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XSPY > SEC Filings for XSPY > Form 10-K/A on 5-Nov-2013All Recent SEC Filings

Show all filings for SPY INC.

Form 10-K/A for SPY INC.


5-Nov-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Annual Report contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report. Additionally, statements concerning future matters such as the development of new products, our ability to increase sales levels, manage expense levels, fund our operations and other statements regarding matters that are not historical are forward-looking statements. See "Special Note Regarding Forward-Looking Statements" at the beginning of this Annual Report.

Although forward-looking statements in this report 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. Factors that could cause or contribute to such differences in results and outcomes include those described in Item 1A of Part I of this Annual Report under the caption "Risk Factors," as well as those discussed elsewhere in this Annual Report. Readers are urged not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report. Except as required by law, we undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Annual Report. Readers are urged to carefully review and consider the various disclosures made in this Annual Report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

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

Overview

SPY Inc. designs, markets and distributes premium sunglasses, goggles and prescription frame eyewear. In 1994, we began as a grassroots brand in Southern California with the goal of creating innovative and aesthetically progressive eyewear, and, in doing so, we believe we captured the imagination of the action sports market with authentic, distinctive, performance-driven products 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 high quality, style and innovation.

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

References in this report to "we," "our," "us," "SPY," and "SPY Inc." refer to SPY Inc. and its two operating subsidiaries - Spy Optic Inc. ("SPY North America") and Spy Optic Europe S.r.l. S.U. ("SPY Europe") - except where the context clearly indicates that the term refers only to SPY Inc. Effective December 31, 2010, we sold substantially all of our interest in LEM S.r.l. ("LEM") and entered into a supply agreement with the purchaser. See "LEM Purchase Commitments" in Note 14 "Commitments and Contingencies" to the Consolidated Financial Statements.

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.

Results of Operations

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 report.

Year Ended December 31, 2012 and 2011

Net Sales

Consolidated net sales increased by $2.2 million or 7% to $35.6 million for the year ended December 31, 2012 from $33.4 million for the year ended December 31, 2011.

Sales of our SPY® brand products in North America and internationally increased by $4.0 million or 13% to $35.1 million during the year ended December 31, 2012 from $31.1 million for the year ended December 31, 2011. SPY® sales included approximately $2.6 million of sales during the year ended December 31, 2012 considered to be closeouts, defined as (a) older styles not in the current product offering, or (b) the sales of certain excess inventory of current products sold at reduced prices generally to closeout channels, compared to $3.0 million of such sales during the year ended December 31, 2011. A significant portion of the SPY® sales growth was from increased North American sales of sunglasses, and our new prescription frame and performance sport sunglass product lines that were launched in late 2011.

Sales of licensed brands (O'Neill®, Melodies by MJB® and Margaritaville®) were $0.5 million during the year ended December 31, 2012 compared to $2.2 million during the year ended December 31, 2011. All of our sales of licensed brands during the year ended December 31, 2012 were considered to be closeout sales based on our decision during 2011 to cease making purchases of new 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 had sold substantially all of our Margaritaville® products by December 31, 2012.

Sunglass sales represented approximately 77% and 73% of net sales during the year ended December 31, 2012 and 2011, respectively. Goggle sales represented approximately 22% and 27% of net sales during the year ended December 31, 2012 and 2011, respectively. Apparel and accessories represented approximately 1% of net sales during the year ended December 31, 2012 and less than 1% during 2011. North America net sales represented 86% and 84% of total net sales for the year ended December 31, 2012 and 2011, respectively. International (excluding Canada) net sales represented 14% and 16% of total net sales for the year ended December 31, 2012 and 2011, respectively.

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Cost of Sales and Gross Profit

Our consolidated gross profit increased by $2.0 million or 14% to $16.4 million for the year ended December 31, 2012 from $14.4 million for the year ended December 31, 2011, primarily attributable to the sales increase at a higher gross profit as a percent of sales in 2012, as discussed below.

Gross profit, as a percentage of net sales, increased to 46% for the year ended December 31, 2012, from 43% for the year ended December 31, 2011, primarily due to (i) the negative effect of lower licensed brand margins in 2011, related to inventory reserves recorded in 2011 to reflect inventory at its then estimated net realizable value; (ii) a higher percentage of lower cost inventory purchases in 2012 from lower cost sources in China; (iii) significantly higher gross margin achieved on the close out sales of SPY® products in 2012 compared to 2011; and (iv) improved overall sales mix of our higher margin products, partially offset by increased levels of discounting in 2012, primarily due to increased levels of sales to major accounts. These gross margin increases were partially offset by (i) lower sales levels and the reduced gross margin in our international business primarily driven by weakness in the European economy, coupled with a change in our international sales mix between a higher margin European direct business and a lower margin distribution business and inventory reserves related to our decision in 2012 to change to a full distribution business model in Europe and the impact of foreign exchange; (ii) selling a portion of inventory during the year ended December 31, 2011 that was originally purchased from LEM in 2010 at its lower historical manufacturing cost and was being sold on a FIFO basis, thereby resulting in higher gross margins from the sale of those products during 2011, prior to generally higher cost purchases made from LEM after December 31, 2010, which comprised the vast majority of products purchased from LEM and sold during 2012; and (iii) increased freight costs primarily associated with generally increased level of air shipments in 2012.

Sales and Marketing Expense

Sales and marketing expense increased by $1.5 million or 12% to $13.8 million for the year ended December 31, 2012 from $12.3 million for the year ended December 31, 2011. The increase is principally attributable to increased marketing efforts to promote our SPY® brand and our new SPY® products, and to a lesser extent the portion of the 2012 restructure expense in the third quarter included in sales and marketing expense. These increases were partially offset by reduced expense related to promotional efforts surrounding licensed brands that were significant during the year ended December 31, 2011, and nearly non-existent during the year ended December 31, 2012. The $1.5 million increase included: (i) $0.5 million attributable to a portion of the 2012 restructure expense included in sales and marketing; (ii) a $0.2 million increase in advertising, public relations, marketing events, and related marketing costs;
(iii) a $0.1 million increase in sales and marketing related expenses primarily for additions in headcount; (iv) a $0.4 million increase in the cost of product displays; and (v) a $0.3 million increase in sales incentives and commissions associated with the sales growth during the year ended December 31, 2012.

General and Administrative Expense

General and administrative expense decreased by $2.2 million or 26% to $6.3 million for the year ended December 31, 2012, from $8.5 million for the year ended December 31, 2011. The decrease was primarily due to a reduction in expense related to severance, performance-based compensation, general corporate matters, legal and other professional services fees, which were at elevated levels for the year ended December 31, 2011 due to the restructuring of management in April 2011, partially offset by $0.1 million attributable to the portion of third quarter 2012 restructure expense that was included in general and administrative expense.

Shipping and Warehousing Expense

Shipping and warehousing expense increased by approximately $0.2 million or 24% to $0.8 million for the year ended December 31, 2012 from $0.6 million for the year ended December 31, 2011. The $0.2 million increase was primarily due to an increase in employee related costs due to an increase in headcount and restructuring expense in 2012.

Research and Development Expense

Research and development expense increased by less than $0.1 million or 6% to $0.6 million for the year ended December 31, 2012 from $0.6 million for the year ended December 31, 2011, which increase was principally attributable to R&D activity associated with the development of the Happy Lens™ and other new SPY® designs in 2012. R&D expense in 2011 included spending associated with the O'Neill™ and Melodies by MJB™ eyewear brands, which did not occur in 2012.

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Other Operating Expense

Other operating expense was zero for the year ended December 31, 2012 and $1.8 million during the year ended December 31, 2011. The decrease is due to the decision during the year ended December 31, 2011 that the cash flow from the sale of the O'Neill™ and Melodies by MJB® eyewear brands would be insufficient to cover the net present value due to the remaining royalty obligations. In addition, the Company decided to cease issuing future purchase orders of additional inventory of all licensed brands. These decisions resulted in substantially all of the $1.8 million of other operating expense during the year ended December 31, 2011.

Restructuring

During the third quarter of 2012, we decided to take certain restructuing 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. The employee reductions included reductions in shipping and warehousing, sales, marketing, and general and administrative staff by approximately 20 employees in North America and Europe substantially all of which occurred in 2012. We recorded a one-time charge of approximately $0.6 million in the third quarter of 2012 related to these actions including the reduction in workforce, of which approximately $50,000 is included in shipping and warehousing, $0.5 million is included in sales and marketing and $0.1 million is included in general and administrative expense. These actions are intended to reduce spending and the level of our sales required to break even on an operating basis.

Other Expense Net

Other expense net was $2.2 million for the year ended December 31, 2012, compared to other net expense of $1.5 million for the year ended December 31, 2011. The difference was primarily due to increased interest related to the increase in borrowings from Costa Brava and BFI. Commencing in 2012, the interest expense attributable to Costa Brava and Harlingwood borrowings was paid in kind, resulting to an increase to the outstanding principal balances due Costa Brava and Harlingwood (sometimes referred to as "Accrued PIK Interest").

Income Tax Provision

The income tax expense for the year ended December 31, 2012 and 2011 was $8,000 and $32,000, respectively, and is mainly comprised of minimum taxes due in Italy. We have recorded a full valuation allowance for deferred tax assets both in the U.S. and in Italy at December 31, 2012 and 2011, respectively.

Liquidity and Capital Resources

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

As of January 1, 2011, we had borrowed $7.0 million under promissory notes from our largest stockholder, Costa Brava, and entered into capital leases for certain long-term asset purchases. In February 2011, we raised $1.2 million from the sale of shares of our common stock to Harlingwood. In June 2011, we entered into a $6.0 million line of credit with Costa Brava and had borrowed $6.0 million under that line of credit as of December 31, 2011. In December 2011 we expanded our borrowing capabilities with Costa Brava by receiving the right to pay interest in kind by adding it to the outstanding principal balances until maturity, rather than by paying in cash. In December 2011, we expanded our borrowing capabilities under our $7.0 million line of credit with BFI by increasing the amount that we can borrow against inventory and by including Canadian accounts receivable as potential borrowing collateral.

In June 2012, we increased our $6.0 million line of credit with Costa Brava to $7.0 million, and further increased it to $10.0 million in August 2012. We had outstanding borrowings under this line of credit of $8.5 million as of December 31, 2012. In September 2012, we borrowed $1.0 million in a convertible debt financing from Harlingwood (the "Harlingwood Note"), which required us to pay interest in kind as Accrued PIK Interest with respect to the Costa Brava and Harlingwood indebtedness. In September 2012, the Costa Brava Term Note and Costa Brava Line of Credit were further amended to eliminate our ability to elect to make any interest payments in cash prior to the April 1, 2014 maturity date. In December 2012, we issued an additional $0.5 million in convertible promissory notes to Harlingwood under substantially identical terms as the September 2012 $1.0 million Harlingwood Note.

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As of December 31, 2012, we had a total of $23.9 million in debt under all lines of credit, capital leases and notes payable. We recorded approximately $2.4 million and $1.4 million in interest expense during the year ended December 31, 2012 and 2011, respectively, of which $2.1 million related to Accrued PIK Interest at December 31, 2012. Cash on hand at December 31, 2012 was $0.8 million.

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 used in operating activities for the year ended December 31, 2012 was $5.2 million, which consisted of a net loss of $7.2 million, adjustments for aggregate non-cash items of $3.3 million (primarily paid in kind interest of $1.8 million, share-based compensation of $0.8 million, depreciation and amortization of $0.5 million and others of $0.2 million) and an aggregate $1.3 million used for working capital and in other activities. Working capital and other activities includes uses of cash of $1.5 million primarily from (i) a $0.9 million increase in accounts receivable, due to the timing of cash receipts and payment terms primarily due to a significant pre-pay sale made in the fourth quarter of 2011, (ii) a $0.4 million increase in prepaid expense and other current assets primarily associated with deferred loan fees and the timing of prepaid expense payments, (iii) $0.1 million of inventories, and (iv) $0.1 million in other uses. The uses in working capital and other activities were partially offset by sources of cash related to a net increase of $0.2 million in the net amount of accounts payable, accrued expenses and other liabilities, primarily due to the timing of vendor receipts.

Cash used in operating activities for the year ended December 31, 2011 was $7.0 million, which consisted of a net loss of $10.9 million, adjustments for non-cash items of approximately $1.6 million (primarily share-based compensation of $1.2 million, depreciation and amortization of $0.5 million, partially offset by other changes of $0.1 million) and an aggregate of $0.6 million used in working capital and other activities. The net loss also included $1.8 million of other operating expense primarily related to the decision that the future cash flows from the sale of the O'Neill™ and Melodies by MJB™ eyewear brands would be insufficient to cover the net present value of the remaining minimum royalties. Working capital and other activities total $0.6 million net source of cash. The working capital sources of cash were primarily from (i) a $2.7 million reduction in inventories, (ii) a $0.2 million reduction in prepaid expenses and other current assets, and (iii) other sources aggregating $0.1 million. The working capital uses of cash were primarily from (i) increased accounts receivable of $0.7 million, due primarily to increased sales in the fourth quarter of 2011 compared to the fourth quarter of 2010, and (ii) decreased accounts payable and accrued liabilities of $1.7 million, due to the reduced aging and timing of vendor purchases.

Cash used in investing activities during the year ended December 31, 2012 was $0.2 million, and was attributable to the purchase of property and equipment and patents related to new technologies.

Cash used in investing activities during the year ended December 31, 2011 was $0.2 million, and was primarily attributable to the purchase of property and equipment.

Cash provided by financing activities for the year ended December 31, 2012 was $5.6 million, and was attributable primarily to (i) $2.1 million in net proceeds associated with increased availability under our BFI Line of Credit, (ii) $2.5 million received from our increased Costa Brava Line of Credit, and (iii) $1.5 million received from our Harlingwood convertible debt, partially offset by
(iv) $0.5 million, primarily due to the repayment of our note payable to Rose Colored Glasses LLC during the three months ended March 31, 2012 associated with a settlement agreement executed in 2011, which, among other matters, resulted in the termination of our existing license agreement for Melodies by MJB®, and (v) other debt reductions aggregating less than $0.1 million.

Cash provided by financing activities for the year ended December 31, 2011 was $7.6 million, and was primarily attributable to (i) $6.0 million in proceeds received from the Costa Brava Line of Credit, (ii) $1.1 million in proceeds received from the sale of common stock to Harlingwood, (iii) $0.2 million in proceeds received from the exercise of stock options, and (iv) $0.2 million in increased borrowings on our BFI Line of Credit.

Lines of Credit

BFI. On February 26, 2007, SPY North America entered into a Loan and Security Agreement with BFI with a maximum borrowing limit of $5.0 million, which was subsequently modified on December 7, 2007 and February 12, 2008 to, among other things, increase the maximum borrowing limit to $8.0 million (the "BFI Line of Credit"). Effective April 30, 2010, the maximum borrowing limit was reduced to $7.0 million.

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On December 21, 2011, BFI increased SPY North America's borrowing capability within the $7.0 million limit by (a) increasing the amount which SPY North America is able to borrow against its inventory to a range of $1.5 million to $2.0 million, depending on seasonality in 2012 and no greater than $1.5 million after December 31, 2012, from the previous range of $0.5 million to $0.75 million, subject to limitations and sub limits on the level of inventory borrowing of (i) 35% of eligible inventory and (ii) 50% of eligible accounts receivable, and (b) agreeing to finance up to 80% of eligible Canadian accounts receivable subject to limitations, whereas SPY North America was not previously able to borrow against any Canadian accounts receivable.

Actual borrowing availability under the BFI Line of Credit is based on eligible trade receivables and inventory levels of SPY North America. As a result of the December 2011 changes to the BFI Line of Credit, SPY North America is permitted to borrow up to $7.0 million, 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) 35% of eligible United States inventory, provided such amount does not exceed 50% of eligible United States and Canadian accounts receivable and do not exceed the maximum inventory borrowing range limits of $1.5 million to $2.0 million, depending on seasonality. Borrowings under the BFI Line of Credit 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. SPY North America granted BFI a security interest in substantially all of SPY North America's assets as security for its obligations under the BFI Line of Credit. Additionally, the obligations under the BFI Line of Credit are guaranteed by SPY Inc. The BFI Line of Credit renews annually in February for one additional year unless otherwise terminated by either SPY North America or by BFI.

The BFI Line of Credit was renewed in February 2013 under substantially identical terms, but with an increase in the eligible inventory borrowing percentage from 35% to 40% and BFI affirming that the seasonal inventory borrowing limits shall continue to range between $1.5 million to $2.0 million. The BFI Line of Credit is subject to its next annual renewal in February 2014.

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 has cross default provisions. Further, the BFI Line of Credit provides that BFI may declare SPY North America in default if SPY North America experiences a material adverse change in its business or financial condition or in its ability to perform the obligations owed under the BFI Line of Credit. BFI's prior consent, which shall not be unreasonably withheld, 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 "Collateral Accounts"). Pursuant to the deposit control account agreements between SPY North America and BFI with respect to the Collateral Accounts, BFI is entitled to sweep all amounts deposited into the Collateral Accounts and apply the funds to outstanding obligations under the BFI Line of Credit; provided that BFI is required to distribute to SPY North America any amounts remaining after payment of all amounts due under the BFI Line of Credit. SPY North America was in compliance with the covenants under the BFI Line of Credit at December 31, 2012.

At December 31, 2012 and 2011, there were outstanding borrowings of $4.6 million and $2.5 million, respectively, under the BFI Line of Credit. At December 31, 2012, the remaining unused availability under this line was $1.1 million and the interest rate was 5.75%.

At both December 31, 2012 and 2011, approximately $3.0 million and $1.7 million, respectively, of the outstanding borrowings were attributable to accounts receivable. At December 31, 2012 and 2011, approximately $5.7 million and $2.8 million, respectively, of related accounts receivable were collateralized in connection with the outstanding borrowings.

At December 31, 2012 and 2011, approximately $1.6 million and $0.8 million, respectively, of the outstanding borrowings were attributable to inventory. At December 31, 2012 and 2011, approximately $4.6 million and $4.8 million, respectively, of related inventory were collateralized in connection with the outstanding borrowings.

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As of December 31, 2012, SPY Europe had no lines of credit. As of December 31, 2011, SPY Europe had two lines of credit with Banca Popolare di Bergama for an aggregate maximum of €160,000 (approximately $200,000) bearing interest at 5.0%. The aggregate outstanding balance under this line of credit balance was zero at December 31, 2011.

Notes Payable

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