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ROX > SEC Filings for ROX > Form 10-K on 1-Jul-2013All Recent SEC Filings

Show all filings for CASTLE BRANDS INC | Request a Trial to NEW EDGAR Online Pro

Form 10-K for CASTLE BRANDS INC


1-Jul-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Our objective is to continue building a distinctive portfolio of global premium and super premium spirits brands as we move towards profitability. To achieve this, we continue to seek to:

increase revenues from our more profitable brands. We continue to focus our distribution relationships, sales expertise and targeted marketing activities on our more profitable brands; improve value chain and manage cost structure. We continue to review and analyze our supply chains and cost structures both on a company-wide and brand-by-brand basis, to improve operations and operating results; and
selectively add new premium brands to our portfolio. We intend to continue developing new brands and pursuing strategic relationships, joint ventures and acquisitions to selectively expand our premium spirits portfolio, particularly by capitalizing on and expanding our partnering capabilities. Our criteria for new brands focuses on underserved areas of the beverage alcohol marketplace, while examining the potential for direct financial contribution to our company and the potential for future growth based on development and maturation of agency brands. We evaluate future acquisitions and agency relationships on the basis of their potential to be immediately accretive and their potential contributions to our objectives of becoming profitable and further expanding our product offerings. We expect that future acquisitions, if consummated, would involve some combination of cash, debt and the issuance of our stock.

Recent Events

Keltic Facility

In July 2012, we entered into a First Amendment to the revolving loan agreement (the "Loan Agreement") with Keltic Financial Partners II, LP ("Keltic"), which we refer to as to the Keltic Facility, providing for availability (subject to certain terms and conditions) of a facility of up to $7.0 million for the purpose of providing working capital. The Loan Agreement amended the August 2011 facility between us and Keltic, which provided for a facility of up to $5.0 million. In addition to a $100,000 commitment fee paid on the original Loan Agreement, we paid a $40,000 commitment fee paid on the amended Loan Agreement.

In March 2013, we entered into a Second Amendment (the "Loan Amendment") to the Keltic Facility, providing for an increase in available borrowings (subject to certain terms and conditions) under the revolving facility for working capital purposes from $7.0 million to $8.0 million (the "Facility"). The Loan Amendment also provided for a term loan of $2.5 million (the "Term Loan") that was used for the purchase of bourbon inventory in March 2013. Unless sooner terminated in accordance with their respective terms, the Facility and Term Loan expire on December 31, 2016 (the "Maturity Date"). We may borrow up to the maximum amount of the Keltic Facility, provided that we have a sufficient borrowing base (as defined in the Loan Agreement). The Facility interest rate is the rate that, when annualized, is the greatest of (a) the Prime Rate plus 3.25%, (b) the LIBOR Rate plus 5.75% and (c) 6.50%. The Term Loan interest rate is the rate that, when annualized, is the greatest of (a) the Prime Rate plus 4.25%, (b) the LIBOR Rate plus 6.75% and (c) 7.50%. Interest is payable monthly in arrears, on the first day of every month on the average daily unpaid principal amount of the Facility. After the occurrence and during the continuance of any "Default" or "Event of Default" (as defined under the Loan Agreement) we are required to pay interest at a rate that is 3.25% per annum above the then applicable Facility or Term Loan, as applicable, interest rate. The Facility currently bears interest at 6.50% and the Term Loan currently bears interest at 7.50%. We are required to pay down the principal balance of the Term Loan within 15 banking days from the completion of a bottling run of bourbon from the bourbon inventory stock purchased on or about the date of the Term Loan in an amount equal to the purchase price of such bourbon. The unpaid principal balance of the Term Loan, all accrued and unpaid interest thereon, all fees, costs and expenses payable in connection with the Term Loan are due and payable in full on the Maturity Date. Upon execution of the Loan Amendment, we paid Keltic a $70,000 closing and commitment fee, and Keltic will also continue to receive an annual facility fee and a collateral management fee (each as set forth in the Loan Agreement).

The Loan Agreement contains standard borrower representations and warranties for asset-based borrowing and a number of reporting obligations and affirmative and negative covenants. The Loan Agreement includes negative covenants that, among other things, restrict our ability to create additional indebtedness, dispose of properties, incur liens, and make distributions or cash dividends. At March 31, 2013, we were in compliance, in all material respects, with the covenants under the Keltic Facility.

Keltic required as a condition to funding the Term Loan that Keltic had entered into a participation agreement (the "Participation Agreement") providing for an aggregate of $750,000 of the Term Loan to be purchased by junior participants. Certain related parties purchased a portion of these junior participations in the Term Loan, including Frost Gamma Investments Trust ($500,000), an entity affiliated with Phillip Frost, M.D., a director and principal shareholder, Mark E. Andrews, III ($50,000), a director and our Chairman, and an affiliate of Richard J. Lampen ($50,000), a director and our President and Chief Executive Officer. Under the terms of the Participation Agreement, the junior participants will receive interest at the rate of 11% per annum. We are not a party to the Participation Agreement. However, we are party to a fee letter with the junior participants (including the related party junior participants) pursuant to which we are obligated to pay the junior participants an aggregate commitment fee of $45,000 in three equal annual installments of $15,000.

Reduced focus on wine brands

In March 2013, we determined to reduce our sales and marketing efforts on our wine brands, which do not provide a material contribution to our results of operations. We made this decision to optimize our resources and focus on our faster growing and more profitable spirits brands, and to reduce the levels of working capital required to maintain necessary inventory levels of bulk wine and finished goods. We intend to continue selling existing finished goods wine inventory through our current sales channels, but are actively seeking buyers for large lots and for our bulk wine. In connection with this decision, we recognized a loss of $1.7 million, consisting of $0.8 million on the write-off of net intangible assets and $0.9 million in goodwill, as well as $0.3 million charged to the provision for obsolete inventory to adjust both bulk wine and finished goods to estimated net realizable value, for the year ended March 31, 2013.

Operations overview

We generate revenue through the sale of our products to our network of wholesale distributors or, in control states, state-operated agencies, which, in turn, distribute our products to retail outlets. In the U.S., our sales price per case includes excise tax and import duties, which are also reflected as a corresponding increase in our cost of sales. Most of our international sales are sold "in bond", with the excise taxes paid by our customers upon shipment, thereby resulting in lower relative revenue as well as a lower relative cost of sales, although some of our United Kingdom sales are sold "tax paid", as in the U.S. The difference between sales and net sales principally reflects adjustments for various distributor incentives.

Our gross profit is determined by the prices at which we sell our products, our ability to control our cost of sales, the relative mix of our case sales by brand and geography and the impact of foreign currency fluctuations. Our cost of sales is principally driven by our cost of procurement, bottling and packaging, which differs by brand, as well as freight and warehousing costs. We purchase certain products, such as Gosling's rums, Pallini liqueurs, Gozio amaretto and Tierras tequila, as finished goods. For other products, such as Jefferson's bourbons, we purchase the components, including the distilled spirits, bottles and packaging materials, and have arrangements with third parties for bottling and packaging. Our U.S. sales typically have a higher absolute gross margin than in other markets, as sales prices per case are generally higher in the U.S.

Selling expense principally includes advertising and marketing expenditures and compensation paid to our marketing and sales personnel. Our selling expense, as a percentage of sales and per case, is higher than that of our competitors because of our brand development costs, level of marketing expenditures and established sales force versus our relatively small base of case sales and sales volumes. However, we believe that maintaining an infrastructure capable of supporting future growth is the correct long-term approach for us.

While we expect the absolute level of selling expense to increase in the coming years, we expect selling expense as a percentage of revenues and on a per case basis to decline, as our volumes expand and our sales team sells a larger number of brands.

General and administrative expense relates to corporate and administrative functions that support our operations and includes administrative payroll, occupancy and related expenses and professional services. We expect general and administrative expense in fiscal 2014 to be comparable to fiscal 2013, as we continue to control core spending. We expect our general and administrative expense as a percentage of sales to decline due to economies of scale.

We expect to increase our case sales in the U.S. and internationally over the next several years through organic growth, and through the extension of our product line via line extensions, acquisitions and distribution agreements. We will seek to maintain liquidity and manage our working capital and overall capital resources during this period of anticipated growth to achieve our long-term objectives, although there is no assurance that we will be able to do so.

We continue to believe the following industry trends will create growth opportunities for us, including:

the divestiture of smaller and emerging non-core brands by major spirits companies as they continue to consolidate;
increased barriers to entry, particularly in the U.S., due to continued consolidation and the difficulty in establishing an extensive distribution network, such as the one we maintain; and
the trend by small private and family-owned spirits brand owners to partner with, or be acquired by, a company with global distribution. We expect to be an attractive alternative to our larger competitors for these brand owners as one of the few modestly-sized publicly-traded spirits companies.

Our growth strategy is based upon partnering with other brands, acquiring smaller and emerging brands and growing existing brands. To identify potential partner and acquisition candidates we plan to rely on our management's industry experience and our extensive network of industry contacts. We also plan to maintain and grow our U.S. and international distribution channels so that we are more attractive to spirits companies who are looking for a route to market for their products. We expect to compete for foreign and small private and family-owned spirits brands by offering flexible and creative structures, which present an alternative to the larger spirits companies.

We intend to finance our brand acquisitions through a combination of our available cash resources, third party financing and, in appropriate circumstances, the further issuance of equity and/or debt securities. Acquiring additional brands could have a significant effect on our financial position, and could cause substantial fluctuations in our quarterly and yearly operating results. Also, the pursuit of acquisitions and other new business relationships may require significant management attention. We may not be able to successfully identify attractive acquisition candidates, obtain financing on favorable terms or complete these types of transactions in a timely manner and on terms acceptable to us, if at all.

Financial performance overview

The following table provides information regarding our beverage alcohol case sales for the periods presented based on nine-liter equivalent cases, which is a standard industry metric:

Years ended March 31,

                          2013           2012
Cases
United States              302,602       272,610
International               69,457        60,919

Total                      372,059       333,529

Rum                        152,696       127,978
Vodka                       69,600        72,059
Liqueurs                    86,431        83,827
Whiskey                     53,798        40,194
Tequila                      1,337         1,494
Wine                         7,469         6,382
Other                          728         1,595

Total                      372,059       333,529

Percentage of Cases
United States                 81.3 %        81.7 %
International                 18.7 %        18.3 %

Total                        100.0 %       100.0 %

Rum                           41.0 %        38.4 %
Vodka                         18.7 %        21.6 %
Liqueurs                      23.2 %        25.1 %
Whiskey                       14.5 %        12.1 %
Tequila                        0.4 %         0.4 %
Wine                           2.0 %         1.9 %
Other                          0.2 %         0.5 %

Total                        100.0 %       100.0 %

The following table provides information regarding our case sales of non-beverage alcohol products for the periods presented:

Years ended March 31,

                    2013           2012
Cases
United States        248,309       156,359
International         16,272         9,585

Total                264,581       165,944

United States           93.8 %        94.2 %
International            6.2 %         5.8 %

Total                  100.0 %       100.0 %

Critical accounting policies and estimates

A number of estimates and assumptions affect our reported amounts of assets and liabilities, amounts of sales and expenses and disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate these estimates and assumptions based on historical experience and other factors and circumstances. We believe our estimates and assumptions are reasonable under the circumstances; however, actual results may differ from these estimates.

We believe that the estimates and assumptions discussed below are most important to the portrayal of our financial condition and results of operations in that they require our most difficult, subjective or complex judgments and form the basis for the accounting policies deemed to be most critical to our operations.

Revenue recognition

We recognize revenue from product sales when the product is shipped to a customer (generally a distributor), title and risk of loss has passed to the customer under the terms of sale (FOB shipping point or FOB destination) and collection is reasonably assured. We do not offer a right of return but will accept returns if we shipped the wrong product or wrong quantity. Revenue is not recognized on shipments to control states in the U.S. until such time as the product is sold through to the retail channel.

Accounts receivable

We record trade accounts receivable at net realizable value. This value includes an appropriate allowance for estimated uncollectible accounts to reflect any loss anticipated on the trade accounts receivable balances and charged to the allowance for doubtful accounts. We calculate this allowance based on our history of write-offs, level of past due accounts based on contractual terms of the receivables and our relationships with, and economic status of, our customers.

Inventory valuation

Our inventory, which consists of distilled spirits, bulk wine, dry good raw materials (bottles, labels and caps), packaging and finished goods, is valued at the lower of cost or market, using the weighted average cost method. We assess the valuation of our inventories and reduce the carrying value of those inventories that are obsolete or in excess of our forecasted usage to their estimated realizable value. We estimate the net realizable value of such inventories based on analyses and assumptions including, but not limited to, historical usage, future demand and market requirements. Reduction to the carrying value of inventories is recorded in cost of goods sold.

Goodwill and other intangible assets

As of March 31, 2013 and 2012, we recorded $0.5 million and $1.2 million, respectively, of goodwill that arose from acquisitions. Goodwill represents the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. Intangible assets with indefinite lives consist primarily of rights, trademarks, trade names and formulations. We are required to analyze our goodwill and other intangible assets with indefinite lives for impairment on an annual basis as well as when events and circumstances indicate that an impairment may have occurred. Certain factors that may occur and indicate that an impairment exists include, but are not limited to, operating results that are lower than expected and adverse industry or market economic trends. We evaluate the recoverability of goodwill and indefinite lived intangible assets using a two-step impairment test approach at the reporting unit level. In the first step the fair value for the reporting unit is compared to its book value including goodwill. If the fair value of the reporting unit is less than the book value, a second step is performed which compares the implied fair value of the reporting unit's goodwill to the book value of the goodwill. The fair value for the goodwill is determined based on the difference between the fair values of the reporting units and the net fair values of the identifiable assets and liabilities of such reporting units. If the fair value of the goodwill is less than the book value, the difference is recognized as an impairment.

The fair value of each reporting unit was determined at each of March 31, 2013 and 2012 by weighting a combination of the present value of our discounted anticipated future operating cash flows and values based on market multiples of revenue and earnings before interest, taxes, depreciation and amortization ("EBITDA") of comparable companies. Other than the write downs of intangible and goodwill related to the wine brands discussed below, we did not record any impairment on goodwill or other intangible assets for fiscal 2013 or 2012.

Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to the estimated residual values and reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We are required to amortize intangible assets with estimable useful lives over their respective estimated useful lives to the estimated residual values and to review intangible assets with estimable useful lives for impairment in accordance with the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 310, "Accounting for the Impairment or Disposal of Long-lived Assets."

In March 2013, we determined to reduce our sales and marketing efforts on our wine brands, which do not provide a material contribution to our results of operations. We made this decision to optimize our resources and focus on our faster growing and more profitable spirits brands, and to reduce the levels of working capital required to maintain necessary inventory levels of bulk wine and finished goods. We intend to continue selling existing finished goods wine inventory through our current sales channels, but are actively seeking buyers for large lots and for our bulk wine. In connection with this decision, we recognized a loss of $1.7 million, consisting of $0.8 million on the write-down of net intangible assets and $0.9 million in goodwill, as well as $0.3 million charged to the provision for obsolete inventory to adjust both bulk wine and finished goods to estimated net realizable value, for the year ended March 31, 2013.

Stock-based awards

We follow current authoritative guidance regarding stock-based compensation, which requires all share-based payments, including grants of stock options, to be recognized in the income statement as an operating expense, based on their fair values on the grant date. Stock-based compensation was $0.3 million and $0.2 million for fiscal 2013 and 2012, respectively. We used the Black-Scholes option-pricing model to estimate the fair value of options granted. The assumptions used in valuing the options granted during fiscal 2013 and 2012 are included in note 13 to our consolidated financial statements.

Fair value of financial instruments

ASC 825, "Financial Instruments" ("ASC 825"), defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties and requires disclosure of the fair value of certain financial instruments. We believe that there is no material difference between the fair value and the reported amounts of financial instruments in the balance sheets due to the short-term maturity of these instruments, or with respect to the debt, as compared to the current borrowing rates available to us.

Results of operations

The following table sets forth, for the periods indicated, the percentage of net sales of certain items in our consolidated financial statements.

                                                                 Years ended March 31,
                                                                2013               2012
Sales, net                                                   $     100.0 %            100.0 %
Cost of sales                                                       63.8 %             63.9 %
Provision for obsolete inventory                                     1.7 %              0.8 %

Gross margin                                                        34.5 %             35.3 %

Selling expense                                                     27.2 %             29.6 %
General and administrative expense                                  11.7 %             14.0 %
Depreciation and amortization                                        2.2 %              2.6 %
Loss on wine assets                                                  4.1 %              0.0 %

Loss from operations                                               (10.7 )%           (10.9 )%

Loss from equity investment in non-consolidated affiliate           (0.1 )%            (0.1 )%
Foreign exchange loss                                               (0.6 )%            (2.0 )%
Interest expense, net                                               (1.4 )%            (1.6 )%
Net change in fair value of warrant liability                        0.7 %              0.3 %
Income tax benefit                                                   0.4 %              0.4 %

Net loss                                                           (11.7 )%           (14.0 )%
Net income attributable to noncontrolling interests                 (1.5 )%            (0.8 )%

Net loss attributable to controlling interests                     (13.2 )%           (14.8 )%

Dividend to preferred shareholders                                  (1.8 )%            (2.0 )%

Net loss attributable to common shareholders                       (15.0 )%           (16.8 )%

The following is a reconciliation of net loss attributable to common shareholders to EBITDA, as adjusted:

                                                                 Years ended March 31,
                                                                 2013             2012
Net loss attributable to common shareholders                 $ (6,193,225 )   $ (5,947,155 )
Adjustments:
Interest expense, net                                             587,308          589,781
Income tax benefit                                               (148,152 )       (148,152 )
Depreciation and amortization                                     920,305          914,361
EBITDA (loss)                                                  (4,833,764 )     (4,591,165 )
Allowance for doubtful accounts                                    86,869           68,599
Allowance for obsolete inventory                                  684,830          275,000
Stock-based compensation expense                                  282,314          190,462
Loss on wine assets                                             1,715,728                -
Loss from equity investment in non-consolidated affiliate          22,549           28,923
Foreign exchange loss                                             247,431          722,253
Net change in fair value of warrant liability                    (302,734 )       (109,767 )
Net income attributable to noncontrolling interests               610,492          272,200
Dividend to preferred shareholders                                744,468          714,830
EBITDA (loss), as adjusted                                       (741,817 )     (2,428,665 )

Earnings before interest, taxes, depreciation and amortization, or EBITDA, adjusted for allowances for doubtful accounts and obsolete inventory, loss on wine assets, non-cash compensation expense, loss from equity investment in non-consolidated affiliate, foreign exchange, net change in fair value of warrant liability, net income attributable to noncontrolling interests and dividend to preferred shareholders is a key metric we use in evaluating our financial performance. EBITDA is considered a non-GAAP financial measure as defined by Regulation G promulgated by the SEC under the Securities Act of 1933, as amended. We consider EBITDA, as adjusted, important in evaluating our performance on a consistent basis across various periods. Due to the significance of non-cash and non-recurring items, EBITDA, as adjusted, enables our Board of Directors and management to monitor and evaluate the business on a consistent basis. We use EBITDA, as adjusted, as a primary measure, among others, to analyze and evaluate financial and strategic planning decisions regarding future operating investments and allocation of capital resources. We believe that EBITDA, as adjusted, eliminates items that are not indicative of our core operating performance or are based on management's estimates, such as allowance accounts, are due to changes in valuation, such as the effects of changes in foreign exchange or fair value of warrant liability, or do not involve a cash outlay, such as stock-based compensation expense. Our presentation of EBITDA, as adjusted, should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items or by non-cash items, such as non-cash compensation, which is expected to remain a key element in our long-term incentive compensation program. EBITDA, as adjusted, should be considered in addition to, rather than as a substitute for, income from operations, net income and cash flows from operating activities.

Our EBITDA, as adjusted, improved 69.7% to ($0.7) million for the year ended March 31, 2013, as compared to ($2.4) million for the comparable prior-year period, primarily as a result of our increased revenue and gross margin.

Fiscal 2013 compared with fiscal 2012

Net sales. Net sales increased 16.8% to $41.4 million for the year ended March 31, 2013, as compared to $35.5 million for the comparable prior-year period. Our U.S. case sales as a percentage of total case sales remained relatively constant at 81.3% for the year ended March 31, 2013, as compared to 81.7% for the comparable prior-year period, due to the continued organic growth of Gosling's rums and Jefferson's bourbons in the U.S. and the introduction of new brands . . .

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