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XSPY > SEC Filings for XSPY > Form 10-K on 20-Mar-2014All Recent SEC Filings

Show all filings for SPY INC.

Form 10-K for SPY INC.


20-Mar-2014

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®, Spy Optic® 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.

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Overview

We happily design, market and distribute premium sunglasses, goggles and prescription frame eyewear, as well as apparel and other accessories. 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 products, style and innovation, most notably showcased in our Happy LensTM technology.

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.

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, 2013 and 2012

Net Sales

Consolidated net sales increased by $2.2 million or 6% to $37.8 million for the year ended December 31, 2013 from $35.6 million for the year ended December 31, 2012.

Sales of our SPY® brand products in North America and internationally increased by $2.6 million or 8% to $37.7 million during the year ended December 31, 2013 from $35.1 million for the year ended December 31, 2012. SPY® sales included approximately $2.8 million of sales during the year ended December 31, 2013 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 $2.6 million of such sales during the year ended December 31, 2012. A significant portion of the SPY® sales growth was from increased sales of our snow goggles and our prescription frame and product lines.

Sales of licensed brands (O'Neill®, Melodies by MJB® and Margaritaville®) during the year ended December 31, 2013 were $48,000 compared to $514,000 during the year ended December 31, 2012. All of our sales of licensed brands during the year ended December 31, 2013 and 2012 were considered to be closeout sales based on our decision during 2011 to cease making purchases of new licensed brand inventory. We sold all of our licensed brand products by March 31, 2013 and will have no sales of any of these licensed brand products in the future.

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Sunglass sales represented approximately 69% and 74% of net sales during the year ended December 31, 2013 and 2012, respectively. Goggle sales represented approximately 22% of net sales during the year ended December 31, 2013 and 2012. Optical sales represented approximately 7% and 3% of net sales during the years ended December 31, 2013 and 2012, respectively. Apparel and accessories represented approximately 2% of net sales during the year ended December 31, 2013 and 1% during 2012. North America net sales represented 86% and 87% of total net sales for the years ended December 31, 2013 and 2012, respectively. International (excluding Canada) net sales represented 14% and 13% of total net sales for the years ended December 31, 2013 and 2012, respectively.

Cost of Sales and Gross Profit

Our consolidated gross profit increased by $2.4 million or 15% to $18.9 million for the year ended December 31, 2013 from $16.4 million for the year ended December 31, 2012, primarily attributable to the sales increase at a higher gross profit as a percent of sales in 2013, as discussed below.

Gross profit, as a percentage of net sales, increased to 50% for the year ended December 31, 2013, from 46% for the year ended December 31, 2012, primarily due to (i) improved overall sales mix of our higher margin products; (ii) a higher percentage of lower cost inventory purchases from China; (iii) lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America; and (iv) higher margin sales on closeout products.

Sales and Marketing Expense

Sales and marketing expense decreased by $2.5 million or 18% to $11.3 million for the year ended December 31, 2013 from $13.8 million for the year ended December 31, 2012. The decrease is principally attributable to: (i) a $1.6 million decrease in advertising, public relations, marketing events, and related marketing costs; and (ii) a $0.9 million decrease in sales and marketing salary and travel related expenses primarily for reductions in headcount.

General and Administrative Expense

General and administrative expense decreased by $0.2 million or 3% to $6.1 million for the year ended December 31, 2013, from $6.3 million for the year ended December 31, 2012. The decrease was primarily due to a reduction in expense related to employee related costs driven by lower headcount, general corporate matters and legal fees. The decrease is partially offset by increased expenses during the year ended December 31, 2013 of $0.4 million related to: (i) a modification in the vesting period of certain stock options in connection with the resignation of two members of the board of directors which aggregated $0.1 million; and (ii) severance costs of $0.3 million attributable to an officer resignation.

Shipping and Warehousing Expense

Shipping and warehousing expense decreased by approximately $0.3 million or 30% to $0.5 million for the year ended December 31, 2013 from $0.8 million for the year ended December 31, 2012. The decrease was primarily due to lower employee related costs related to lower headcount.

Research and Development Expense

Research and development expense decreased by $0.1 million or 14% to $0.5 million for the year ended December 31, 2013 from $0.6 million for the year ended December 31, 2012. The $0.1 million decrease was principally attributable to lower development expenses during 2013.

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Restructuring

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. 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. These actions reduced our spending and the levels of our sales required to break even on an operating basis, and are substantial contributing factors to our lower operating expenses during the year ended December 31, 2013.

Other Expense Net

Other expense net was $3.3 million for the year ended December 31, 2013, compared to other net expense of $2.2 million for the year ended December 31, 2012. The difference was primarily due to increased interest related to the borrowings from Costa Brava, Harlingwood and BFI. Beginning on January 1, 2012, the interest expense attributable to Costa Brava and Harlingwood borrowings was paid as Accrued PIK Interest, rather than cash, resulting in an increase to the outstanding principal balances due Costa Brava and Harlingwood.

Income Tax Provision

The income tax expense for the year ended December 31, 2013 and 2012 was approximately $1,600 and $8,000, 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, 2013 and 2012, respectively. During 2013, income tax expense was recorded in general and administration expense.

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 net losses and other factors, including working capital requirements.

Cash on hand at December 31, 2013 was $0.7 million. At December 31, 2013, we had a total of $25.7 million in debt under all lines of credit, capital leases and notes payable, of which $4.1 million was classified as short-term liabilities and $21.6 million was classified as long-term liabilities in the Company's Consolidated Balance Sheet. Our primary debt arrangements as of December 31, 2013 are further described below in Short-Term Debt and Long-Term Debt.

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 year ended December 31, 2013 was $0.7 million, which consisted of a net loss of $2.9 million, adjustments for aggregate non-cash items of $4.2 million (primarily Accrued PIK Interest of $2.4 million, share-based compensation of $0.8 million, provision for doubtful accounts of $0.4 million, depreciation and amortization of $0.3 million and others of $0.3 million) and an aggregate $0.6 million used in working capital. Working capital changes include use of cash of $1.3 million from a net increase in accounts receivable due to increase sales attributable to growth and seasonality and $0.2 million in accounts payable due to timing of payables. The use of cash from working capital is partially offset by sources of cash from working capital of $0.9 million primarily related to increase in accrued expenses of $0.5 million due to timing of payments and decrease in inventory of $0.4 million due to increase in sales.

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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 Accrued PIK Interest of $1.8 million, share-based compensation of $0.7 million, depreciation and amortization of $0.5 million and others of $0.3 million) and an aggregate $1.3 million used by working capital. Working capital and other activities includes uses of cash of $1.5 million primarily from (i) a $0.9 million increase in accounts receivable; (ii) a $0.4 million increase in prepaid expense and other current assets; (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 investing activities during the year ended December 31, 2013 was $0.2 million, and was attributable to the purchase of property and equipment.

Cash used in investing activities during the year ended December 31, 2012 was less than $0.2 million and was primarily attributable to the purchase of property and equipment.

Cash used in financing activities for the year ended December 31, 2013 was $0.7 million, and was attributable primarily to $0.6 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 relate to lower capital lease balances due to normal principal payments.

Cash provided by financing activities for the year ended December 31, 2012 was $5.6 million and was attributable primarily to $2.1 million in net proceeds received from our BFI line of credit, $2.5 million received from our Costa Brava line of credit and $1.5 million received from our Harlingwood convertible debt to fund our net loss and working capital requirements. These borrowings were partially offset by $0.5 million primarily due to the net repayment of our note payable to Rose Colored Glasses LLC associated with a settlement agreement in which, among other matters, we agreed to terminate our existing license agreement for Melodies by MJB® effective March 31, 2012.

Short-Term and Long-Term Debt Summary. As of December 31, 2013, we had a total of $25.7 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 December 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 December 31, 2013 was $5.1 million, of which $4.0 million was outstanding at that date;

• Costa Brava Term Note. A $7.0 million subordinated term loan with Costa Brava, of which $2.25 million is convertible into common stock; due April 1, 2015 as amended in May 2013. $­­­­­7.0 million outstanding at December 31, 2013 (excluding Accrued PIK Interest of $2.1 million);

• 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 December 31, 2013 (excluding Accrued PIK Interest of $2.1 million);

• 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 December 31, 2013 (excluding Accrued PIK Interest of $0.2 million); and

• Interest attributable to the Costa Brava Term Note and Costa Brava Line of Credit due subsequent to January 1, 2012, and on Harlingwood Notes has been and will continue to be paid by Accrued PIK Interest. Aggregate Accrued PIK Interest was $4.4 million at December 31, 2013 and is due April, 2015.

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Each of our primary debt facilities is more fully described in Note 8, "Long-Term Debt", in the notes to our Consolidated Financial Statements.

Future Capital Requirements

During the year ended December 31, 2013, we had positive cash flow from operations principally as a result of a significant reduction in operating expenses and increases in gross profit; however, we incurred significant negative cash flow from operations, operating and net losses and significant working capital requirements during and prior to the year ended December 31, 2012. 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 the BFI Line of Credit and our credit facilities with Costa Brava. In addition, we have relied on debt and equity financing from Harlingwood. Costa Brava and Harlingwood are related parties. (See Short-Term Debt and Long-Term Debt above and Note 13 "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 and gross margin improvement, (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) if necessary, 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.

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 2015, 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 2015 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 if necessary, would have an immediate and substantial adverse impact on our business, financial condition or results of operations. Although we have a history of extending our maturity dates for Costa Brava and Harlingwood, and expect to obtain future extensions, the inability to extend the maturity date of Costa Brava and Harlingwood indebtedness 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 over) such as market conditions, the general availability of credit, the overall availability of credit to our industry, our credit ratings and credit capacity, as well as the possibility that lenders could develop a negative perception of our 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.

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Off-Balance Sheet Arrangements

We did not enter into any off-balance sheet arrangements during the years ended December 31, 2013 and 2012, nor did we have any off-balance sheet arrangements outstanding at December 31, 2013 and 2012.

Income Taxes

In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based on the level of historical operating results and the uncertainty of the economic conditions, we have recorded a full valuation allowance for SPY North America and SPY Europe at December 31, 2013 and December 31, 2012.

We may have had 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.

Backlog

Historically, purchases of sunglass, motocross and prescription frame eyewear products have not involved significant pre-booking activity. Purchases of our snow goggle products are generally pre-booked and shipped during August to October.

Seasonality

Our net sales fluctuate from quarter to quarter as a result of changes in demand for our products. Historically, we experience greater net sales in the second and third quarters of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products, and our first and fourth fiscal quarters are traditionally our weakest operating quarters due to seasonality. We generally sell more of our sunglass products in the first half of the fiscal year and a majority of our goggle products in the second half of the fiscal year. We anticipate this seasonal impact on our net sales will continue. As a result, our net sales and operating results have fluctuated significantly from period to period in the past and are likely to do so in the future.

Inflation

We do not believe inflation has had a material impact on our operations in the past, although there can be no assurance that this will be the case in the future.

Critical Accounting Policies and Estimates

Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of Consolidated Financial Statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosures. On an ongoing basis, we evaluate our estimates, including those related to inventories, sales returns, income taxes, accounts receivable allowances, share-based compensation, impairment testing, warranty and severance. We base our estimates on historical experience, performance metrics and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results will differ from these estimates under different assumptions or conditions.

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We apply the following critical accounting policies in the preparation of our Consolidated Financial Statements:

Revenue Recognition and Reserve for Returns

Our revenue is primarily generated through sales of sunglasses, goggles, prescription frames, and apparel, net of returns and discounts. Revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. These criteria are usually met upon delivery to our "common" carrier, which is also when the risk of ownership and title passes to our customers.

Generally, we extend credit to our customers after performing credit evaluations and do not require collateral. Our payment terms generally range from net-30 to net-90, depending on the country or whether we sell directly to retailers or to a distributor. Our distributors are typically set up as prepay accounts; however, credit may be extended to certain distributors, sometimes upon receipt of a letter of credit. Generally, our sales agreements with our customers, including distributors, do not provide for any rights of return or price protection. However, we do approve returns on a case-by-case basis, in our sole . . .

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