SPY’s Quarter; Strategy and the View from the Balance Sheet.

About a hundred years ago, around 1998, I spent a year as one in a long line of people who believed in the Sims brand enough to try and get it some traction (Some of you who are reading this are smiling; some are laughing. At me or with me- who knows). 

Sims benefitted from having a group of really competent people who had been with the company for a long time and were totally loyal to the brand. In difficult circumstances, while I was there and after, they cleaned up the brand and created a company that was doing $20 plus million a year, earning an operating profit, and had the potential to grow some.
 
But no matter how well they operated, they couldn’t overcome the high level of debt on the balance sheet and the discontinuities this created between what was good for the brand and what was good for the shareholders/debt holders.
 
Which, as you were probably expecting, gets me around to SPY.
 
Strategy and Balance Sheet
 
SPY’s sales grew 7.6% in during the quarter ended September 30, rising from $9.2 million to $9.9 million. They cut their operating loss from $2.4 million to $1.2 million and their net loss from $2.98 million to $1.78 million compared to the same quarter last year. As usual, there are some details to be discussed, and we’ll get to that. But first, let’s talk about the strategy and the balance sheet.
 
If you’ve followed SPY over the last few years through what I’ve written or other sources, you know that they’ve experienced a lot of challenges; some self-inflicted, some not. There’s been the Italian factory they bought then sold, a lawsuit with a former CEO, the detour into, and then out of, licensed brands, some inventory problems, management issues and turnover (now apparently ended), a lousy economy, and the August 2012 announcement that the company was reducing “…the level of its expenses to lower its breakeven point on an operating basis.”   Through all of the tumult, the SPY brand has somehow maintained credibility in the market.
 
Now, the company is refocused exclusively on that brand and it feels like the company is making progress. But sunglasses are a very competitive category produced by an awful lot of companies. It’s a high margin product so naturally everybody wanted a piece of that. Inevitably, that margin will come down (is already coming down?) because that’s what happens.
 
SPY needs to grow its revenues so that it can afford the cost structure it has to have to compete against much larger and better capitalized companies. To accomplish that, and to clean up all the problems mentioned above, they’ve had to invest and invest and invest. That gets us over to the balance sheet.
 
In the year since September 30, 2011 notes payable to stockholder have risen from $10.5 million to $17.5 million. The majority shareholder has lent the company another $7 million over the year. Interest on the debt is not being paid in cash, but is accrued as additional debt. Under current liabilities, the line of credit outstanding has risen by $2.1 million from $2.5 million to $4.6 million. Stockholders’ equity has dropped from an already negative $4.3 million to a deficit of $12.8 million. The only thing keeping SPY afloat is the willingness of the majority shareholder to lend the company money, and the 10Q tells us they are going to need more; “The Company anticipates that it will continue to have requirements for significant additional cash to finance its ongoing working capital requirements and net losses.”
 
Well, it’s hardly unusual for a company in this industry to find itself at the point where it needs the financial, back office and/or design/manufacturing strength of a larger company so they can “Take it to the next level” whatever the hell that means.
 
If it’s a company like Sanuk, who was more or less the same size as SPY when it was acquired by Decker and was growing, profitable and no doubt had a solid balance sheet, you can get paid a lot of money. But if you’re losing money, require more investment, and your balance sheet is upside down you don’t quite get such a good deal. In those circumstances, in our industry, “Taking it to the next level” has meant some of your debt gets assumed, you get an earn out if the company performs, and people get to keep their jobs.
 
My guess is it would make sense for SPY to be bought by a larger corporation. But whatever we might conclude the brand is worth, nobody is going to come anywhere close to paying the majority shareholder the $17.5 million he’s owed for a company that’s losing money and needs further investment.
 
There are also, of course, other shareholders who’d probably rather not lose their money. I don’t know exactly why or how SPY came to be a public company in the first place, but this would probably be more easily managed if it wasn’t a public company, though way less fun for me.
 
Nuts and Bolts
 
In the August restructuring, they took a $700,000 charge for the reduction in expenses I mentioned above. This one-time cost was for changing the direct part of its European business to a distribution model and for reducing its marketing spend. The result was a staff reduction of 20 positions.
 
For the quarter, 16.4% of its revenue, or $1.63 million, was international. I would expect that going from a direct to a distribution in Europe, while reducing some costs, will also lower their gross margin on the product being sold there. The reduction in their marketing spend, while understandable given their financial condition, is the opposite of what they’d indicated they were going to do in the past. See the conflict between what the brand and the balance sheet requires?
 
While overall sales grew by 7.6% in the quarter, the sale of the SPY brand during the quarter rose $1.4 million or 17% to $9.8 million. That included $800,000 of SPY closeouts. In the same quarter last year, the closeout number was $300,000. As we’ve noted, total sales were $9.9 million. Only $100,000 of revenue came from the left over inventory of licensed brands they’ve been getting out of. They don’t expect any significant future sales from those brands. It’s great to see that done.
 
The gross profit margin was 44% compared to 35% in last year’s quarter. The increase was the result of a number of factors, including the negative impact of the write down of the licensed brand inventory last year, purchasing more lower cost product from China, and decreased freight cost (they avoided some air freight). These positive factors were somewhat offset by lower international margins, increased closeouts, inventory reserves, and discounting, and some changes in accounting for product from the Italian factory.
 
Increased inventory reserves, discounting, and closeouts don’t sound all that positive. What would be really nice is if they would tell us the gross margins on just the SPY branded product since that’s where the company’s focus is.
 
Selling and marketing expense increased by $0.4 million, or 12%, to $3.8 million. They say this was “…driven primarily by increased marketing efforts to promote our SPY brand and our new SPY products and a portion of restructure expense included in 2012.” Yet if we breakdown the increase, there was a $500,000 charge as part of the restructuring which was meant to reduce exactly those costs. They spend an extra $100,000 in marketing costs and had a $200,000 decline in consulting and other marketing expenses.
 
So the increase was to promote the brand, but some part of the increase was a charge to cut those costs. Once again, I can only point to the conflict between the interests of the brand and the reality of the balance sheet.
 
I would expect there will come a point when the major shareholder who’s been financing SPY will be tired of putting in more money and it will be interesting to see what happens then. In the meantime, SPY has whittled its non-operating issues down to not much, and perhaps a good holiday season will result in a strong December quarter.