, we decided to focus our development, marketing and sales activity on our SPY®products. As part of that focus, we decided to cease any new purchase orders of additional inventory for the O'Neill®, Melodies by MJB® and Margaritaville® licensed eyewear brands. In July 2011, we entered into an agreement with Rose Colored Glasses LLC in which, among other matters, the parties agreed to terminate the existing license agreement for Melodies by MJB ® effective March 31, 2012. Additionally, in December 2011, SPY North America gave O'Neill ® a 180 day notice of termination in accordance with the allowable termination clause in the agreement, thereby terminating the agreement effective as of June 24, 2012.

Results of Operations

Three Months Ended September 30, 2012 and 2011

Net Sales

Consolidated net sales increased by $0.7 million or 8% to $9.9 million for the three months ended September 30, 2012 from $9.2 million for the three months ended September 30, 2011.

Sales of our SPY® brand products in North America and internationally increased by $1.4 million or 17% to $9.8 million during the three months ended September 30, 2012 from $8.4 million for the three months ended September 30, 2011. SPY® sales amounts included approximately $0.8 million of sales during the three months ended September 30, 2012 considered to be closeouts, defined as
(i) older styles not in the current product offering or (ii) the sales of certain excess inventory of current products sold at reduced pricing levels generally to closeout channels, compared to $0.3 million of such sales during the three months ended September 30, 2011. A significant portion of the SPY® sales growth was from increased North America sales of sunglasses, snow goggles and our new prescription frames, this increase was partially offset by lower SPY®brand sales primarily in Europe. The prescription frame product line was launched in late 2011 and had insignificant sales during the three months ended September 30, 2011.

Sales of licensed brands (O'Neill®, Melodies by MJB® and Margaritaville®) were less than $0.1 million during the three months ended September 30, 2012 compared to $0.8 million during the three months ended September 30, 2011. All of our sales of licensed brands during the three months ended September 30, 2012 and 2011 were considered to be closeout sales based on our decision during 2011 to cease making purchases of new licensed brand inventory and we do not expect to generate any significant sales from the licensed brands (O'Neill®, Melodies by MJB® and Margaritaville®) in the future.

Sunglass sales represented approximately 64% and 57% of net sales during the three months ended September 30, 2012 and 2011, respectively. Goggle sales represented approximately 35% and 43% of net sales during the three months ended September 30, 2012 and 2011, respectively. Apparel and accessories represented approximately 1% of net sales during the three months ended September 30, 2012 and less than 1% during the same period in 2011. North America net sales represented 84% and 79% of total net sales for the three months ended September 30, 2012 and 2011, respectively. International net sales represented 16% and 21% of total net sales for the three months ended September 30, 2012 and 2011, respectively.

Gross Profit

Our consolidated gross profit increased by $1.1 million or 33% to $4.3 million for the three months ended September 30, 2012 from $3.2 million for the three months ended September 30, 2011. The increased gross profit contribution was primarily attributable to the increased level of sales as well as the significant increases in gross profit as a percentage of sales during the three months ended September 30, 2012 compared to the three months ended September 30, 2011 as discussed below.

Gross profit, as a percentage of net sales, was 44% for the three months ended September 30, 2012 compared to 35% for the three months ended September 30, 2011. The increase in our gross profit as a percent of net sales during the three months ended September 30, 2012 compared to the same period last year was primarily due to (i) the negative effect of lower licensed brand margins in 2011, primarily due to inventory reserves recorded in the three months ended September 30, 2011 to reflect inventory at its then estimated net realizable value, (ii) a higher percentage of lower cost inventory purchases in 2012 from lower cost sources in China, and (iii) decreased freight costs primarily associated with decreased portion of air shipments and greater portion of ocean shipments in 2012. These gross margin increases were partially offset by the impact of (i) reduced gross margin in our international business primarily driven by lower sales levels and the European economic situation, coupled with a change in sales mix between a higher margin direct business and a lower margin distribution business and inventory reserves related to our decision in 2012 to change to a full distribution model in Europe, (ii) selling a portion of inventory during the three months ended September 30, 2011 that was originally purchased from LEM in 2010 at its lower historical manufacturing cost and was being sold on a FIFO basis, thereby resulting in higher gross margin from the sale of those products during 2011, prior to generally higher cost purchases made from LEM after December 31, 2010 which comprised the vast majority of products purchased from LEM and sold during 2012, (iii) increased SPY closeouts,
(iv) increased inventory reserves and (v) increased levels of discounting in 2012 primarily due to increased levels of sales to major accounts.


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Sales and Marketing Expense

Sales and marketing expense increased by $0.4 million or 12% to $3.8 million for the three months ended September 30, 2012 from $3.4 million for the three months ended September 30, 2011, driven primarily by increased marketing efforts to promote our SPY® brand and our new SPY®products and a portion of restructure expenses included in 2012. The $0.4 million increase consists of (i) $0.5 million attributable to restructure expenses in the third quarter of 2012 which were zero in 2011, (ii) an increase of $0.1 million in advertising, public relations, promotions and marketing events costs, partially offset by (iii) a $0.2 million decrease primarily related to consulting and other marketing expenses.

General and Administrative Expense

General and administrative expense decreased by $0.7 million or 34% to $1.3 million for the three months ended September 30, 2012 from $2.0 million for the three months ended September 30, 2011. The decrease was primarily due to a reduction in expenses related to severance, performance-based compensation, general corporate matters, legal and other professional services fees, which were at elevated levels for the three months ended September 30, 2011 related to the restructuring of management in April 2011. These decreases were partially offset by the impact of $0.1 million from the portion of the third quarter 2012 restructure costs included in general and administrative expenses.

Shipping and Warehousing Expense

Shipping and warehousing expense increased by less than $0.1 million or 36% to $0.2 million for the three months ended September 30, 2012 from $0.2 million for the three months ended September 30, 2011. The increase was primarily due to restructure expenses in the third quarter of 2012 which were zero in 2011.

Research and Development Expense

Research and development expense was essentially unchanged at $0.1 million for the three months ended September 30, 2012 from $0.1 million for the three months ended September 30, 2011.

Other Net Expense

Other net expense was $0.6 million for the three months ended September 30, 2012 compared to other net expense of $0.5 million for the three months ended September 30, 2011. The difference was primarily due to increased interest expense related to the increase in borrowings from Costa Brava Partnership III, L.P ("Costa Brava") and BFI Business Finance ("BFI"). Commencing in 2012, the Costa Brava borrowings interest expense was paid in kind by being added to the outstanding principal balances rather than paid in cash.

Income Tax Provision

Income tax expense for the three months ended September 30, 2012 and 2011 was zero and $21,000, respectively. The income tax provision is mainly comprised of minimum taxes due in Italy. We have recorded a full valuation allowance for deferred tax assets both in the U.S. and in Italy at September 30, 2012 and 2011, respectively. The effective tax rate for the three months ended September 30, 2012 and 2011 was less than 1% in both periods.

We may have had one or more ownership changes, as defined by Section 382 of the Internal Revenue Code ("IRC Section 382") in the current and previous years, and, as such, the use of our net operating losses may be limited in future years. We have not completed a formal IRC Section 382 study and analysis to determine the annual limitation on the use of the net operating losses; however, the limitations could be substantial.

Nine Months Ended September 30, 2012 and 2011

Net Sales

Consolidated net sales increased by $2.6 million or 10% to $27.5 million for the nine months ended September 30, 2012 from $24.9 million for the nine months ended September 30, 2011.

Sales of our SPY® brand products in North America and internationally increased by $3.9 million or 17% to $27.1 million during the nine months ended September 30, 2012 from $23.2 million for the nine months ended September 30, 2011. SPY® sales amounts included approximately $2.0 million of sales during the nine months ended September 30, 2012 considered to be closeouts, defined as
(a) older styles not in the current product offering or (b) the sales of certain excess inventory of current products sold at reduced pricing levels generally to closeout channels, compared to $1.2 million of such sales during the nine months ended September 30, 2011. A significant portion of the SPY® sales growth was from increased North American sales of sunglasses, and our new prescription frame and performance sport sunglasses product lines that were launched in late 2011 which had lower sales during the nine months ended September 30, 2011.


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Sales of licensed brands (O'Neill ®, Melodies by MJB® and Margaritaville®) were at $0.4 million during the nine months ended September 30, 2012 compared to $1.7 million during the nine months ended September 30, 2011. All of our sales of licensed brands during the nine months ended September 30, 2012 were considered to be closeout sales based on our decision during 2011 to cease making purchases of new licensed brand inventory and we do not expect to generate any significant sales from the licensed brands (O'Neill ®, Melodies by MJB® and Margaritaville®) in the future.

Sunglass sales represented approximately 81% and 77% of net sales during the nine months ended September 30, 2012 and 2011, respectively. Goggle sales represented approximately 18% and 23% of net sales during the nine months ended September 30, 2012 and 2011, respectively. Apparel and accessories represented approximately 1% of net sales during the nine months ended September 30, 2012 and less than 1% during the same period during 2011. North America net sales represented 90% and 87% of total net sales for the nine months ended September 30, 2012 and 2011, respectively. International net sales represented 10% and 13% of total net sales for the nine months ended September 30, 2012 and 2011, respectively.

Cost of Sales and Gross Profit

Our consolidated gross profit increased by $1.3 million or 11% to $12.9 million for the nine months ended September 30, 2012 from $11.5 million for the nine months ended September 30, 2011, primarily attributable to the sales increase at a slightly higher gross profit as a percent of sales in 2012 as discussed below.

Gross profit, as a percentage of net sales, increased to 47% for the nine months ended September 30, 2012 from 46% for the nine months ended September 30, 2011 primarily due to (i) the negative effect of lower licensed brand margins in 2011, primarily due to inventory reserves recorded in 2011 to reflect inventory at its then estimated net realizable value, and (ii) a higher percentage of lower cost inventory purchases in 2012 were from lower cost sources in China. These gross margin increases were partially offset by (i) lower sales levels and the reduced gross margin in our international business primarily driven by the European economic situation, coupled with a change in sales mix between a higher margin direct business and a lower margin distribution business and inventory reserves related to our decision in 2012 to change to a full distribution business model in Europe, (ii) selling a portion of inventory during the nine months ended September 30, 2011 that was originally purchased from LEM in 2010 at its lower historical manufacturing cost and was being sold on a FIFO basis, thereby resulting in higher gross margin from the sale of those products during 2011, prior to generally higher cost purchases made from LEM after December 31, 2010 which comprised the vast majority of products purchased from LEM and sold during 2012, (iii) increased levels of discounting in 2012 primarily due to increased levels of sales to major accounts, and (iv) increased freight costs primarily associated with an increased level of air shipments prior to the third quarter of 2012, (v) increased SPY closeout sales and (vi) increased inventory reserves.

Sales and Marketing Expense

Sales and marketing expense increased by $2.4 million or 27% to $11.2 million for the nine months ended September 30, 2012 from $8.9 million for the nine months ended September 30, 2011, driven primarily by increased marketing efforts to promote our SPY® brand and our new SPY®products and a portion of the 2012 restructure expenses in the third quarter, partially offset by reduced expenses related to promotional efforts surrounding licensed brands that were significant during the nine months ended September 30, 2011 and nearly non-existent during the nine months ended September 30, 2012. The $2.4 million increase included:
(i) $0.5 million attributable to a portion of the 2012 restructure expense included in sales and marketing, (ii) a $1.3 million increase in advertising, public relations, marketing events, and related marketing costs, (iii) a $0.2 million increase in sales and marketing related expenses primarily for additions in headcount, (iv) a $0.3 million increase in the cost of product displays,
(v) a $0.3 million increase in sales incentives and commissions associated with the sales growth during the nine months ended September 30, 2012. These expense increases for the nine months ended September 30, 2012 were partially offset by a decrease in consulting costs of $0.1 million and royalty related costs related to licensed brands which totaled $0.3 million during the nine months ended September 30, 2011 and were nearly non-existent during the nine months ended September 30, 2012.

General and Administrative Expense

General and administrative expense decreased by $1.2 million or 19% to $5.0 million for the nine months ended September 30, 2012 from $6.2 million for the nine months ended September 30, 2011. The decrease was primarily due to a reduction in expenses related to severance, performance-based compensation, general corporate matters, legal and other professional services fees, which were at elevated levels for the nine months ended September 30, 2011 related to the restructuring of management in April 2011, partially offset by $0.1 million attributable to the portion of third quarter 2012 restructure expenses that were included in general and administrative expenses.


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Shipping and Warehousing Expense

Shipping and warehousing expense increased by less than $0.2 million or 34% to $0.6 million for the nine months ended September 30, 2012 from $0.5 million for the nine months ended September 30, 2011. The $0.2 million increase was primarily due to an increase in employee related costs due to an increase in headcount and restructuring expenses in 2012.

Research and Development Expense

Research and development expense decreased by less than $0.1 million or 19% to $0.4 million for the nine months ended September 30, 2012 from $0.4 million for the nine months ended September 30, 2011 primarily due to a decrease in R&D activity associated with the spending related to O'Neill™ and Melodies by MJB™ eyewear brands during the nine months ended September 30, 2012 and reduced outside design consulting services in 2012.

Other Operating Expense

Other operating expense was zero for the nine months ended September 30, 2012 and $2.0 million during the nine months ended September 30, 2011. The decrease is substantially all due to the decision during the nine months ended September 30, 2011 that the cash flow from the sale of the O'Neill™ and Melodies by MJB™ eyewear brands would be insufficient to cover the net present value due to the remaining royalty obligations. In addition, the Company decided to cease making future purchase orders of additional inventory. These decisions resulted in an expense of $1.9 million included in operating expenses during the nine months ended September 30, 2011.

Other Net Expense

Other net expense was $1.6 million for the nine months ended September 30, 2012 compared to other net expense of $1.1 million for the nine months ended September 30, 2011. The difference was primarily due to increased interest related to the increase in borrowings from Costa Brava and BFI. Commencing in 2012, the Costa Brava and Harlingwood (Alpha), LLC ("Harlingwood") borrowings interest expense was paid in kind by being added to the outstanding principal balances rather than paid in cash.

Income Tax Provision

The income tax expense for the nine months ended September 30, 2012 and 2011 was zero and $27,000, respectively, and is mainly comprised of minimum taxes due in Italy. We have recorded a full valuation allowance for deferred tax assets both in the U.S. and in Italy at September 30, 2012 and 2011, respectively.

Liquidity and Capital Resources

We finance our working capital needs and capital expenditures through a combination of operating cash flows and bank revolving lines of credit supplied by our lenders, substantially all in the U.S. We have also required debt and equity financing because cash used by operations has been substantial due to ongoing operating and net losses and other factors, including working capital requirements.

During 2010, we borrowed $7.0 million from our largest stockholder, Costa Brava Partnership III, L.P. ("Costa Brava" and entered into capital leases for certain long-term asset purchases. In February 2011, we raised $1.2 million from the sale of shares of our common stock to Harlingwood (Alpha) LLC ("Harlingwood"). In June 2011, we entered into a $6.0 million line of credit with Costa Brava and had borrowed $6.0 million under that line of credit as of December 31, 2011. In December 2011 we expanded our borrowing capabilities with Costa Brava by receiving the right to pay interest in kind by adding it to the outstanding principal balances until maturity rather than pay in cash. In December 2011, we expanded our borrowing capabilities within our $7.0 million borrowing limit with BFI by increasing the amount that we can borrow against inventory and by including Canadian accounts receivable as potential borrowing collateral. In June 2012, we increased our line of credit with Costa Brava to $7.0 million and further increased it to $10.0 million in August 2012. In August 2012, the Costa Brava Line of Credit was amended to require us to repay up to $4.0 million of our indebtedness to Costa Brava under the Costa Brava Line of Credit, at the election of Costa Brava, if we complete an equity financing or certain debt financing aggregating $4.0 million or more by December 31, 2012. Any amount so repaid will reduce dollar-for-dollar Costa Brava's commitment to make advances under the Costa Brava Line of Credit. In September 2012, we borrowed $1.0 million in a convertible debt financing from Harlingwood (the "Harlingwood Note"), which also has the effect of reducing by $1.0 million the $4.0 million needed to trigger the requirements by $1.0 million for us to repay amounts due under the Costa Brava Line of Credit at the election of Costa Brava. In September 2012, the Costa Brava Term Note and Costa Brava Line of Credit were further amended to eliminate our ability to elect to make any interest payments in cash prior to the April 1, 2014 due date.

As of September 30, 2012, we had a total of $22.4 million in debt under lines of credit, capital leases and notes payable. We recorded approximately $0.6 million and $0.4 million in interest expense during the three months ended September 30, 2012 and 2011, respectively, and recorded approximately $1.7 million and $1.0 million in interest expense during the nine months ended September 30, 2012 and 2011, respectively. Cash on hand at September 30, 2012 was $1.0 million.


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Cash flow activities

Cash used in operating activities consists primarily of net loss adjusted for certain non-cash items, including depreciation and amortization, paid-in-kind interest on borrowings, share-based compensation, provision for doubtful accounts, impairment of property and equipment, foreign currency gains and losses, amortization of debt discount, and the effect of changes in working capital and other activities.

Cash used in operating activities for the nine months ended September 30, 2012 was $4.1 million, which consisted of a net loss of $6.0 million, adjustments for aggregate non-cash items of $2.5 million (primarily paid in kind interest and share-based compensation) and an aggregate $0.7 million used in working capital and other activities. Working capital and other activities includes uses of cash of $2.9 million primarily from (i) a $1.4 million increase in accounts receivable due to the increased level of sales, seasonality and the timing of cash receipts, (ii) a $1.4 million increase in inventories primarily due to seasonality and (iii) $0.1 million of other working capital items. The uses in . . .

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