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XSPY > SEC Filings for XSPY > Form 10-Q on 6-May-2014All Recent SEC Filings

Show all filings for SPY INC.

Form 10-Q for SPY INC.


6-May-2014

Quarterly Report


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

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements. The words or phrases "would be," "will allow," "intends to," "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project," or similar expressions are intended to identify "forward-looking statements." Actual results could differ materially from those projected in the forward looking statements as a result of a number of risks and uncertainties, including those risks factors contained in our Annual Report on Form 10-K for the year ended December 31, 2013, previously filed with the Securities and Exchange Commission on March 20, 2014, which Annual Report is incorporated herein by reference. Statements made herein are as of the date of the filing of this Form 10-Q with the Securities and Exchange Commission and should not be relied upon as of any subsequent date. Unless otherwise required by applicable law, we do not undertake, and specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences, developments, unanticipated events or circumstances after the date of such statement.

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

Overview

We happily design, market and distribute premium sunglasses, goggles and prescription frame eyewear 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 its high quality products, style and innovation, most notably showcased in our Happy Lens™ 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.

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Our Products and Target Markets

We have a happy disrespect for the usual way of looking (at life) and this helps drive our innovative design, marketing and distribution of premium products, especially eyewear for youth minded people who love to be outside doing what makes them feel most alive and happy. We feel a primary strength is our ability to create distinctive products that embody our unique and irreverent point of view, and this has helped us become what we believe is one of the most recognizable action sports brands in the world, with a twenty-year heritage in surfing, motocross, snowboarding, cycling, skateboarding, snow skiing, motorsports, wakeboarding, multi-sports and mountain biking. Our position as a premier brand is underscored by the development of innovative, proprietary, performance-based products with quality materials and lens technologies that have a definitive styling along with an incredible value proposition. Our core products - sunglasses, goggles and prescription frames - marketed under the SPY® brand have allowed us to develop collaborations with athletes, musicians, celebrities, and other significant likeminded brands, as well as important multi-store action sports, sporting goods, sunglass specialty and lifestyle retailers in North America and other strategically-selected, individually owned-and-operated specialty retailers worldwide.

We create products that we believe lead our industry in terms of style and quality, and we continually seek to serve both active lifestyle participants and their aspirational counterparts. We separate our eyewear products into three groups: (i) sunglasses, which includes fashion, Happy Lens™, performance sport and women specific sunglasses; (ii) goggles, which includes snow sport and motocross goggles created for our core demographics, and a new goggle line extension for the SPY® brand that targets new distribution opportunities and customers; and (iii) prescription frames, which includes optical-quality frames and sunglasses for our youthful demographic. In addition, we sell branded accessories for sunglasses and goggles, as well as a variety of other accessories and apparel. In December 2013, we entered into a merchandising license agreement, pursuant to which we licensed certain trade styles, trademarks logos, designs and other proprietary materials ("SPY IP") to a third party ("Licensee"). The agreement provides that the Licensee shall develop, introduce, market and sell certain licensed products incorporating the SPY IP, including men's and boy's apparel, bags and luggage, consumer electronics, protective cases, and other unisex accessories, throughout North America through certain distribution channels, other than deep discount retail channels. We currently anticipate that licensed products incorporating SPY IP will generate revenue beginning in late 2014.
The SPY® brand, as symbolized by the SPY® cross icon [[Image Removed]] is a creative, performance-driven brand that is fueled by collaborative efforts across various facets of youth culture, including competition, art, music and day-to-day athletic performance. We strive to ensure that our products are relevant in function and design, as well as style. We do this, in part, through partnerships with our world class athletes who help us design, then wear and test our products during training and competition. We believe that the intimate knowledge of our customers' lifestyles is what helps us develop a stronger, more relevant product offering for our market. We reinforce our irreverent brand profile through unique and disruptive marketing, using traditional and non-traditional means to convey our branded point of view to both entertain and edify people across a multitude of psychographics.

SPY's newest product innovation is the Happy Lens™, which is a patent-pending proprietary technology that was developed over the course of several years and released in February of 2013. The Happy Lens™ enjoyed a successful initial pre-launch marketing and promotion campaign during the fall of 2012, which was followed by strong initial sales of the collection during the year ended December 31, 2013. We believe Happy Lens™ is a natural product extension of the happy and irreverent SPY® brand positioning and we anticipate that it will continue to be an important part of the SPY® collection moving forward.

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Results of Operations

Comparison of Three Months Ended March 31, 2014 to the Three Months Ended March 31, 2013

Net Sales

Consolidated net sales increased by $0.2 million or 2.0% to $9.2 million for the three months ended March 31, 2014 from $9.0 million for the three months ended March 31, 2013. The increase in sales growth was from sales of our prescription frame product line which increased by 97.3% or $0.5 million to $1.0 million for the three months ended March 31, 2014, compared to $0.5 million during the same period last year. SPY® sales amounts included approximately $0.4 million and $0.6 million of sales during the three months ended March 31, 2014 and March 31, 2013, respectively, which were considered to be closeouts, defined as (i) older styles not in the current product offering or (ii) the sales of certain excess inventory of current products sold at reduced pricing levels.

Sunglasses represented approximately 79.4% and 83.8% of net sales during the three months ended March 31, 2014 and 2013, respectively. Goggle sales represented approximately 8.9% and 9.0% of net sales during each of the three months ended March 31, 2014 and 2013, respectively. Prescription frames represented approximately 10.5% and 5.4% of net sales during the three months ended March 31, 2014 and 2013, respectively. Apparel and accessories represented approximately 1.2% and 1.8% of net sales each of the three months ended March 31, 2014 and 2013, respectively. Sales to customers in North America represented 86.8% and 91.7% of total net sales for the three months ended March 31, 2014 and 2013, respectively. Sales to international customers (excluding Canada) represented 13.2% and 8.3% of total net sales for the three months ended March 30, 2014 and 2013, respectively.

Gross Profit

Our consolidated gross profit increased by $0.2 million or 3.9% to $4.8 million for the three months ended March 31, 2014 from $4.6 million for the three months ended March 31, 2013, primarily attributable to an increase in our overall gross margins, as discussed below.

Gross profit as a percentage of net sales was 52.0% for the three months ended March 31, 2014, compared to 51.1% for the three months ended March 31, 2013. The increase in our gross profit as a percent of net sales during the three months ended March 31, 2014 compared to the same period in 2013 was primarily due to:
(i) improved overall sales mix of our higher margin products; (ii) a higher percentage of lower cost inventory purchases from China; and (iii) lower sales of closeout products at reduced price levels.

Sales and Marketing Expense

Sales and marketing expense was essentially unchanged at $2.9 million for three months ended March 31, 2014. While the expense remained relatively unchanged, the Company spent a higher percentage of the marketing related costs on trade shows to further develop the SPY brand, which was offset by a reduction in salary related costs.

General and Administrative Expense

General and administrative expense increased by $0.1 million or 2.5% to $1.5 million for the three months ended March 31, 2014 from $1.4 million for the three months ended March 31, 2013. The increase is primarily due to increased use of outside consultants and higher bonus accrual in 2014 compared to 2013.

Shipping and Warehousing Expense

Shipping and warehousing expense decreased by $0.1 million or 17.5% to $0.1 million for the three months ended March 31, 2014 from $0.2 million for the three months ended March 31, 2013. The decrease was primarily due to a decline in the use of temporary labor.

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Research and Development Expense

Research and development expense increased by $0.1 million or 50.8% to $0.2 million for the three months ended March 31, 2014 compared to $0.1 million for the three months ended March 31, 2013, due to testing performed on our lenses.

Other Net Expense

Other net expense was essentially unchanged at $0.8 million for the three months ended March 31, 2014 and 2013. While our net expenses remained relatively unchanged, interest expense increased slightly due to higher debt balances with Costa Brava and Harlingwood.

Income Tax Provision

Income tax expense was approximately $3,000 for the three months ended March 31, 2014 and 2013, respectively. We have recorded a full valuation allowance for deferred tax assets both in the U.S. and in Italy at March 31, 2014 and 2013. The effective tax rate for the three months ended March 31, 2014 and 2013 was less than 1% in both periods.

We may have incurred one or more ownership changes, as defined by Section 382 of the Internal Revenue Code ("IRC Section 382") in the current and previous years, and, as such, the use of our net operating losses may be limited in future years. We have not completed a formal IRC Section 382 study and analysis to determine the annual limitation on the use of the net operating losses; however, the limitations could be substantial.

Liquidity and Capital Resources

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

Cash on hand at March 31, 2014 was $0.7 million. At March 31, 2014, we had a total of $23.9 million in debt under all lines of credit, capital leases and notes payable, of which $2.4 million was classified as current liabilities and $21.5 million was classified as long-term liabilities in the Company's Consolidated Balance Sheet. Our primary debt arrangements as of March 31, 2014 are further described below in Short-Term Debt and Long-Term Debt.

Future Capital Requirements and Resources

During the three-months ended March 31, 2014 and 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 have a history of incurring significant negative cash flow from operations, operating and net losses and significant working capital requirements. The Company anticipates that it will continue to have ongoing cash requirements to finance its seasonal and ongoing working capital requirements and net losses.

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

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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) 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 Harlingwood 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 notes, as amended, when they become due in December 2016. Therefore, we will need to renew the BFI Line of Credit at its annual renewal in February 2015 and continue to extend the maturity dates of the Costa Brava and Harlingwood indebtedness. If we are unable to renew the BFI Line of Credit and further extend future maturity dates of the Costa Brava and Harlingwood indebtedness, we will need to raise substantial additional capital through debt or equity financing to continue our operations. No assurances can be given that any such financing will be available to us on favorable terms, if at all. The inability to obtain debt or equity financing in a timely manner and in amounts sufficient to fund our operations, or the inability to renew the BFI Line of Credit or to extend future maturity dates of the Costa Brava and Harlingwood indebtedness, if necessary, would have an immediate and substantial adverse impact on our business, financial condition or results of operations.

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

Cash Flow Activities

Cash used in operating activities consists primarily of the net loss adjusted for certain non-cash items, including depreciation and amortization, paid-in-kind interest on borrowings, share-based compensation, provision for doubtful accounts, impairment of property and equipment, foreign currency gains and losses, amortization of debt discount, and the effect of changes in working capital and other activities.

Cash provided by operating activities for the three months ended March 31, 2014 was $2.3 million, which consisted of a net loss of $0.7 million, adjustments for aggregate non-cash items of $0.9 million (primarily Accrued PIK Interest of $0.6 million, share-based compensation of $0.1 million, depreciation and amortization of $0.1 million and others of $0.1 million) and an aggregate $2.2 million provided by working capital. Working capital changes include sources of cash of $2.5 million primarily from: (i) a net increase of $1.5 million related to decrease in inventory from sales and timing if inventory purchase and (ii) $1.0 million from lower accounts receivable due to increased collection efforts. The sources of cash from working capital were partially offset by uses of cash from working capital of $0.3 million primarily related to decreased accounts payable of $0.3 million primarily due to the timing of inventory purchases.

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

Cash used in investing activities during the three months ended March 31, 2014 was less than $0.1 million, and was attributable to the purchase of property and equipment, which was slightly offset by a small gain on disposal a vehicle.

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

Cash used in financing activities for the three months ended March 31, 2014 was $2.3 million, and was attributable primarily to a $2.3 million reduction in debt under our BFI Line of Credit due to our improved liquidity and timing of working capital requirements.

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

Short-Term and Long-Term Debt

Summary. As of March 31, 2014, we had a total of $23.9 million in debt under all lines of credit, capital leases and notes payable. A brief summary of our primary short-term and long-term debt facilities outstanding and available sources of liquidity from debt at March 31, 2014 is as follows:

? BFI Line of Credit. A short-term line of credit with BFI with a maximum borrowing limit of $7.0 million. The maximum availability based on eligible accounts receivable and inventory at March 31, 2014 was $5.2 million, of which $1.7 million was outstanding at that date;

? Costa Brava Term Note. A $7.0 million subordinated term loan with Costa Brava, of which $6.0 million is convertible into common stock; due December 31, 2016, as amended in April 2014. $7.0 million outstanding at March 31, 2014 (excluding Accrued PIK Interest of $2.4 million). ("Costa Brava Term Note");

? Costa Brava Line of Credit. A $9.0 million subordinated line of credit with Costa Brava, due December 31, 2016 as amended in April 2014. $8.5 million outstanding as of March 31, 2014 (excluding Accrued PIK Interest of $2.4 million). ("Costa Brava Line of Credit");

? Harlingwood Notes. Two subordinated convertible term loans with Harlingwood aggregating $1.5 million; due December 31, 2016 as amended in April 2014. $1.5 million outstanding at March 31, 2014 (excluding Accrued PIK Interest of $0.3 million). ("Harlingwood Notes"); 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 be paid in kind. Aggregate Accrued PIK Interest was $5.1 million at March 31, 2014.

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

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Off-Balance Sheet Arrangements

We did not enter into any off-balance sheet arrangements during the three months ended March 31, 2014 and 2013, respectively, nor did we have any off-balance sheet arrangements outstanding at March 31, 2014 and December 31, 2013.

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 March 31, 2014 and December 31, 2013.

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 and motocross 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 . . .

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