Spy’s June 30 Quarter. Brand Sales Up, But Gross Margin Falls. What to do About the Balance Sheet?

In the conference call discussion of their results Michael Marckx, Spy’s President and CEO, emphasized two things. The first was the total focus on the Spy brand. The second was that they had a solid and complete management team that was in agreement on the company’s strategy and direction.

Those are good things. In spite of the sales increase, however, the company continues to lose money, and can only pursue its strategy with the help of continuing loans from its largest shareholder. Here are the details.     
 
Sales for the quarter rose from about $9 million to $9.5 million, or by 5.3% compared to the same quarter last year. Sales of Spy products were up $1.1 million, or 13%, to $9.3 million. That number includes $300,000 of Spy brand closeouts. There was also $200,000 in closeout sales of the licensed brands (O’Neill, Melodies by MJB, and Margaritaville) that they no longer sell. I’d note that the licensed brands closeout sales were down from $800,000 in the same quarter last year, so hopefully we’re coming to the end of that. Sunglasses represented 94% of revenue during the quarter.
 
 
Total gross profit fell from $4.88 million to $4.75 million even with the sales increase. Gross profit margin was down from 54.3% to 50.3%. They give four reasons for the decline.
 
The first is reduced gross margin on international business due to poor European economic conditions (International sales in the quarter were $790,000). Second, some of the product they sold that they bought from LEM (the Italian factory they used to own) has gotten more expensive, but they’ve got a deal that requires them to continue to buy some product there. Third, there was an increased level of discounting which they say is “…primarily due to increased levels of sales to major accounts.” Finally, there were some higher freight costs because of more air freight shipments. Having to pay for air freight sucks I can say from personal experience.
 
These higher costs were offset, they say, by some increased purchases of lower cost product from China and the higher margins they got from sale of the old licensed product after they wrote it down last year.
 
Let’s focus on that last one for a minute. If you carry product in inventory at $50 and sell it for $100, you have a 50% gross margin. Assume you figure out you have way too much of that product and it’s not worth anything, so you write it off, charging the $50 to expense. Next year, to your surprise, you figure out how to sell it for $25. You carry it in inventory for nothing, so that $25, from an accounting point of view, is all gross profit. That will boost your gross profit margin nicely. We don’t know how much of that Spy had.
 
Sales and marketing expense rose 43.3% from $2.6 million to $3.8 million. The increase was “…driven primarily by increased marketing efforts to promote our SPY brand and our new SPY products…” The biggest piece of the increase was $500,000 for marketing costs. There was also $300,000 spent on product displays and $200,000 on compensation. For all of 2012, Spy has minimum annual payments to sponsored athletes of $919,000. They are betting on the Spy brand, so where else would the money go.
 
General and administrative expenses were down $900,000, or 33.8%, to $1.73 million. That reduction is largely related to the one time management restructuring costs from April 2011. 
 
As reported, total operating expenses fell 22.4% from $7.5 million to $5.8 million and the operating loss for the quarter fell from $2.64 million last year to $1.07 million in this year’s quarter. The net loss for the quarter was $1.63 million, down 45% from a loss of $2.95 million in the same quarter last year.
 
But in the quarter last year, there were the one-time charges of $1.95 million associated with getting out from under the deals for the licensed brands and the $900,000 for the management restructuring.
 
Ignoring those two charges, operating income in last year’s June 30 quarter on a proforma basis was a positive $214,000 and the reported operating income can be viewed as a decline compared to last year’s quarter caused by the fall in gross margin and the marketing spend to build the brand.
 
As you already know, Spy has financed its continuing losses mostly through loans from Costa Brava, an entity controlled by Spy’s largest shareholder. As of June 30, 2012, those loans totaled $15.1 million. A year ago, they were about $9.5 million. In a year then, Costa Brava put an additional $5.6 million into Spy. In August 2012, the amount of the line of credit from Costa Brava was increased from $7 to $10 million. Spy borrowed an additional $1 million on August 3.
 
Spy says in its 10Q, “The Company anticipates that it will continue to have requirements for significant additional cash to finance its ongoing working capital requirements and net losses, which have included increased spending and marketing and sales activities deemed necessary to achieve its desired business growth.” This seems to indicate that they expect continued losses. There’s no information on how much those losses might be or how long they might continue.
 
You may recall that Spy announced on July 2 that it was planning to raise some additional capital by the end of August. I am writing this on August 24th, but nothing has happened as far as I know.
 
With the accumulated losses and shareholder debt, the balance sheet shows a stockholders’ deficit of $11.2 million.
 
Accounts receivables have grown 16.4% over the year, from $5.5 to $6.4 million. That number is net of an allowance for doubtful accounts of $277,000 and a $1.665 million allowance for returns.   Total sales, as you recall, were up 5.3%. Inventories fell 9.5% from $8.5 million to $7.7 million. That’s good to see, though I have no idea how much of that is better inventory management as opposed to write downs of overvalued product. The inventory number is “…net of an allowance for excess and obsolete inventories of approximately $0.9 million…”
 
I think Spy is doing the right things. Certainly focusing on the brand, and spending money to build it, is what they have to do. And the management team seems stabilized, strong, and focused. As long as Costa Brava is willing to fund them, they can continue to pursue their strategy. To justify the investment that’s been made in the company, however, Spy requires a faster rate of growth and, obviously, to make a profit. Next quarter, I hope to see real improvement in their operating performance.