Good Things Happening at Spy.

You may remember that until a few months ago Spy, as a public company, was releasing the usual filings and I was analyzing them.  But they stopped releasing them and, though still public, its shares are now traded on the OTC pink sheets under the symbol XSPY.

As I wrote every quarter, I always liked the brand and thought they were doing most things right.  But I couldn’t quite see how they could be successful.  It’s beginning to look like they might have figured it out.

On July 15, they let fly with a couple of press releases.  One of them announced that they had converted $22.8 million of debt into convertible preferred stock.  As I’d write every quarter, that debt was effectively equity any way.  Now, they’ve acknowledged that and cleaned up the balance sheet.  I don’t recall all the terms and conditions of that debt, but certainly it stood in the way of any deals the company might make.  So on the one hand, the change is kind of window dressing, but on the other hand, it gives the Spy some flexibility going forward.

More impressive were the summary financial results they released for the six months ended June 30 2015 and 2016.

Revenues fell 14.9% from $17.25 million last year to $14.68 million this year.  Okay, so that doesn’t sound very impressive, but it is.  Here’s why.

Spy increased its gross profit margin from 53.4% to 54.1%.  Of course total gross profit declined with the fall in sales, but hold on.

Operating expenses fell from $8.88 to $7.27 million, or by 18.1%.  As a percentage of revenues, they dropped from 51.4% to 49.5% even with the decline in revenue.

The result, according to the press release, was that operating income rose from $150,000 to $671,000 and net income went from a loss of $927,000 to a profit of $443,000 for the six month periods.

What!?  On a 15% revenue decline they had a monster turnaround on the bottom line!?  What the hell is going on here?

Seth Hamos, who is the Chairman of the Board and Acting Chief Executive Officer, is the guy who owned most of the debt in the company.  He stepped in after Michael Marckx resigned.  Seth had at least two things going for him.  First, he wasn’t from our industry and apparently didn’t suffer from all the preconceptions we all have about THE WAY THINGS ARE.  Second, he looked and said, “Well, I’m not going to get my money back if the company keeps losing money, so I guess I better try something different.”

That’s not an actual quote, but it’s how I always feel when I walk into a turnaround situation- nothing is sacred.

I’m guessing a few sacred cows were slaughtered for the barbecue.  Probably stopped selling to a few people who weren’t paying, didn’t merchandise the product right, or where they weren’t earning a good enough margin.  Wouldn’t be surprised if the number of SKUs declined.  I’m guessing there was some panic among the marketing staff when Seth asked, “What the hell are we spending money on this for?”

Again, not an actual quote.

The wailing and gnashing of teeth no doubt continued as he sliced some of those expenses.  But let’s remember the premise here.  Continuing to fund losses was a non-starter.

I’ve been in that position myself.  There’s always another way to spend marketing money to support retailers.  It’s always considered critical.  But, with some limits, most of the time when you cut a chunk of it, you find that nothing bad happens- at least immediately.  An open question is whether any of those cuts might impact the brand’s results down the road.

As always, if your product is checking at retail at a good margin, the retailer will want it.  If it isn’t, they won’t.  Spy believes itself to be a specialty brand.  It looks, with the actions it’s taking, that the company is confirming that and is positioning itself accordingly.

Three other brief financial comments; First, Spy’s net operating losses means no income tax is payable.  Second, I’m guessing Seth isn’t taking a salary.  Not paying whatever they were paying Michael Marckx and not paying income taxes didn’t hurt the bottom line.  Finally, there was interest expense being incurred on the debt before it was converted to preferred stock.  The press release doesn’t mention a dividend payment on the preferred stock.  In the future, a decline in interest expense could result in another boost in Spy’s bottom line from an accounting perspective.

What Spy seems to be doing is pretty much what I’ve been recommending since around 2007; sales growth is harder to come by so focus on your distribution, gross margin and controlling operating expenses with the goal of improving the bottom line.  That’s consistent with building and protecting your brand in an industry where actual product differentiation is hard to come by.

I’m sure Spy figured all this out without my help, but it’s nice to have a poster child to point to.