SPY Optic’s Quarter: Sales and Loss Both Grow

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SPY’s sales for the quarter ended March 31 increased 22% during the quarter to $8.1 million compared to $6.7 million in the same quarter last year. The company had a net loss of $2.58 million compared to $1.52 million in the quarter last year.

Sale of SPY branded products were also up 22% to $7.9 million. The remaining sales represented close out product from the licensed brands (O’Neill, Melodies by MJB, Margaritaville). Apparently those sales represent the last of the licensed brand inventory and that’s really good news.

Though gross profit grew from $3.4 to $3.8 million, the gross profit percentage fell from 50.9% to 46.5%. Most of this decline came from blowing out the remaining inventory of the licensed brands, but there were also “…modest increases in close-out sales related to our SPY products…” SPY closeout sales were $600,000 (7.6% of SPY brand sales) during the quarter compared to $500,000 in the same quarter last year.
 
Total operating expenses rose from $4.75 million to $5.95 million. As a percentage of sales, they grew from 70.9% to 73.1%. Almost all of that came from growth in sales and marketing and general and administrative expenses. The 10Q (which you can review here) says that most of this is related to staffing for growth and marketing the SPY brand.
 
This is a good place to pause and remind you of where SPY is and how it got here. Or, you can read my earlier reports on SPY as long as you’re on my web site.
 
SPY is in business and independent only because its largest shareholder has been in a position to put a whole lot of money into SPY. The balance sheet shows $13.7 million of subordinated stockholder long-term debt. Aside from the same problems with the economy we’ve all had, SPY has had the issue (and cost) of the licensed brands, the purchase, then the sale and ongoing liability of its Italian factory, endless (and hopefully now ended) management changes, The No Fear lawsuit, and has generally been through a whole bunch of chaos- self-inflicted and otherwise.
 
But through it all somehow the SPY brand itself is still here and now growing. But to justify the expense structure they’ve put in place, it needs to grow a lot more. There’s light at the end of the tunnel, and if they can just finally get out from under all these non-operating expenses and distractions (which they are closer to) and keep growing the brand, they’ll have a viable business. But it’s going to be a long time before the major shareholder has a return on his investment.
 
Okay, back to the analysis. 
 
Interest expense has approximately doubled to $505,000 for the quarter. This reflects the increase in debt from a year ago.
 
Speaking of cash, though the company had a loss of $2.6 million, they only used $0.4 million in operating activities. That’s because they had $800,000 of noncash expenses (much of their interest, depreciation, amortization, stuff like that) and they generated $1.5 million from their “…working capital, which relates primarily to cash generated from significantly higher accounts payable and accrued expenses primarily associated with the timing of inventory purchases…” They note that paying these will require the use of cash in the second quarter.
 
Accounts payable are up almost $1.4 million since December 31, 2011. Increasing liabilities is a way to generate cash. Simply put, you have the money because you haven’t paid the other guy. Not that it would ever happen in this industry. Likewise, decreasing assets increases cash; like collecting a receivable for example. Cash flow represents the changes in balance sheet accounts. You can be making an accounting profit but be in trouble because you aren’t generating enough cash.
 
There must be a finance professor in me struggling to break out. Let’s move on to SPY’s balance sheet.
 
The balance sheet has deteriorated since a year ago, but in some ways it doesn’t matter as long as there’s willingness on the part of somebody to continue to lend to the company. Equity has declined from $840,000 to a negative $9.8 million. Total liabilities have risen from $13.3 million to $22.8 million.
 
Net inventory has risen over the year from $3.4 million to $6.3 million. Even with the sales increases, that seems like a lot. We know the March 31, 2012 inventory is clean of the licensed brand inventory because they say it is. And that number is net of a $900,000 reserve for obsolete inventory. There was a note that they had purchased some inventory during the year for anticipated sales that did not materialize, so maybe they are still working through that and perhaps it’s part of the $900,000 reserve. I would love to have more detail on the quality of that $6.3 million of inventory.
 
Gross trade receivables are $6.7 million. There’s an allowance for doubtful accounts of $300,000 then an allowance for returns of $1.4 million. The net account receivable number of $5.011 million is what’s on the balance sheet. This, I think, is related to the licensed brands. Since the reserve is already established, and the income statement hit taken, any product that comes back can just be sold without an income statement impact but will generate cash.
    
However, “The Company anticipates that it will continue to have requirements for additional cash to finance its working capital requirements and to invest in marketing and sales activities deemed necessary to achieve its desired business growth.”
 
They discuss that they have borrowed the maximum allowed under the arrangement with Costa Brava (owned by the major shareholder), though they will continue to accrue rather than pay the interest in cash. They say they intend to borrow more under their line with BFI, but as it’s an asset based line, it’s hard to know how much will be available. BFI can also yank it any time they want if they get nervous.
 
Then the company says, “However, the Company believes that it will have sufficient cash on hand and cash available under existing credit facilities to enable the Company to meet its operating requirements for at least the next twelve months without having to raise additional capital if the Company is able to achieve some or a combination of the following factors: (i) achieve desired net sales growth, (ii) improve its management of working capital, (iii) decrease its current and anticipated inventory to lower levels, (iv) manage properly the increase in sales and marketing expenditures required to achieve the desired level of business growth, and (v) achieve and maintain the anticipated increases in the available portion of its BFI credit facilities.”
 
So they are going to need additional cash. They think they’ll have enough for the year if things go well, if Costa Brava lets them continue to not pay interest in cash and if BFI lends them more money. Lots of ifs.
 
The brand seems to be performing, the impact of the licensing deals is apparently a thing of the past and they’ve got, as far as I can tell, a good team in place. There still appear to be some inventory issues and commitments to their former Italian factory that may continue to cost them money. And then there’s the acknowledgement that more cash will be required and at least some uncertainty of where it will come from if things don’t go really well.
 
At the end of the day, though, the brand seems strong enough to justify the effort, though more and higher margin sales are needed to support the infrastructure and make a profit.   

 

 

Spy (Formerly Orange 21): Their Results for the Year

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As I’ve noted pretty much every time I write about them, we’re lucky to have a smaller brand like Spy that’s public (though I don’t quite know why they are public) because we get to look over their shoulder as they manage their way through issues and opportunities. It’s much better than hoping VF gives us some clue as to how Reef is doing during their conference call.
 
It’s a tribute to the brand that it’s still around and growing after all its false starts, management changes, and financial issues. It’s also a tribute to the approximately 50% owner who’s been willing to put a whole lot of money into the company.
 
You’ve watched with me as the Italian factory (LEM) has come and gone, partnerships with entertainment industry figures have come and gone, management has come and gone (and come, and gone, and come, and gone), litigation with former CEO Mark Simo was settled, the economy whacked the brand, and it dealt with some big inventory issues.
 
The 10,000 Foot Level
 
Let’s start way up here so you see clearly what their challenge is. Here’s how they describe their debt on page 37 of their 10K. You can review that document here.
 
“As of December 31, 2011, we had a total of $16.2 million in debt under lines of credit, capital leases and notes payable. We recorded approximately $1.4 million in interest expense during the year ended December 31, 2011.”
 
That includes the note payable to stockholder of $13 million. The balance sheet shows a negative equity of $7.5 million, but you really need to look at that $13 million note as effectively equity. Interest on that note isn’t being paid in cash. The note principal balance is just being increased by the amount of the interest to conserve cash.
 
They indicate that at December 31, that had an additional $1.1 million in loan availability from their asset based lender, BFI. What they think is that with that availability and with normal cash flow they’ll be able to meet their operating requirements for the next 12 months “…if we are able to achieve some or a combination of the following factors: (i) achieve desired net sales growth, (ii) improve our management of working capital, (iii) decrease our current and anticipated inventory to lower levels, (iv) manage properly the increase in sales and marketing expenditures required to achieve the desired level of business growth, and (v) achieve and maintain the anticipated increases in the available portion of our BFI credit facilities.”
 
They don’t put any numbers to just how well they need to do in any of those areas, but I don’t think anybody would characterize doing those things as a slam dunk in any business at any time.
 
This capital structure and cash flow situation is for a company that had $33.4 million in revenues for the year ended December 31, 2011 and a loss of $10.9 million. Last year, sales were $35 million and they had a loss of $4.7 million.
 
To finish off the 10,000 foot level thing, you’ve basically got a company that needs to grow its sales pretty dramatically for some years before it can begin to support and reduce the level of debt it has. Right now, Spy is completely dependent on the balance sheet of its major shareholder.
 
They note that Spy expects “…that the amount of our indebtedness to Costa Brava (controlled by their major shareholder) that will become due in June 2013 will increase. It’s not clear if that’s just from capitalizing the interest on the existing loan as it becomes due, or from some additional borrowings. Guess it depends on how the year goes.
 
Notes on the Income Statement
 
I want to point out that there are some significant noncash items in the 2011 loss (like the interest being accrued but not paid) as well as expenses for the Italian factory and some costs for winding down the various deals with O’Neill, Mary J. Blige, and Margaritaville (Let’s call these three “the deals.”). Spy is also still struggling to get rid of some inventory they don’t need. It looks to me like those costs should mostly all go away this year, which will reduce expenses. If you eliminate the LEM business, sales for the year actually grew 10% from $30.3 to $33.4 million.
 
Gross margin percentage fell from 47.9% to 43% in the most recent year. They only talk about why the gross margin changed “on a proforma basis.” There was almost $400,000 for product they were required to take from LEM but didn’t take, so that’s a cost of goods against which you don’t sell any product. They also had some inventory reserves for the deals.
 
2011 revenues also included $3.0 million in Spy closeouts. There was $1.9 million the previous year. Spy had an “allowance for obsolescence” in their inventory of $1.3 million at the end of 2011. Their net inventory was $6.2 million. That’s quite an inventory reserve.
 
When you write down inventory, you take a noncash charge in the amount of the write down the year you take it. If you sell that inventory in the next year, you calculate your gross profit margin based on the cost at which you are carrying the inventory after the write down. This can move your gross margin percentage around a bit. It’s kind of confusing.
 
Wish they’d just tell us what the gross margin percentage was for in line Spy product so we could see how they were doing. If Spy did a conference call, I’d love it if somebody asked when this out of the ordinary closeout business would be done with.
 
Sales and marketing expense grew by 33% to $12.3 million during the year. Basically, this is a good thing. There’s a couple of hundred thousand of LEM expense in there, but most of this is for athletes, marketing, and building the management team. The strategy is to refocus exclusively on the Spy brand and, inevitably, that requires some money be spent.
 
There’s an “other operating expense” of $1.8 million, but it’s all for the deals. Hopefully, that expense disappears for 2012.
 
Strategy
 
Spy characterizes itself as “a creative, athlete-driven brand.” “We design, market and distribute premium products for hard core participants in action sports, motorsports, snow sports, cycling and multi-sports markets, which embrace their attendant lifestyle subcultures, crossing over into more mainstream fashion, music and entertainment markets.”
 
They identify their operating and growth strategies as brand development, driving product demand through quality and innovative design, brand authenticity, and actively manage retail relationships. You can read the detailed descriptions on pages three and four of the 10K if you’re interested.
 
They are committing resources to these strategies, but most of their revenue comes from sunglasses, a highly competitive market (show me one that isn’t) where there are a lot of really big players, as I pointed out many articles on Spy ago. I like what they’re doing and the renewed focus on the brand, but they need to be bigger to play in this space. I’ve said that before too.
 
My hope for them is that they get some growth this year, and that we’ve heard more or less the last of the deals, bad inventory, and LEM.  Wouldn’t it be nice to just focus on growing the brand. 

Orange 21’s September 30 Quarter: Sales are Up, But So Is the Loss

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This is one of the few times where it makes sense to start on the balance sheet to really understand what’s going on. It shows stockholders’ equity of a negative $4.3 million. How, you might ask, are they paying their bills? If you look under liabilities, you’ll see a “Note payable to stockholder” of $10.5 million.

That $10.5 million is owed to Costa Brava. Costa Brava “beneficially owns” approximately 50% (depends on how you calculate) of Orange 21’s common stock. The sole general partner of Costa Brava is Mr. Seth Hamot, who is the Chairman of the Board of Orange 21. To put it succinctly, if Mr. Hamot didn’t have a whole lot of money and wasn’t willing to lend a bunch of it to Orange 21, the company would have been closed or sold long ago.

It would be great fun to speculate on why this company went public in the first place, what the original plans for the public platform was, and why Mr. Hamot has been willing to commit this level of resources to the company (more to come according to the 10Q). But it would be only speculation and I guess I’ll stick to what we know. In any event, the fact that it is public has allowed us to watch it move through various management and strategic direction changes, and it’s been interesting. It continues to be interesting actually.
 
Since the end of the September 30 quarter, former CEO Carol Montgomery has resigned and been added to the board of directors. Michael Marcks is the new CEO, consultant Michael Angel has become the permanent CFO, and Greg Hagerman is the Executive VP for Sales and Operations. Meanwhile, as reported in the 10Q, the company has given up on its licensing agreements with O’Neill, Melodies by MJB, and Margaritaville and is still feeling the impact of the sale of its Italian factory (LEM). I should point out that I thought the licensing agreements were a good idea because, if successful, they’d give the company volume it needed to cover expenses it was going to incur in growing the Spy brand. I don’t know if licensing turned out to just be a bad idea or if there was some slippage in implementing the strategy.
 
Anyway, all this stuff has and is costing them a lot of money. They are refocused now on growing the Spy brand. Here’s how the company put it:
 
“We have recently decided to focus our development, marketing and sales activity on our SPY products. As part of that focus, we decided to cease any new purchase orders of additional inventory for the O’Neill , Melodies by MJB or Margaritaville eyewear brands.”
 
Reported sales for the quarter were up 11.7% to $9.2 million. If we ignore the LEM sales in the September 30 quarter last year, we see that proforma sales actually increased by $2.3 million, from $6.9 million to $9.2 million. Sales of Spy products were up $1.6 million. Closeout sales during the quarter were $900,000 and were primarily O’Neill and Melodies by MJB product. Sunglasses and goggles represented 57% and 43% of sales, respectively, during the quarter.
 
Reported gross profit fell from $3.9 million to $3.2 million. As a percentage of sales reported gross profit fell from 47.1% to 35.3%. This was largely the result of selling O’Neill and Melodies by MJB product at cost and of taking inventory reserves for Margaritaville product.
Sales and marketing expense rose almost 51% from $2.3 million to $3.4 million. $400,000 of the increase was for commission on higher sales (can’t argue with that). Another $400,000 was for staff additions and the remaining $300,000 represented additional marketing costs.
 
Total operating expenses were up 21.3%. $1.5 million of this was to terminate the Melodies by MJB deal. A million was paid in cash in July and $500,000 will be paid next March 31, but was accrued during the quarter. 
 
The loss from operations rose from $819,000 to $2.4 million. Not unexpectedly given the borrowing from Costa Brava, interest expense was up from $160,000 to $413,000. The net loss was $3 million, up from $932,000 in the same quarter the previous year.
 
Cash flow remains an issue for Orange 21 and “The Company anticipates that it will need additional capital during the next 12 months to support its planned operations, and intends both to borrow more on its existing lines of credit from Costa Brava and BFI, provided they remain available and on terms acceptable to the Company, and to, if necessary, raise additional capital through a combination of debt and/or equity financings.”
 
It’s too long to quote, but they then go on to describe the circumstances under which the existing lines of credit from Costa Brava and BFI will be adequate. Recognizing that a 10Q is a legal document that’s by definition focused on what could go wrong, I still walked away with a sense there’s a not insignificant chance that capital from another source might be required. I know you let me read SEC filings so you don’t have to, but you might use the link above to look at the first three paragraphs of page 12 of the 10Q to see what I mean.
 
Where we’d like to focus now is on the potential and growth of the Spy brand. But there are still some significant required minimum purchases from LEM in 2012 and I don’t know if we’ll see any more write downs of licensed brand inventory or not. The saga continues.

 

 

Orange 21’s Quarter. Sales Improvement, But More Ongoing Cash Needs

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As you know, I tend to hate proforma financial statements, but once in a while they make sense. Orange’s quarter ended June 30 is one of those times. They sold their factory in Italy (LEM) on December 31, 2010. The June 30, 2010 quarter contains sales and expenses associated with LEM. The June 30, 2011 quarter does not. 

Happily, Orange has helped us out and provided a pro forma income statement for the June 30, 2010 quarter as if LEM was gone. We’re going to use that one to evaluate what’s going on.

The “as filed” income statement for the June 30, 2010 quarter showed revenue of $9.53 million and a profit of $408,000. The proforma statement for that quarter, taking out the LEM sales and expenses, showed revenue of $8.4 million and a loss of $925,000. Now, most people would think a profit of $408,000 would be better than a loss of $925,000 and they’d be right. But our interest is in figuring out how Orange might do going forward and it’s much easier to see that without the late, not so lamented, LEM in the way.
 
They do a really good job explaining this in their conference call. It might be worth a listen, but I suspect most of you prefer that I listen to it and tell you what they said.
 
Sales for the quarter ended June 30, 2011 were $8.99 million, up 6.8% from the pro forma sales number for last year’s quarter. For the six months ended June 30, sales were essentially flat compared to the previous year excluding the LEM sales.
 
Aside from the Spy brand, we know Orange also has had deals to sell licensed product from Margaritaville, O’Neil, and Mary J. Blige. So far sales from those products haven’t been significant, and I’ve already written about the deal to get out from under the contract with Mary. It’s costing them $1.5 million, but they would have had to pay royalties of $2.5 million if they hadn’t renegotiated. They also indicated that, as a result of the revised deal, that they have more flexibility to get rid of the existing inventory.
 
So most of that sales increase is the Spy brand. Good for the Spy brand. Not so good for the licensed brands effort. They note in the conference call that the management reorganization that started in mid-April put the Margaritaville product sales on hold and that sales of that brand have been “lackluster.” They said they were working together to determine the true value of the Margaritaville eyewear brand.   No, I don’t know what that means exactly.
 
The net loss was $2.95 million, much worse than the same quarter last year whether as filed or proforma. This is progress?
Yes, if you look at some of the charges during the quarter that resulted in the loss. There was non-cash stock and warrant compensation, severance payments, and the settlement with Mary J. Bilge charged to the company during the quarter. Together, these three come close to the total loss.
 
I do see their point that if you ignore all the “stuff” things can be construed to be looking up. But the stuff happened and continues to impact the company. This is like “The Turnaround That Wouldn’t End.” Yet the fact that it hasn’t ended (badly) suggests two things. First, that there is some significant brand strength there.
 
Second, moving over to the balance sheet and cash flow, it suggests that 45% shareholder Seth Hamot has a lot of money. As of June 30, 2011 his company, Costa Brava, had lent Orange $9.5 million and is prepared, under a line of credit established in June, to lend them $3.5 million more if they need it.
 
They say they are going to need it and will borrow it either from the Costa Brava line of credit or from their asset based lender BFI, assuming that line continues to be available. They think these lines will be enough over the next 12 months “If the Company is able to achieve some or a combination of…” sales growth, improved working capital management, reduce inventory, and/or better operating expense management.
 
They do have a lot of money tied up in inventory ($8.5 million down from $9 million a year ago). But a year ago, a bunch of that inventory had to involve LEM. I don’t know how much. Inventory is higher due to purchases “…in anticipation of sales that did not occur,” including for the licensed brands, and product purchased from LEM under a take or pay contract. Orange is required to purchase almost $5 million in product from LEM during 2011.
 
Net receivables have fallen from $6.5 million last June 30 to $5.5 million this June 30. But their gross receivables are $7.4 million. Against that they have an allowance for doubtful accounts of $625,000 and an allowance for returns of $1.25 million. If you happen to look at the whole 10Q, you can see on page 33 a discussion and table of how they calculate the return allowance. You’ll see that the average return percentage at June 30 for the Melodies by MJB brand was 18.8%. Gives you some indication of why they decided to renegotiate that deal. The Spy brand, by way of comparison was 5.4%.
 
The conference call included a rather lengthy discussion of all the operational and marketing changes they are making. These include new sales and marketing initiatives, advertising campaign, online ecommerce and branding platforms, revamping of the marketing mix, a more focused approach to sales, and a newly invigorated sales team.
 
That all sounds good of course, but the devil’s in the details we didn’t get. And when they said, “The rollout of the focused and fun Spy brand identity, with a creative execution in the market that will have a measureable effectiveness which will include a new level of sales and operational performance to meet the new demand for the brand,”  I decided we’d just have to wait and see what happened.
Strategically, I think it’s their plan to take the Spy brand into all the niches they think it fits in. That’s going to include optical retailers, just as an example, and they are looking at some surf space as well.
 
I can imagine a time in the not too distant future where this brand might be for sale. Well, I’m sure it is right now for some price (all brands are), so let me rephrase that. I won’t be surprised to see a sale after the promised turnaround is a little more evident. When that is, I guess, depends on Mr. Hamot’s appetite for continuing to finance Orange 21.

 

 

Orange 21 Revises Its Mary J. Blige Licensing Deal; It Will Terminate Early

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On July 18, Orange 21 (Spy Optic)  amended its licensing agreement with Rose Colored Glasses (Mary J. Blige’s company). The amendment provides “…for an earlier expiration of the Company’s license to sell Mary J. Blige (“MJB”) branded sunglasses (the “License”) on March 31, 2012.” For this, they paid Rose Colored Glasses $1,000,000 at signing and issued a non-interest bearing promissory note for $500,000 that’s due March 31, 2012. The filing only provides about half a page of real information. You can read it here.

My take on Orange 21, as you know if you’ve been reading what I’ve written about them, is that the tough economy and some management issues left them without the sales volume and margins they needed to support their required advertising and promotional programs. To try and address this issue, they took what I thought was the reasonable step of making licensing agreements with O’Neil, Jimmy Buffett’s Margaritaville brand, and Mary J. Blige to produce and market sunglasses under their names.

As of their last filing, we hadn’t been told that these programs were generating any meaningful sales, but there had been a lot of expense incurred for design, promotion, inventory and required contractual payments. It appears from the amendment that the licensing deal with Ms. Blige isn’t working out quite the way Orange 21 hoped it would. We don’t have any sales numbers from any of the licensing agreements.
 
Mr. Seth Hamot, Orange 21’s principal shareholder and Chairman, through his company Costa Brava, has previously invested $7 million in Orange 21. If the licensing agreements don’t produce the hoped for revenue increases, and the fundamental strategic issue of the brand not generating enough sales to pay for a competitive marketing program can’t be resolved, he may be called on to put in some more.
 
We should see the quarterly financials shortly.  That will give us a better feel for what might be next.                

 

 

Orange 21’s (Spy Optic) March 31 Quarterly Results; Additional Financing Required.

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Really, not that much has changed at Orange 21 since I wrote about their annual report and management restructuring back in April. But its quarterly 10Q “…anticipates that it will need additional capital during the second quarter of 2011 and in subsequent periods to support its planned operations in 2011, and intends to raise cash through a combination of debt and/or equity financing from existing investors.” The discussions with the shareholders had already started at the date of the filing.

With revenues for the quarter of $6.7 million (down from $8.3 million in the same quarter last year) Orange is pretty small for a public company. Frankly, I have no idea why it went public. Probably, when times were better, there was a plan to use it as a base to build a larger company through acquisitions. But it’s to our benefit that it went public because they are required to tell us what’s going on.

Sales for the quarter were below expectations, falling 9% even ignoring the $900,000 decline that resulted from the sale of its factory in Italy (LEM). Gross profit fell, but gross margin rose from 45% to 51%. However, most of that increase resulted from the sale of LEM and the elimination of the lower margin product it produced for third parties.
 
Sales and marketing expenses were up 40% to $2.8million. Around half of the increase was due to the new licensed brands. General and administrative expenses, in contrast, fell by 15% due mostly to the elimination of costs associated with LEM.  There was a net loss of $1.57 million compared with a loss of $937,000 in the same quarter last year.    
 
As you may recall, Orange was a smaller, solid brand that got into some trouble due to a bit of management chaos, and the general economic and competitive environment. I’ve told the complete saga on my web site in various articles as well as the public filings allow me to. More recently, to make a long story short, they decided (correctly I think) that the Spy brand by itself didn’t have enough critical mass to support the expense structure it needed and they didn’t see it getting that mass quickly enough. So they diversified  by making deals to make and market sunglasses for O’Neil, Jimmy Buffet’s Margaritaville brand, and Mary J. Blige.
 
Those deals came with various financial requirements, including minimum royalty payments, research and development expense, marketing costs, and the need to build inventory prior to the launch. As enumerated in other articles, it was a bunch of money. The major shareholder, whose company owns nearly 50% of the stock, has already contributed $7 million to Orange and apparently, along with other shareholders, he’s being asked to put in more.
 
Three things have happened that explain the need for more capital. The first one I’m certain of; the economic recovery just hasn’t gotten the traction we all hoped it would.   The second I don’t know for certain but strongly suspect; sales of the licensed brands haven’t been as strong as was hoped. Finally, the deal to sell LEM included certain minimum purchases from LEM for 2011 and 2012. As of March 31st, the minimum purchase amount for 2011 was almost $5 million at the current exchange rate. For 2012, it’s about $2.5 million. It would be interesting to know what kinds of gross margins those purchases will generate. Certainly part of the reason you get rid of an Italian factory is that the product is expensive- especially when the Euro is fairly strong. We’ll see how long that lasts.
 
The really interesting thing to focus on in the story of Orange 21 is the dynamics of entrepreneurial companies that get into some trouble. That where the learning is for us and it seems to be more or less the same in every turnaround I’ve ever worked with or heard about.
 
It all begins, as I’ve said before, with denial and perseverance in a period of change. It starts with some unrealistic expectations (entrepreneurs are, by definition, optimists). There are frequently some clashes of egos and often an entrepreneur can’t get out of their own way as the business grows and changes. The environment that’s created can be highly charged. Employees can be intimidated and pointing out issues or suggesting that some plans are too aggressive can be viewed as negative.
 
With a bias towards believing that the sky’s the limit and a conviction they can solve any problem, it’s hard to ever get to the point where you don’t see it working out and consider cutting your loses. Suddenly, you find yourself “all in” with no obvious options but to march forward.
 
I don’t know that this describes the evolution at Orange 21. Certain events, such as the purchase of the factory, and the dispute with former CEO Mark Simo might fit the pattern but it’s hard to know. Whatever the internal dynamics, the company finds itself with a weak balance sheet supported by their major shareholder and with additional cash requirements. There’s now a new management team and we’ll have to give them some time to work. But lacking a stronger economic recovery or a takeoff in sales of the licensed brands, one wonders what the next step is.

 

 

Orange 21 Year End Results and Management Restructuring

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I unexpectedly had to spend about 10 days back east on family issues. Everything turned out fine, but I got way, way behind on my analysis. But sometimes things work out, and Orange 21’s management changes of last week gave me the perfect opportunity to tie those changes to their financial results and write a way more interesting piece.

I’ve been writing about the saga of Orange 21 (Spy Optic) for a while now. You remember the basic story. Solid, small brand has some self-inflicted management and operational problems (Bought a factory in Italy- now sold, too much inventory, the Mark Simo/No Fear episode, etc.). Went public for no reason I could ever figure out. Things are tough enough then the recession hits. Stone Douglass, a turnaround guy with no experience in our industry (that is not a criticism) is brought in to clean up the mess and get things back on the right track. He does, as far as I can tell, all the stuff he should do. But, so far at least, we haven’t seen sales growth and the company continues to lose money.

The income statement for the year ended December 31 showed a loss of $4.6 million on revenue of $35 million. When you read through the overview of the business, the target markets, the growth strategy and the products sections of the 10K report you can’t help but think that maybe a $34 million revenue business just doesn’t have the resources it needs to compete in the sunglass and goggle business given the competitors and their resources. Sunglasses and goggles represented 99% of Orange 21’s revenues in 2010.
 
Given those factors and the economic environment, I’d guess that Orange 21 management reached the same conclusion. They responded, in September of 2009, by licensing the O’Neill brand for eyewear. In February and May of 2010 respectively, they made deals with Jimmy Buffett and Mary J. Blige to design, produce and distribute a line of eyewear for each of them. 
 
Seems like a good idea. But it required expenditures for royalties, design, production and building inventory before the first pair could be sold. In 2010, the company spent $1.2 million associated with those brands but generated “minimal” sales. Inventory increased between the end of 2009 and the end of 2010 by $1.14 million to $8.9 million. Much of that increase was in preparation for the launch of the new products. The discussion of cash flow activities (page 34 of the 10K if you care) states, “Working capital and other activities includes a $2.9 million increase in net inventories for the addition of the O’Neill™, Margaritaville™ and Melodies by MJB™ eyewear lines, and a buildup of mainly top selling Spy™ sunglasses in anticipation of both an increase in sales of such Spy™ sunglasses and the sale of 90% of LEM.”  LEM is the factory in Italy they sold.
 
Anyway, they’ve got a lot of money tied up in these initiatives. Where’d it all come from since the company is losing money?
 
It came from the Chairman of Orange 21’s board and largest shareholder Seth Hamot. Actually, it came from Costa Brava Partnership III, L.P. Mr. Hamot “…is the President and sole member of Roark, Rearden & Hamot, LLC, which is the sole general partner of Costa Brava.” Costa Brava has invested $7 million in Orange 21 in 2010. Through Costa Brava, he put in $3 million, $1 million and another $ 1million in March 2010, October 2010 and November 2010, respectively. On December 20, he put in another $2 million and rolled all that debt into one promissory note for the entire $7 million. 
 
The whole $7 million is subordinated to any borrowings under the asset based line of credit from BFI Business Finance. $2.235 million in borrowings were outstanding under that line at the end of 2010.
 
Basically, that $7 million funded the loss for the year and the inventory build for the newly licensed brands. But those brands still aren’t producing significant sales- at least as of the end of the year.
 
You know, it always seems to be the case that new deals have bumps in the road you don’t expect, cost more than you expect, and don’t produce revenue as quickly as you’d hoped. I’m guessing that might be the case here. Add that to the fact that the Spy brand isn’t growing as they had hoped, and you get to last week’s management restructuring.
 
Stone Douglas resigned, but he’s going to get paid his $300,000 salary for a year. Carol Montgomery, who has quite a background in the sunglass/optical industry, was hired as the CEO at a base salary of $360,000. I read that change mostly as the board of directors deciding that the clean up the mess and restructuring part of the job was largely done and that the strategic positioning build the brands part required somebody who knew the industry better. I agree with that thinking, though I imagine that if Spy was growing and sales of the Buffett and Blige brands were ahead of schedule, we might not have seen the change at this time.
 
Michael Marx, who joined the company in February as VP of Marketing, was promoted to President with a salary of $250,000. I’m not quite clear why a company this size needs a CEO and a President. There must be a plan. 
 
And I think that partly because on April 11, Orange 21 entered into a retainer agreement with Regent Pacific Management Corporation to provide the services of Michael D. Angel as interim chief financial officer. Orange is paying $50,000 every four weeks for his services. Regent Pacific will also be paid some fees for achieving certain goals and get a warrant to purchase 1.5% of the company’s fully diluted common stock at an exercise price of $1.85.
 
I’m not sure that a company of this size expecting some modest growth and, I assumed, with Stone Douglass having done most of the blocking and tackling a turnaround usually requires, would really require this kind of management and financial fire power. Stone Douglass was acting chief financial officer after Jerry Collazo left in February, 2010 until his resignation last week.
 
The company’s costs, as a result of all these arrangements, have increased by north of $100,000 a month. With this new expense level, the required royalties for the Buffett and Blige brands, and even with some reasonable growth by the Spy Brand, it feels like Orange 21 could need some more cash or a different kind of deal in 2011 unless the Buffett, Blige and O’Neill brands really take off. Let’s hope they do.           

 

 

Making Changes in a Difficult Market; Orange 21’s Sept. 30 Quarter and Nine Months

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Orange 21 (Spy Optic) is one of my favorite brands for a couple of reasons. First, over the last couple of years they’ve worked themselves through some really tough issues, making difficult decisions when required. And they’ve had to do it during the recession. Second, for better or worse they’re public. We get to see the numbers, actions, and management strategies of a smaller company in this industry. 

 Finally, they are representative of the issues that most smaller companies are facing right now, and we can learn a lot from how they are responding. Let’s get learning. I should make it clear that the following analysis is mine based strictly on their public documents. Nobody at Orange 21 has talked to me about it.   
 
Key Strategic Decision
 
Orange 21’s sales fell 6.3% for the quarter to $8.2 million compared to the same quarter the prior year. For nine months, they increased 2.8% to $26 million. Like almost every other company, they know that sales increases are harder to come by than they use to be and that there are some pressures on margins. I’d say the latter is especially true in the sun glass business and would be (though to a lesser extent) even if there was no recession. Sun glasses are (were?) a high margin product that inevitably attracted competition from many sources and put pressure on those margins.
 
Orange 21 is at that awkward stage of its life- too big to be small and too small to be big. There are margin pressures and fewer core retailers to sell product to. They’ve been disciplined in controlling expenses, but a brand needs advertising and promotional support, and you can only reduce expenses by so much for so long. Essentially, they need to grow but I don’t think they thought they could grow as much as they need to with their core product lines.
 
The last article I wrote was about Volcom. In that, I talked about how brands, and maybe our whole industry, was transitioning from action sports, to youth culture, to the fashion market. The markets are of course not as distinct as I make it sound, and moving from one to the other is in no sense linear or inevitable for all companies. But Orange 21 has decided they need to move towards the fashion market in order to find the growth they need.   
 
Enter their licensing agreements. In September of 2009, they signed a licensing agreement to develop and sell O’Neill branded eyewear. Along with Spy and Spy Optic, the O’Neill brand is targeted at the action sports market. In February 2010, they signed a licensing agreement with Jimmy Buffett and his Margaritaville brand for eyewear. They did the same with Mary J. Blige in May. Blige is pretty clearly the fashion business.  I don’t quite know if you’d characterize Buffett as fashion, but it’s sure not action sports or youth culture. Is “parrot head” a market segment?  
 
A few years ago, Orange 21 bought the factory that was making some of its product in Italy. At the time I thought maybe that was mistake. But since the purchase, they’ve worked hard to restructure, revamp and generally rejigger that factory so that it’s an asset. I’m guessing it will never compete on price with Chinese made glasses. But for the market Orange 21 is aiming at with the newly licensed brands, the factory may be just what they need. In fact, I’d bet that a desire to increase its throughput was a factor in the licensing decisions.
 
So Orange 21’s key strategic decision was to recognize their need for growth and that the amount they needed couldn’t come from their traditional sales channels. Hence the licensing agreements.
 
The downside is that the licensing agreements come with certain design, development and marketing expenses before they generate the first dollar of revenue. They spent about $400,000 in license related operating expenses during the quarter. There are also various minimum payments under the licensing agreements that total $479,000 for the year ending December 31, 2010. For the next three years, those minimums are $1.4 million, $1.1 million, and $0.8 million.    The Blige product started to sell in September. The Buffett product was to have hit markets in November. It better sell well.
 
The company’s decision to seek its growth outside of its traditional channels had a financial impact that we’ll now examine.
 
The Balance Sheet- Inventory is What I’ll Be Watching
 
Back in March, Orange 21 borrowed $3 million from Costa Brava Partnership. Costa Brava and its general partner own 46% of the company’s stock. $2.6 million of the $3 million was used to pay down its asset based line of credit from BFI. We can tell from the current balance sheet that they later drew down part of that line of credit again. At September 30, their line of credit outstanding was at $2.6 million. Subsequent to the September 30 balance sheet date, the company borrowed an additional $2 million from Costa Brava in two loans for $1 million each dated October 5 and November 1. What are they doing with this $5 million?
 
The first thing we notice is that in the nine months ending Sept. 30 2010, inventory has increased 41% from $7.76 million to $10.9 million, so there’s over $3 million in additional cash  tied up there. As noted above, sales over the same period were up only 2.8%. I expect part of this increase is for the holiday season. But some, I assume, is also to meet expected sales from the newly licensed brands that have launched or are launching now. They’ve are also funding, as noted, significant royalty payments and expenses for the new brands that are not yet generating income.
 
Income Statement- Improved Gross Margin and Expenses in a Good Cause
 
The gross margin for nine months rose from 42% to 50%. For the quarter, it was up from 33% to 47%. I’m glad to see those increases. Orange 21 had some problem inventory and if the problem isn’t solved, the increasing gross margin at least suggests they are getting it under control. They’ve got gross accounts receivable of $6.885 million. Their allowance for doubtful accounts is $720,000 (10.5%) and a further allowance for returns of $1.114 million. Subtracting those two gets us down to the balance sheet reported receivables number of $5.051 million. So some of the slow moving inventory may still be around, but it’s been written down or off and when they do sell it, the margin in big.
 
In spite of the small sales decline for the quarter, total operating expenses were up 17.8%. From what they said in their 10Q, I expect most of this is for the newly licensed brands. They’ve been too good at controlling their expenses to let them increase like that without a very strong justification.
 
I would note that in spite of these increased expenses and a decline in sales, their loss for the quarter fell from $1.136 to $932,000. Witness the power of an improved gross profit margin! What Orange 21 is really doing right now is investing in their new product lines. If we weren’t seeing those investments, they’d have no chance these new brands could succeed.
 
We can see that Orange 21 is getting hit by most of the problems that afflict other brands in this industry. A tough economy, a decline in the number of specialty retailers, smaller orders from the ones that are still standing, and some difficulty getting paid. The sunglass and goggle market is also very competitive and, as I’ve written before, brands with their own retail have a bias towards replacing other brands with their owned brands. Lousy West Coast summer weather also hit reorders during the sunglass season, and they had some vendor delays on snow goggle product.
 
All about par for the course. What seems to me to be different at Orange 21 is that they didn’t limit their response to struggling with those issues on a day to day basis, though they have certainly had to do some struggling. They said, “Hey! Doing more of the same isn’t going to cut it. What can we do differently?” They came up with the licensing.
 

These licensing deals are a risk.   But business is a risk and my personal opinion is that if they hadn’t tried something new, their longer term future might be problematic. I wrote years ago that when things change, the biggest risk is to do nothing. I wish I could take credit for Orange 21’s decisions, but I think they figured it out all by themselves.

 

Orange 21’s (Spy Optics) June 30 Quarter; What Doesn’t Kill You Makes You Strong

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Orange 21 turned a profit of $408,000 in the quarter ended June 30 after losing $254,000 in the same quarter last year. For six months, a loss of $1.058 million was reduced to $529,000. For the quarter, they did it by increasing sales 4.5% and increasing their gross profit margin from 45.9% to 57.8%. And they did it while incurring two hundred thousand dollars of expenses for new sales initiatives that haven’t generated the first dollar of revenue.

If you’ve followed my earlier comments on Orange, you know that they had a lawsuit with a big shareholder and former CEO, some problems with inventory (at the end of the quarter they had an allowance for obsolete inventory of $966,000), expenses that needed to be brought under control, losses that resulted in cash flow issues (managed at least partly by a rights offering to existing shareholders and a $3.0 million loan from the biggest shareholder), a factory in Italy that needed to be better managed, and some pretty heavy duty management transitions.  Oh, and there was (is?) a little recession going on, but I guess we all have to deal with that.

You can see the better management of the factory this quarter in the fact that it generated operating income of $218,000 compared to a loss of $338,000 in the same quarter last year. There’s some exchange rate impact in there, but that’s a $550,000 different in a quarter compared to a year ago.
 
Anyway, the company’s circumstances are improving and if the war isn’t over, they have certainly won some key battles.
 
The new sales initiatives that cost them $200,000 during the quarter but aren’t generating revenue yet are the Margaritaville and Melody by MJB brands.   They’ve also entered into a license agreement to develop and sell O’Neill branded eyewear.
 
Without saying how much is for which brand, the company noted that it had a minimum payment of $478,000 payable under various licensing agreements through the end of the end of the year, of which $178,000 has been paid as of August 10. During the next three calendar years, the company has minimum amounts of $1.4 million, $1.1 million, and $0.8 million, respectively, payable. They better get to selling those new brands.
 
They further noted that if they achieve certain minimum sales of some products, they will have to pay a percentage of net profits under the license agreements.
 
I would speculate that it wasn’t all that easy for Orange 21 to negotiate these agreements with these brands given their recent history. Wish I knew the back story to those discussions. But I think it’s a great thing for them to do. They need more volume to be solidly profitable and can’t sit around and wait for big sales increases through their traditional channels to bring that volume in our new economic reality.
 
90% of sales during the quarter were sunglasses, and domestic sales represented 81% of the total. The company believes the sales increase was due to improvement in the economy and consumer confidence as well as “…efforts with certain key accounts and focus on close out sales.” Hmmm. Does that mean close out sales to key accounts?
 
The explanation for the big increase in gross margin percentage is worth spending a little time on. First, there was only a $13,000 decrease in overhead allocation for the quarter compared to a $346,000 decrease in the quarter last year. What I think that means is that due to their cost controls they had a lot less expenses that got put on cost of goods sold. Well, gross margin is way up, so that’s obviously a good thing even if I’m not entirely sure what it means. And an allocation can simply be from one place to another even lacking any cost reductions. That could improve one category at the expense of another but not change the overall financial result. But in this case, it obviously did change the result, so there’s more to it than an allocation.
 
Opps, I’m rambling on about cost accounting and guessing you’ve heard enough. Sorry.
 
Next they were able to increase inventory reserves by $200,000 compared to $100,000 in the same quarter last year “…as a result of the sale and disposal of previously reserved inventory.” Selling it sounds good; disposing of it not so good.
 
They got some product cost reductions due to more favorable exchange rates against the Euro for product made in their factory and product cost decreases due to the addition of a lower cost manufacturer in China.
 
Finally, they had a decrease in sales returns of about $0.2 million and “…a slightly larger decrease in our sales return reserve.”
Overall then, you have to applaud their gross profit margin improvement. But you also have to notice that some of the improvements are accounting adjustments that reflect the hangover from and resolution of old problems. Others, like exchange rates, are out of their control. Let’s hope they can maintain the high margin going forward.
 
General and administrative expenses were reduced an impressive 7% for the quarter. Sales and marketing and research and development expense were both up, but if they weren’t you’d worry about the prospects for the new brands.
 
Over on the balance sheet, the current ratio has improved only slightly from 1.3 to 1.4. The total liabilities to equity ratio rose from 2.0 to 3.2 mostly, I think, as a result of the $3 million loan from the shareholder. Of course, when the lender owns 44% of your shares, practically speaking you might call that $3 million equity whatever the accounting treatment.
 
I’ll watch the launch of the new brands with interest. For all the things they’ve done right, the company’s ability to grow significantly, become consistently profitable, and improve its balance sheet may depend on those brands.

 

 

Orange 21’s Results for Quarter Ended March 31

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Orange 21 (Spy Optic) has been through a lot. The recession and resulting economic conditions were enough, I’m sure we’d all agree, for any company to deal with. But since CEO Stone Douglass came in, they’ve also settled a dispute with former CEO Mark Simo and No Fear, done a rights offering (they raise about $2.5 million net), replaced their bank line with an asset based line of credit, dealt with a bunch of bad inventory, rationalized and restructured their factory in Italy, borrowed $3 million from Costa Brava, which is owned by its largest shareholder, and cut expenses including ten percent pay cuts for employees, which are still in effect.

They’ve also negotiated deals with O’Neill, Jimmy Buffett and his Margaritaville brand and, recently, Mary J. Blige to design, manufacture and market sun glass lines under their names. If those lines are successful, it will give them volume and help utilize their factory’s capacity.

And as if doing all this wasn’t a full time job, they still had to run the business.
 
Yet every time I go in a shop and ask how Spy Optics is doing (most recently last week), people say good things and tell me it’s selling well. So in spite of all the distractions, the brand still seems to be well positioned.
 
Sales rose 11.4% to $8.3 million, and they saw improvement across all products lines. Sunglasses represent around 80% of sales and goggles, 20%. They believe “…the overall increase is partly due to an improvement in the economy and consumer confidence as well as an increase in our efforts with certain key accounts and focus on close out sales.”
 
You can see the impact of the closeout sales on the gross margin. There was “…an increase of $0.7 million in discounts related to an increase in close out and key accounts sales in the U.S.” Total gross profit grew 2.5% from $3.6 to $3.7 million, but gross profit margin fell from 48.9% to 45%.
 
Sales and marketing expense grew 13% to $2 million due mostly to commissions on sales increases and the addition of a VP of sales. General and administrative expenses fell 9% to $2 million. Here’s the link to the whole filing if you want to pour over the details yourself. http://www.sec.gov/Archives/edgar/data/932372/000119312510117198/d10q.htm
 
Research and development expenses were up 69% to $400,000. There was some additional head count, travel and entertainment, and some expenses for the newly licensed brands. You’d expect that.
 
Overall, the loss from operations grew from $776,000 to $889,000 and the net loss went up from $804,000 to $937,000.
I retrieved the balance sheet from March 31, 2009 to compare to the most current one. We see that receivables have fallen 6% from $5.3 million to $4.9 million. You like to see receivables fall as sales increase, though typically they rise.  Inventory was down 20% to $8.3 million, also a good thing. Total current assets were down 14.9%.
 
Current liabilities were down 25.2%. The biggest decreases were in the line of credit, which fell from $3.5 to $2.2 million, accounts payable, which were down 33.6% to $4.3 million. Looks a lot like good financial management and expense control. The current ratio improved from 1.21 to 1.38. Not a big improvement, but progress.
 
There were no big changes in the non-current assets. Long term notes payable jumped from $270,000 to $3.2 million due to the $3 million note from Costa Bravo. Much of the proceeds from that note were used to pay off the BFI line. I have to believe it’s easier and cheaper to have longer term money from a major shareholder than short term money from an asset based lender.
 
Total stockholders’ equity fell from $7 million to $4.6 million, or by 35%. Total debt to equity has increased (a bad thing) from 2.28 to 3.36 times.
 
Orange 21 is doing everything they can to control spending and improve their balance sheet. What they need most is higher revenue. Hopefully, a continuing economic recovery and sales from their new licensing arrangements will give them that. I guess it may also help that the cost of the product they make in their Italian factory will decline in dollars if the Euro continues to weaken.