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XSPY > SEC Filings for XSPY > Form 10-Q on 14-May-2013All Recent SEC Filings

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Form 10-Q for SPY INC.


14-May-2013

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, 2012, previously filed with the Securities and Exchange Commission on March 20, 2013.

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

Overview

We design, market and distribute 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 marketed and sold 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 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.

SPY® and Spy Optic® are the registered trademarks of SPY Inc. and its subsidiaries. O'Neill®, Margaritaville®, Melodies by MJB®, which were licensed brands previously sold by us, and other brands, names and trademarks contained in this report are the property of their respective owners.

Our Products and Target Markets

We design, market and distribute premium products for people who are happy to be outside, especially youthful people who love action sports, motorsports, snow sports, cycling and multi-sports markets. Our products embrace their attendant lifestyle subcultures, crossing over into more mainstream fashion, music and entertainment markets. We believe a primary strength is our ability to create distinctive products for young-minded, active people with a very different and irreverent point of view. Our core 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 primarily by our 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.

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We separate our eyewear products into three groups: (i) sunglasses, which includes fashion, Happy Lens™, 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, as well as a variety of other accessories and apparel.

SPY is a creative, performance-driven brand. We strive to ensure that our products are relevant in function and design, as well as style. We do this, in part, through collaboration with our star athletes who first help us design, then wear and test our products during training and competition. We also intimately know the lifestyles of our target customers, which help us, we believe, offer a stronger, more relevant product offering to our target market.

SPY's newest product is the Happy Lens™, which we developed in 2011 and 2012 based on proprietary technology. The Happy Lens™ had its initial pre-launch marketing and promotion campaign during the fall of 2012, and the product was launched in February 2013. It is an extension of the happy and irreverent SPY brand positioning that we anticipate will be featured in the SPY® collection moving forward.

Results of Operations

Comparison of Three Months Ended March 31, 2013 to the Three Months Ended March 31, 2012

Net Sales

Consolidated net sales increased by $0.9 million or 11% to $9.0 million for the three months ended March 31, 2013 from $8.1 million for the three months ended March 31, 2012.

Sales of our SPY® brand products increased by $1.1 million or 14% to $9.0 million during the three months ended March 31, 2013, compared to $7.9 million for the three months ended March 31, 2012. A significant portion of the SPY® sales growth was from North American sales of sunglasses in our core markets and optical channels, and from our optical frame product line. SPY® sales amounts included approximately $0.6 million of sales during each of the three months ended March 31, 2013 and March 31, 2012 which were 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.

Sales of licensed brands (O'Neill®, Melodies by MJB® and Margaritaville®) were less than $50,000 during the three months ended March 31, 2013, compared to $0.3 million during the three months ended March 31, 2012. All sales of licensed brands during the three months ended March 31, 2013 and 2012 were considered to be closeout sales based on our decision during 2011 to cease making purchases of licensed brand inventory. 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, effective June 24, 2012, SPY North America terminated its agreement with O'Neill®. We sold all of our Margaritaville® products by March 31, 2013 and will have no sales of any of these licensed brand products in the future.

Sunglass sales represented approximately 89% and 87% of net sales during the three months ended March 31, 2013 and 2012, respectively. Goggle sales represented approximately 10% and 12% of net sales during the three months ended March 31, 2013 and 2012, respectively. Apparel and accessories represented approximately 1% of net sales during each of the three months ended March 31, 2013 and March 31, 2012. Sales to customers in North America represented 91% and 90% of total net sales for the three months ended March 31, 2013 and 2012, respectively. Sales to international customers (excluding Canada) represented 9% and 10% of total net sales for the three months ended March 31, 2013 and 2012, respectively.

Gross Profit

Our consolidated gross profit increased by $0.8 million or 21% to $4.6 million for the three months ended March 31, 2013 from $3.8 million for the three months ended March 31, 2012, primarily attributable to the sales increase at a higher gross profit as a percent of sales in 2013, as discussed below.

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Gross profit as a percentage of net sales was 51% for the three months ended March 31, 2013, compared to 47% for the three months ended March 31, 2012. The increase in our gross profit as a percent of net sales during the three months ended March 31, 2013 compared to the same period in 2012 was primarily due to:
(i) the negative effect of higher sales of lower gross margin licensed brand products in 2012 compared to 2013 (combined with inventory reserves attributable to licensed brands in 2012); (ii) a higher percentage of lower cost inventory purchases from China; (iii) an improved product and customer mix for our international sales together with lower international overhead due to the consolidation of our European distribution center to North America; and (iv) improved overall sales mix of our higher margin products primarily due to increased levels of sales to specialized core accounts and optical channels.

Sales and Marketing Expense

Sales and marketing expense decreased by $0.8 million or 21% to $2.9 million for the three months ended March 31, 2013 from $3.6 million for the three months ended March 31, 2012. The decrease is principally attributable to: (i) a $0.6 million decrease in advertising, public relations, marketing events, and related marketing costs; (ii) a $0.3 million decrease in sales and marketing salary and travel related expenses primarily for reductions in headcount. These decreases were partially offset by a $0.1 million increase in sales incentives and commissions associated with the sales growth during the three months ended March 31, 2013.

General and Administrative Expense

General and administrative expense decreased by $0.6 million or 28% to $1.4 million for the three months ended March 31, 2013 from $2.0 million for the three months ended March 31, 2012. The decrease was primarily due to a reduction in expense related to employee related cost driven by lower headcount, general corporate matters, legal and other professional services fees.

Shipping and Warehousing Expense

Shipping and warehousing expense decreased by less than $0.1 million or 10% to $0.2 million for the three months ended March 31, 2013 from $0.2 million for the three months ended March 31, 2012. The decrease was primarily due to a decrease in employee related costs offset by an increase in temporary help expense.

Research and Development Expense

Research and development expense decreased by less than $0.1 million or 26% to $0.1 million for the three months ended March 31, 2013 from $0.1 million for the three months ended March 31, 2012. The decrease was principally attributable to more development activity associated with the Happy Lens™ and other new SPY® designs in the first quarter of 2012.

Restructure

During the third quarter of 2012, we decided to take certain restructuring actions including (i) reducing the number of our employees, substantially all of which occurred during the second half of 2012, (ii) changing the direct portion of our European business into a distribution model, and (iii) reducing anticipated spending for our marketing programs. These actions were intended to reduce spending and the level of our sales required to break even on an operating basis, and substantial contributing factors to our lower operating expenses during the three months ended March 31, 2013. Total operating expenses were $4.6 million for the first quarter of 2013, compared to $6.0 million in the first quarter of 2012.

Other Net Expense

Other net expense was $0.8 million for the three months ended March 31, 2013 compared to other net expense of $0.4 million for the three months ended March 31, 2012. The difference was primarily due to increased interest expense as a result of increased borrowings from Costa Brava and BFI. Beginning on January 1, 2012, the interest expense attributable to Costa Brava and Harlingwood borrowings was paid as Accrued PIK Interest, in rather than in cash, resulting in an increase to the outstanding principal balances due Costa Brava and Harlingwood.

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Income Tax Provision

Income tax expense was zero for the three months ended March 31, 2013 and 2012, respectively. We have recorded a full valuation allowance for deferred tax assets both in the U.S. and in Italy at March 31, 2013 and 2012. The effective tax rate for the three months ended March 31, 2013 and 2012 was less than 1% in both periods.

We may incurred 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.

Liquidity and Capital Resources

We have financed our net losses, working capital needs, and capital expenditures through a combination of operating cash flows and revolving lines of credit provided by our U.S. based lenders. We have also required debt and equity financing in the past because cash used by operations and net losses were substantial due to ongoing and seasonal working capital requirements.

Cash on hand at March 31, 2013 was $1.4 million. At March 31, 2013, we had a total of $23.6 million in debt under all lines of credit, capital leases and notes payable, of which $3.8 million was classified as short-term liabilities and $19.8 million was classified as long-term liabilities in the Company's Consolidated Balance Sheet. Our primary debt arrangements as of March 31, 2013 are further described below in Short-term Debt and Long-term Debt.

Future Capital Requirements and Resources

We incurred significant negative cash flow from operations, operating and net losses and had significant working capital requirements during year ended during and prior to the December 31, 2012. During the three months ended March 31, 2013, we had positive cash flow from operations as a result of reduced operating losses and improvements in working capital. However, the Company anticipates that it will continue to have ongoing cash requirements to finance its seasonal and ongoing working capital requirements and net losses.

In order to finance its net losses and working capital requirements, we have relied and anticipate that we will continue to rely on SPY North America's credit line with BFI Business Finance ("BFI ") ("BFI Line of Credit") and our credit facilities with Costa Brava Partnership III, L.P. ("Costa Brava"). In addition, we have relied on debt and equity financing from Harlingwood (Alpha), LLC ("Harlingwood"). Costa Brava and Harlingwood are related parties. (See Short-term Debt and Long-term Debt below and Note 11 "Related Party Transactions" in the Consolidated Financial Statements).

We believe that we will have sufficient cash on hand and cash available under existing credit facilities to enable us to meet our operating requirements for at least the next twelve months, if we are able to achieve some or a combination of the following: (i) achieve our desired sales growth, (ii) continue the improvements in the management of our working capital, and (iii) continue to manage and operate at reduced levels of our sales, marketing, general and administrative, and other operating expenses. However, we will need to continue to access our existing credit facilities during the next twelve months to support our planned operations and working capital requirements, and intend to:
(i) continue to borrow, to the extent available, from the BFI Line of Credit,
(ii) increase the level of our outstanding principal due to Costa Brava by borrowing up to the maximum amount available, including through the ongoing deferral of interest payments which otherwise would have been payable to Costa Brava periodically provided, in each case, that they remain available and on terms acceptable to us, and (iii) if necessary, we may need to raise additional capital through debt or equity financings.

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We do not anticipate that we can generate sufficient cash from operations to repay the amounts due under the BFI Line of Credit, which is scheduled for its next annual renewal in February 2014, and the borrowings from Costa Brava and Harlingwood when they become due in April 2015. Therefore, we will need to renew the BFI Line of Credit at its annual renewal in February 2014 and obtain permission to extend the maturity date of the Costa Brava and Harlingwood indebtedness beyond April 2015. If we are unable to renew the BFI Line of Credit and further extend the maturity date of the Costa Brava and Harlingwood indebtedness, we will need to raise substantial additional capital through debt or equity financing to continue our operations. No assurances can be given that any such financing will be available to us on favorable terms, if at all. The inability to obtain debt or equity financing in a timely manner and in amounts sufficient to fund our operations, or the inability to renew the BFI Line of Credit or to extend the maturity date of the Costa Brava and Harlingwood indebtedness, if necessary, would have an immediate and substantial adverse impact on our business, financial condition or results of operations.

Our access to additional financing will depend on a variety of factors (many of which we maintain little or no control) such as market conditions, the general availability of credit, the overall availability of credit to its industry, its credit ratings and credit capacity, as well as the possibility that lenders could develop a negative perception of its long-term or short-term financial prospects. The current economic environment could also cause lenders, vendors and other counterparties who provide credit to us to breach their obligations or otherwise reduce the level of credit granted to us, which could include, without limitation, lenders or other financial services companies failing to fund required borrowings under our credit arrangements. If access to our existing credit facilities is not available or is not available on acceptable terms, we may not be able to fund our planned operations if we require such capital, which could have an adverse effect on our business.

Cash Flow Activities

Cash used in operating activities consists primarily of the 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 provided by operating activities for the three months ended March 31, 2013 was $1.5 million, which consisted of a net loss of $0.7 million, adjustments for aggregate non-cash items of $0.9 million (primarily Accrued PIK Interest of $0.6 million, share-based compensation of $0.2 million, depreciation and amortization of $0.1 million and others of less than $0.1 million) and an aggregate $1.4 million provided by working capital. Working capital changes include sources of cash of $1.5 million primarily from (i) a $0.6 million decrease in accounts receivable, due to timing of collections of 2012 seasonal snow goggle sales in the first quarter of 2013, (ii) $0.4 million from lower inventories, and (iii) a net increase of $0.5 million in the net amount of accounts payable, accrued expenses and other liabilities, primarily due to the timing of payments made for inventory purchases. The sources from working capital were partially offset by uses of cash from working capital related to increased prepaid expenses and other current assets of less than $0.1 million.

Cash used in operating activities for the three months ended March 31, 2012 was $0.4 million, which consisted of a net loss of $2.6 million, adjustments for non-cash items of $0.8 million (primarily Accrued PIK Interest of $0.4 million, share based compensation of $0.2 million; depreciation and amortization of $0.1 million and others of $0.1 million) and $1.5 million provided by working capital. Working capital changes included sources of cash of $1.8 million primarily generated from significantly higher accounts payable and accrued expenses primarily associated with the timing of payments made for inventory purchases. These sources of cash from working capital were partially offset by $0.3 million of cash used by working capital primarily from modest increases in accounts receivable and inventory during the first quarter of 2012.

Cash used in investing activities during the three months ended March 31, 2013 was less than $0.1 million, and was attributable to the purchase of property and equipment and patents related to new technologies.

Cash used in investing activities during the three months ended March 31, 2012 was less than $0.1 million, and was attributable to the purchase of property and equipment.

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Cash used in financing activities for the three months ended March 31, 2013 was $0.9 million, and was attributable primarily to $0.9 million in reduction in debt under our BFI Line of Credit due to our improved liquidity and other debt reductions aggregating less than $0.1 million.

Cash provided by financing activities for the three months ended March 31, 2012 was $0.1 million and was attributable primarily to $0.6 million in net proceeds from increased borrowings from our line of credit with BFI to support our liquidity requirements, partially offset by a $0.5 million repayment of our note payable to Rose Colored Glasses LLC which we became obligated to pay in connection with a 2011 settlement agreement under which, among other matters, we agreed to terminate our existing license agreement for Melodies by MJB® effective March 31, 2012, and pay a settlement fee which included the issuance of a $0.5 million promissory note to Rose Colored Glasses LLC.

Short-Term and Long-Term Debt

Summary. As of March 31, 2013, we had a total of $23.6 million in debt under all lines of credit, capital leases and notes payable. A brief summary of our primary short-term and long-term debt facilities outstanding and available sources of liquidity from debt at March 31, 2013 is as follows:

· BFI Line of Credit. A short-term line of credit with BFI with a maximum borrowing limit of $7.0 million. The maximum availability based on eligible accounts receivable and inventory at March 31, 2013 was $5.5 million, of which $3.7 million was outstanding at that date. ("BFI Line of Credit").

· Costa Brava Term Note. A $7.0 million subordinated term loan with Costa Brava; due April 1, 2015 as amended in May 2013. $7.0 million outstanding at March 31, 2013 (excluding Accrued PIK Interest of $1.4 million). ("Costa Brava Term Note").

· Costa Brava Line of Credit. A $9.0 million subordinated line of credit with Costa Brava, due April 1, 2015 as amended in May 2013; the total line of credit commitment of $10.0 million was reduced to $9.0 million in May 2013; $8.5 million outstanding as of March 31, 2013 (excluding Accrued PIK Interest of $1.2 million). ("Costa Brava Line of Credit").

· Harlingwood Notes. Two subordinated convertible term loans with Harlingwood aggregating $1.5 million, due April 1, 2015 as amended in May 2013. $1.5 million outstanding at March 31, 2013 (excluding Accrued PIK Interest of $0.1 million). ("Harlingwood Notes").

· Interest attributable to the Costa Brava Term Note and Costa Brava Line of Credit subsequent to January 1, 2012, and on Harlingwood Notes has been and will continue to be paid in kind ("Accrued PIK Interest"). Aggregate Accrued PIK Interest was $2.7 million at March 31, 2013.

Each of our primary debt facilities is more fully described below.

BFI Line of Credit. SPY North America has a Loan and Security Agreement with BFI with a maximum borrowing limit of $7.0 million. The maximum availability was $5.5 million and $5.7 million as of March 31, 2013 and December 31, 2012, respectively, of which SPY North America had borrowed $3.7 million and $4.6 million as of those dates. At March 31, 2013, the unused availability under this line was $1.8 million at a rate of 5.75% per annum. The BFI loan agreement renews annually in February for one additional year unless otherwise terminated by either SPY North America or by BFI

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Actual borrowing availability under the BFI loan agreement is based on eligible trade receivable and inventory levels of SPY North America, subject to the following limitations: (i) up to 80% of eligible United States accounts receivable or a lower percentage in certain circumstances, (ii) 80% of eligible Canadian accounts receivable, or a lower percentage in certain circumstances, and (iii) 40% of eligible United States inventory, provided such amount does not exceed 50% of eligible United States and Canadian accounts receivable and does not exceed the maximum inventory borrowing range limits of $1.5 million to $2.0 million, depending on seasonality. Borrowings under the BFI loan agreement bear interest at a rate per annum equal to the prime rate as reported in the Western Edition of The Wall Street Journal from time to time plus 2.5%, with a minimum monthly interest charge of $2,000. The interest rate was 5.75% per annum at March 31, 2013. The Company and SPY North America granted BFI a security interest in substantially all of SPY North America's assets, and substantially all of the Company's accounts recievable and inventories to secure BFI's position under the BFI Line of Credit. Additionally, the obligations under the BFI loan agreement are guaranteed by SPY Inc.

The BFI Line of Credit imposes certain covenants on SPY North America, including, but not limited to, covenants requiring SPY North America to provide certain periodic reports to BFI, to inform BFI of certain changes in the business, to refrain from incurring additional debt in excess of $100,000, and to refrain from paying dividends. The BFI Line of Credit also contains cross default provisions. BFI may declare SPY North America in default if SPY North America experiences a material adverse change in its business, financial condition or in its ability to perform the obligations owed under the BFI Line of Credit. BFI's prior consent, which BFI will not unreasonably withhold, is required in the event that SPY North America seeks additional debt financing, including debt financing subordinate to BFI. SPY North America has also established bank accounts, in BFI's name in the United States and Canada into which collections on accounts receivable and other collateral are deposited (the . . .

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