Making Changes in a Difficult Market; Orange 21’s Sept. 30 Quarter and Nine Months
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.
Great article. It’s about time action sports brands begin looking at other markets and opportunities. We have a great ability to make products desirable based on a lifestyle. Once we begin applying that ability to new markets the sky is the limit!
Hi Matt,
We’ve been drifting to these other markets for a long time. What I like about Orange 21 is that they didn’t drift- they made a clear and specific decision that it was the way they had to go. What I’d really like to know is how the contacts with Bilge and Buffet were made and how the deals were negotiated. I can’t help but wonder if Costa Brava didn’t provide some sort of assurance that it would fund Orange 21 so that it had the capital to get the new product lines off the ground.
Thanks for the comment.
J.
Jeff, the music tie-in came from Fran Richards, who has deep connections in music entertainment. As we both know, the license game comes at a risk which typically has an “up front” cost to the royalty payments (ie: 50% of projected sales for year one up front). Hence, the CB investment. If all goes well with these launches, look for more entertainment tie-ins to follow.
The Oneill deal was probably set in motion by brand manager Matt Harkin, who was at Oneill for a while… (but ironically isn’t with Spy any longer).
I wish O21 the best!
Mark,
Of course- it had to be Fran. I have no idea why I didn’t just assume that. It had to be my favorite music addict.
J.