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REED > SEC Filings for REED > Form 10-K on 25-Mar-2013All Recent SEC Filings

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Form 10-K for REEDS INC


25-Mar-2013

Annual Report


Item 7. 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 Annual Report. This discussion and analysis may contain forward-looking statements based on assumptions about our future business. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under "Risk Factors" and elsewhere in this Annual Report.

Overview

Our 2012 results reflect 20% growth in revenues to $30 million. Private label sales were approximately $5.2 million of the revenues, $1 million higher than in 2011. Our private label revenues fell a little short of expectations in the fourth quarter due to lower buying from a major customer. We are starting out 2013 with very strong growth in both private label and branded product revenues. In 2013, we anticipate that our Culture Club kombucha line will make an increasing impact on branded sales revenues while we continue to increase our distribution reach for our branded Ginger Brew and Virgil's lines of natural sodas. In addition to revenues from our three great brands, we are exploring additional line extensions and branding opportunities. We are also increasing our consumer marketing and creating excitement around our brands, which will increase general awareness of our products. We believe that we have adequate capital for our existing business plans for 2013 and we are increasing margin contribution at a rate that is faster than increases in operating and sales costs.

Results of Operations

Year ended December 31, 2012 Compared to Year ended December 31, 2011

Sales

Sales of $30,007,000 for the year ended December 31, 2012 represent an increase of $4,994,000, or 20%, as compared to the prior year same period. Sales from branded products increased over 19% during 2012, over 2011, with an overall volume increase of 18% in our core 12-ounce branded beverages. Sales of private label products increased to approximately $5.2 million in 2012, an increase of approximately 23% over 2011. The branded product sales increases are due to higher volumes with key customers as well as the addition of several regional direct store delivery (DSD) distributors selling our products. Promotional allowances, a deduction from revenues, increased at a faster rate than gross sales increases, primarily due to initial discounting on our kombucha sales and to additional promotional activities with our distributors. Our kombucha sales commenced during the second half of 2012, with volume increases primarily in the fourth quarter.

Cost of Tangible Goods Sold

Cost of tangible goods sold consists of the costs of raw materials and packaging utilized in the manufacture of products, co-packing fees, repacking fees, in-bound freight charges, as well as certain internal transfer costs. The total cost of $18,943,000 for the year December 31, 2012 was 63% of net sales, as it also was in 2011. Despite price increases in certain key raw ingredients, we were able to lower our average costs on our 12 ounce branded sodas overall by approximately 2% in the year ended December 31, 2012, as compared to the prior year same period, due primarily to lower costs of certain 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 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 $1,920,000 in the year ended December 31, 2012, from $1,761,000 in the prior year period. The increase is due to higher unabsorbed costs of production, primarily in payroll, workers compensation insurance and depreciation expense. During 2012 we produced about 60% less equivalent cases in our Los Angeles plant than we did in 2011. The lower production is due primarily to our initial kombucha productions, which tied up plant time while we learned and improved processes. During the first half of 2012, we also performed a number of plant upgrades and maintenance that required labor costs which could not be capitalized and which required periods of down time from production. Despite the lower production in 2012, we were able to mitigate the plant losses to an increase of $159,000 or 9% increase over 2011. We anticipate that our plant production will increase to record production rates in 2013, which will help us to reduce the idle capacity costs.

Gross Profit

Our gross profit of $9,144,000 in the year ended December 31, 2012 represents 30% of sales, as compared to 30% in 2011.

Delivery and Handling Expenses

Delivery and handling expenses consist of delivery costs to certain customers and warehouse costs incurred for handling our finished goods after production. Delivery and handling costs increased to $2,634,000 in the year ended December 31, 2012 from $2,307,000 in 2011. The 14% increase is due to higher sales volume, increased freight costs on certain customers and increased inventory handling costs. As a percentage of sales, delivery and handling expenses were 9% in both of the years ended December 31, 2012, and 2011.

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 $3,145,000 in the year ended December 31, 2012 from $2,470,000 in 2011. The $675,000 increase (27%) is primarily due to increased marketing and promotional costs of $403,000, including dealer promotions, sponsorships and trade shows; and to higher compensation related costs of $251,000. Our overall sales staff increased from 13 at the end of 2011 to 17 at the end of 2012. As our sales base continues to grow, we plan to progressively increase our sales staff further. As a percentage of sales, selling and marketing costs in the aggregate were 10% in both the years ended December 31, 2012 and 2011.

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 during the year ended December 31, 2012 increased to $3,229,000 from $2,878,000 in 2011. The $351,000 increase is primarily due to increases in consulting and professional fees of $168,000, an increase in loan fees of $149,000, an increase in facilities-related costs of $142,000, and an increase in the accounts receivable reserve of $122,000. Cost increases were offset by a decrease in compensation-related costs of $103,000. In 2011, a legal matter asserted by a former industrial employee resulted in one-time legal costs of $327,000 that did not recur in 2012.

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

Income from operations was $136,000 in the year ended December 31, 2012, as compared to a loss of $250,000 in 2011. The improvement of $386,000 is primarily due to increased sales and margin contribution.

Interest Expense

Interest expense decreased to $660,000 in the year ended December 31, 2012, compared to interest expense of $691,000 in the same period of 2011. The decrease is due to lower average borrowing under a loan and security agreement with PMC Financial, LLC, secured primarily by our inventory and accounts receivable.

Modified EBITDA

The Company defines modified EBITDA (a non-GAAP measurement) as net loss before interest, taxes, depreciation and amortization, and non-cash share-based compensation expense. 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



                                                   Year ended December 31,
                                                   2012              2011
                                                (unaudited)       (unaudited)
        Net loss                               $    (524,000 )   $    (941,000 )

        Modified EBITDA adjustments:
        Depreciation and amortization                738,000           653,000
        Interest expense                             660,000           691,000
        Stock option and warrant
        compensation                                 107,000           300,000
        Other stock compensation for
        services and finance fees                     23,000           131,000
        Total EBITDA adjustments                   1,528,000         1,775,000

        Modified EBITDA income from
        operations                             $   1,004,000     $     834,000

Liquidity and Capital Resources

As of December 31, 2012, we had stockholders equity of $4,098,000 and we had working capital of $2,298,000, compared to stockholders equity of $4,305,000 and working capital of $2,655,000 at December 31, 2011. The decrease in our working capital of $357,000 was primarily a result of net losses and pay downs on our long-term debt.

Our increase in cash and cash equivalents to $1,163,000 at December 31, 2012 compared to $713,000 at December 31, 2011 was primarily a result of cash provided by operating activities of $1,177,000. Such cash provided by operations was offset primarily by costs of plant improvements of $507,000 and loan pay downs of $397,000. We also gained $177,000 through the exercise of stock options and warrants. In addition to our cash position on December 31, 2012, we had availability under our line of credit of $234,000.

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 December 31, 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 believe that the Company currently has the necessary working capital to support existing operations for at least the next 12 months. Our primary capital source will be positive cash flow from operations. If our sales goals do not materialize as planned, we believe that the Company can reduce its operating costs and can be managed to maintain positive cash flow from 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.

If we 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. 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.

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 year ended December 31, 2012.

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 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 year ended December 31, 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 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. 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 ASC Topic 718 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 year ended December 31, 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 December 2011, the FASB issued ASU No. 2011-11, "Balance Sheet (Topic 210):
Disclosures about Offsetting Assets and Liabilities." This ASU requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. ASU No. 2011-11 will be applied retrospectively and is effective for annual and interim reporting periods beginning on or after January 1, 2013. The Company does not expect adoption of this standard to have a material impact on its results of operations, financial condition, or liquidity.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the "SEC") did not or are not believed by management to have a material impact on the Company's present or future financial statements.

Inflation

Although management expects that our operations will be influenced by general economic conditions, we do not believe that inflation has a material effect on our results of operations.

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