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

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.