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REED > SEC Filings for REED > Form 10-Q on 14-Aug-2013All Recent SEC Filings

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Form 10-Q for REEDS INC


14-Aug-2013

Quarterly Report


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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes appearing elsewhere in this report. This discussion and analysis may contain forward-looking statements based on assumptions about our future business.

Overview

The results for our second quarter of 2013 reflect continuing strong growth in sales volume generally among all of our products. From an operational standpoint, our primary challenges are to reduce freight & handling costs, reduce sales promotions as a percentage of sales, and to generate efficiencies of scale in our Los Angeles plant while we increase volume.

The challenges to reduce delivery costs and scale our Los Angeles plant are related. As we increase production volume of our branded products in our Los Angeles plant, we will also reduce the cross-country freight that we are currently incurring on those products. Freight rates are increasing and our kombucha requires more expensive refrigerated freight, so we are also seeking efficient ways to lower costs in how we arrange for shipments.

Sales promotions are a necessary part of our business and can increase the rate of sales increases. With our kombucha, we have followed a strategy of higher discounts in order to gain a certain scale in this new business. As the kombucha business gains scale, we will reduce our promotions. We believe that our promotions are an effective and efficient way of increasing sales. The promotions are focused and structured toward specific goals.

As discussed below, our second quarter results reflect a write-off of $412,000 from a private label contract. Aside from this one-time loss, we would have posted positive income from operations during the quarter and positive EBITDA.

As we complete our plant improvements, we are confident that we will be able to bring down our freight costs by producing products on the west coast. We are looking forward to the continuing solid increases in our Ginger Brew and Virgil's lines, while our Kombucha sales growth accelerates.

Results of Operations

Three months ended June 30, 2013 Compared to Three months ended June 30, 2012

Sales

Sales of $9,519,000 for the three months ended June 30, 2013 represented an increase of 22% from $7,831,000 in the prior year same period. Sales growth was driven primarily by increased sales volume in our branded products, as well as a 15% increase in private label product revenues. Kombucha sales began after the 2012 second quarter and have increased to become approximately 9% of our total revenues.

Cost of Tangible Goods Sold

Cost of tangible goods sold consists of the costs of raw materials utilized in the manufacture of products, co-packing fees, repacking fees, in-bound freight charges, inventory adjustments, as well as certain internal transfer costs. Our costs of tangible goods sold of $6,630,000 for the three months ended June 30, 2013 represents an increase of 39% from the same period in 2012. Aside from sales volume increases, the primary cause of the increase was a reserve established in the amount of $412,000 covering potential losses from a private label contract.

During the three months ended June 30, 2013, we produced a private label product line for a customer that was rejected by the customer. We isolated the issue and offered to immediately remedy the issues raised. Such remedy was rejected by the customer. We are currently investigating whether the customer had the right to reject the products, under the circumstances. A reserve has been established for the value of the inventory on-hand and the inventory sold to the customer in the total amount of $412,000. The resolution of this matter is in the preliminary stages and measures are being taken to mitigate the losses from this contract.

Aside from the loss reserve on the private label contract, our per-unit costs of goods sold during the three months ended June 30, 2013 have remained fairly constant overall from the prior year period. Per-unit costs of our 12-ounce sodas decreased by approximately 2% in the quarter ended June 30, 2013, as compared to the prior year period.

Cost of Goods Sold - Idle Capacity

Cost of goods sold - idle capacity consists of direct production costs of our Los Angeles plant in excess of charges allocated to our finished goods in production. Plant costs include labor costs, production supplies, repairs and maintenance, and inventory write-off. Our charges for labor and overhead allocated to our finished goods are determined on a market cost basis, which is lower than our actual costs incurred. Plant costs in excess of production allocations are expensed in the period incurred rather than added to the cost of finished goods produced. Idle capacity expenses increased to $432,000 in the three months ended June 30, 2013, from $360,000 in 2012. The 20% increase is primarily due to inefficiencies in producing our kombucha, which has become a much higher portion of our Los Angeles plant output. Our kombucha production runs have become much more efficient recently and we anticipate reductions in our cost of goods sold - idle capacity in the future.

Gross Profit

Our gross profit of $2,457,000 in the three months ended June 30, 2013 represents a decrease of $240,000, or 9% from 2012. As a percentage of sales, our gross profit decreased to 26% in 2013 as compared to 34% in 2012. As discussed above, our gross profit was negatively impacted by a loss of $412,000 on a private label contract, which had a negative effect our gross profit percentage of approximately three basis points. The gross profit percentage decrease is also impacted by an increase in sales promotional discount costs. Since such costs are a deduction from sales, the gross margin percentage is negatively impacted by increased promotional costs. We have been granting substantial discounts on our kombucha, as we expand this product line into new distribution channels and customers, and we have also increased our promotional programs for other branded products. We believe that our promotional investments are effective and are accelerating sales growth.

Delivery and Handling Expenses

Delivery and handling expenses consist of delivery costs to customers and warehouse costs incurred for handling our finished goods after production. Delivery and handling costs increased by 63% to $954,000 in the three months ended June 30, 2013 compared to 2012. The $369,000 increase is primarily due to freight cost increases of $256,000 and warehouse cost increases of $115,000. The freight cost increases are primarily due to a higher portion of our branded products being manufactured at our copacker in Pennsylvania for west coast customers, requiring additional freight costs for delivery. Also, we have offered delivered terms to several new significant customers. The warehouse cost increases are primarily due to increased volume and the addition of several new cold-storage facilities for our kombucha.

Selling and marketing expenses

Selling and marketing expenses consist primarily of direct charges for staff compensation costs, advertising, sales promotion, marketing and trade shows. Selling and marketing costs increased overall to $960,000 in the three months ended June 30, 2013 from $699,000 in 2012. The $261,000 increase is primarily due to increased compensation and travel costs of $135,000, increased brokerage commissions of $69,000, and an increase in trade show and advertising costs of $55,000. Our sales staff increased to 19 members at June 30, 2013, from 15 at June 30, 2012.

General and Administrative Expenses

General and administrative expenses consist primarily of the cost of executive, administrative, and finance personnel, as well as professional fees. General and administrative expenses increased to $912,000 during the three months ended June 30, 2013 from $676,000 in the same period of 2012. Professional, legal and consulting costs increased by $44,000, accounts receivable reserve allowance increased by $38,000, and stock option expense increased by $25,000; offset by a reduction in depreciation costs of $16,000.

Income/Loss from Operations

Our loss from operations was $369,000 in the three months ended June 30, 2013, as compared to income of $608,000 in the same period of 2012. The loss is primarily a result of the accrual for a rejected private label contract, in the amount of $412,000.

Interest Expense

Interest expense decreased to $125,000 in the three months ended June 30, 2013, compared to interest expense of $164,000 in the same period of 2012. The decrease is primarily due to a reversal of over-accrued interest on a long-term liability. The accrued interest was reversed upon full payment of the liability.

Modified EBITDA

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

                            MODIFIED EBITDA SCHEDULE



                                                  Three Months Ended June 30,
                                                     2013                2012
Net (loss) income                               $      (494,000 )     $  444,000

Modified EBITDA adjustments:
Depreciation and amortization                           153,000          189,000
Interest expense                                        125,000          164,000
Stock option compensation                                69,000           29,000
Other stock compensation for services                         -            5,000
    Total EBITDA adjustments                            347,000          387,000

Modified EBITDA income (loss) from operations   $      (147,000 )     $  831,000

Six months ended June 30, 2013 Compared to Six months ended June 30, 2012

Sales

Sales of $17,645,000 for the six months ended June 30, 2013 represented an increase of 23% from $14,370,000 in the prior year same period. Sales growth was driven primarily by increased sales volume in our branded products. Kombucha sales began after June 30, 2012 and have increased to become approximately 9% of our total revenues.

Cost of Tangible Goods Sold

Cost of tangible goods sold consists of the costs of raw materials utilized in the manufacture of products, co-packing fees, repacking fees, in-bound freight charges, inventory adjustments, as well as certain internal transfer costs. Our costs of tangible goods sold of $11,629,000 for the six months ended June 30, 2013 represents an increase of 29% from the same period in 2012. Aside from sales volume increases, the primary cause of the increase was a reserve established in the amount of $412,000 covering potential losses from a private label contract had a negative effect our gross profit percentage of three basis points.

During the three months ended June 30, 2013, we produced a private label product line for a customer that was rejected by the customer. We isolated the issue and offered to immediately remedy the issues raised. Such remedy was rejected by the customer. We are currently investigating whether the customer had the right to reject the products, under the circumstances. A reserve has been established for the value of the inventory on-hand and the inventory sold to the customer in the total amount of $412,000. The resolution of this matter is in the preliminary stages and measures are being taken to mitigate the losses from this contract.

Aside from the loss reserve on the private label contract, our cost of tangible goods sold increased at a rate of 24% in the 2013 six month period, which is generally consistent with the 23% increase in sales during the same periods.

Cost of Goods Sold - Idle Capacity

Cost of goods sold - idle capacity consists of direct production costs of our Los Angeles plant in excess of charges allocated to our finished goods in production. Plant costs include labor costs, production supplies, repairs and maintenance, and inventory write-off. Our charges for labor and overhead allocated to our finished goods are determined on a market cost basis, which is lower than our actual costs incurred. Plant costs in excess of production allocations are expensed in the period incurred rather than added to the cost of finished goods produced. Idle capacity expenses increased to $1,024,000 in the six months ended June 30, 2013, from $670,000 in 2012. The 53% increase is primarily due to inefficiencies in producing our kombucha, which has become a much higher portion of our Los Angeles plant output. Our kombucha production runs have become much more efficient recently and we anticipate reductions in our cost of goods sold - idle capacity in the future.

Gross Profit

Our gross profit of $4,992,000 in the six months ended June 30, 2013 represents an increase of 7% from 2012. As a percentage of sales, our gross profit decreased to 28% in 2013 as compared to 33% in 2012. As discussed above, our gross profit was negatively impacted by a loss of $412,000 on a private label contract. The gross profit percentage decrease is also impacted by an increase in promotional discount costs. Since such costs are a deduction from sales, the gross margin percentage is negatively impacted by increased promotional costs. We have been granting substantial discounts on our kombucha, as we expand this product line into new distribution channels and customers, and we have also increased our promotional programs for other branded products. We believe that our promotional investments are effective and are accelerating sales growth.

Delivery and Handling Expenses

Delivery and handling expenses consist of delivery costs to customers and warehouse costs incurred for handling our finished goods after production. Delivery and handling costs increased by 75% to $1,860,000 in the six months ended June 30, 2013 compared to 2012. The $796,000 increase is primarily due to freight cost increases of $721,000 and warehouse cost increases of $75,000. The freight cost increases are primarily due to a higher portion of our branded products being manufactured at our copacker in Pennsylvania for west coast customers, requiring additional freight costs for delivery. Also, we have offered delivered terms to several new significant customers. The Warehouse cost increases are primarily due to increased volume and the addition of several new cold-storage facilities for our kombucha.

Selling and marketing expenses

Selling and marketing expenses consist primarily of direct charges for staff compensation costs, advertising, sales promotion, marketing and trade shows. Selling and marketing costs increased overall to $1,840,000 in the six months ended June 30, 2013 from $1,421,000 in 2012. The $419,000 increase is primarily due to increased compensation and travel costs of $216,000, increased brokerage commissions of $93,000, and trade show and advertising costs of $88,000. Our sales staff increased to 19 members at June 30, 2013, from 15 at June 30, 2012.

General and Administrative Expenses

General and administrative expenses consist primarily of the cost of executive, administrative, and finance personnel, as well as professional fees. General and administrative expenses increased to $1,900,000 during the six months ended June 30, 2013 from $1,545,000 in the same period of 2012. Compensation and stock option expense increased by $169,000, professional, legal and consulting costs increased by $99,000 and accounts receivable reserve allowance increased by $78,000; offset by a reduction in depreciation costs of $31,000.

Income/Loss from Operations

Our loss from operations was $608,000 in the six months ended June 30, 2013, as compared to income of $652,000 in the same period of 2012. The loss is primarily a result of the accrual for a rejected private label contract, in the amount of $412,000, as well as losses from other operations.

Interest Expense

Interest expense decreased to $289,000 in the six months ended June 30, 2013, compared to interest expense of $332,000 in the same period of 2012. The decrease is primarily due to a reversal of over-accrued interest on a long-term liability. The accrued interest was reversed upon full payment of the liability.

Modified EBITDA

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

                            MODIFIED EBITDA SCHEDULE



                                                  Six Months Ended March 31,
                                                    2013               2012
Net income (loss)                               $    (897,000 )     $   320,000

Modified EBITDA adjustments:
Depreciation and amortization                         298,000           372,000
Interest expense                                      289,000           332,000
Stock option compensation                             188,000            55,000
Other stock compensation for services                   5,000            20,000
    Total EBITDA adjustments                          780,000           779,000

Modified EBITDA income (loss) from operations   $    (117,000 )     $ 1,099,000

Liquidity and Capital Resources

As of June 30, 2013, we had stockholders equity of $3,493,000 and we had working capital of $1,765,000, compared to stockholders equity of $4,098,000 and working capital of $2,298,000 at December 31, 2012. The decrease in our working capital of $533,000 was primarily a result of net losses and pay downs on our long-term debt.

Our decrease in cash and cash equivalents to $816,000 at June 30, 2013 compared to $1,163,000 at December 31, 2012 was primarily a result of cash used by operating activities of $1,200,000, costs of plant improvements of $299,000, and principal payments on debt of $144,000. Such cash used by operations was offset primarily by net drawdown on our revolving line of credit of $1,049,000, an increased advance on our term loan of $217,000, and proceeds from the exercise of stock options and warrants of $30,000. In addition to our cash position on March 31, 2013, we had availability under our line of credit of approximately $154,000.

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. On May 1, 2013 the term loan was increased back to the original balance of $750,000 under the same terms as the existing term loan. The Company was also granted an over advance on its revolving line of credit of $200,000. At June 30, 2013, our term loan balance was $711,000.

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.

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

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

Long-Lived Assets. Our management regularly reviews property, equipment and other long-lived assets, including identifiable amortizing intangibles, for possible impairment. This review occurs quarterly or more frequently if events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. If there is indication of impairment of property and equipment or amortizable intangible assets, then management prepares an estimate of future cash flows (undiscounted and without interest charges) expected to result from the use of the asset and its eventual disposition. If these cash flows are less than the carrying amount of the asset, an impairment loss is recognized to write down the asset to its estimated fair value. The fair value is estimated at the present value of the future cash flows discounted at a rate commensurate with management's estimates of the business risks. Quarterly, or earlier, if there is indication of impairment of identified intangible assets not subject to amortization, management compares the estimated fair value with the carrying amount of the asset. An impairment loss is recognized to write down the intangible asset to its fair value if it is less than the carrying amount. Preparation of estimated expected future cash flows is inherently subjective and is based on management's best estimate of assumptions concerning expected future conditions. No impairments were identified during the three months ended June 30, 2013.

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 . . .

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