SPY’s Results for the Quarter; Operating Income Rises, but Interest Expense is a Killer.

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As usual, SPY had the courtesy to file its 10Q with the SEC about the same time they did their conference call, making my job easier and my analysis more timely. You can see the 10Q here.

Sales for the quarter ended March 31 rose 2% from $9 to $9.2 million compared to the same quarter last year. In this market, I wouldn’t necessarily call 2% increase in revenue a bad result. Especially since we discover during the conference call that SPY lost some revenue in three ways.
For the first time ever, SPY had no goggles to sell during the first quarter because they were all sold out.

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SPY’s Year: Sales and Margin Up, Expenses Down

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When I review SPY’s results, we get to see what a smaller specialty brand is doing. They would prefer, I imagine, that they weren’t public and that we didn’t get to look over their shoulder. But for the time being anyway, we do.

I suppose I need to confess that they are doing most of the things I think, and have written, that smaller specialty brands should do, so I’m likely to approve. Let’s see what those are. 

I’m going to start with the cash flow and note that in the year ended December 31, 2013, they generated positive cash from operating activities of $683,000. Not a huge number, but last year they used $5.2 million in operations. To me, getting to positive operating cash flow is more important than making a profit for a company like SPY that’s recently out from under a few tough years.
 
Sales for the year were up $2.2 million or 6% to $37.8 million. All but $100,000 was SPY branded product. They sold $32.6 million of the total in the U.S. and Canada.
 
Gross profit margin increased to 50% from 46% the previous year because they sold higher margin product, made more product in China (instead of Italy) and earned higher margins on closeout product. They also said it was higher because they had “…lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America.” I don’t really understand that last one because I don’t know how it impacts product cost.
 
Sales and marketing expense was down 18% from $13.8 to $11.3 million. Advertising was reduced from $819,000 to $394,000. That’s because, well, they spent less. They also reduced SG&A expense from $0.2 million to $6.1 million. They did that in spite of $0.1 million spent in relation to two board of director resignations and $0.3 million related to an officer resignation. Shipping and warehouse expense was also down $300,000.
 
So if you increase your sales, improve your gross margin and reduce your expense guess what happens? SPY had a positive income from operations of $399,000 compared to an operating loss of $5 million last year. We learn in the conference call that it’s the first operating profit since they went public in 2004.
 
They still had a bottom line loss of $2.86 million, down from a loss of $7.24 million last year. But that is almost completely the result of $2.97 million in interest expense, up from $2.39 million last year. This is because  of the $21.5 million due to shareholder we see on the balance sheet, up from $19.1 million at the end of last year. There’s also a line of credit outstanding of $4 million due to an asset based lender.
 
If it wasn’t for the shareholder debt, the balance sheet would be okay, though I do note an increase in receivables of 16.6%, way in excess of sales growth. On the other hand, I love the 6.4% reduction in inventory even with the increase in sales. SPY has had some inventory problems in the past, and we can hope this reduction suggests that’s coming to an end.
 
Next, let’s talk about strategy and tie it to the financial results. Here’s where you can see the 10K if you want to follow along.
 
On page nine, talking about product development, they note, “Our products are designed for individuals who embrace the action sports, performance and lifestyle markets.” To me, that correctly sets some limitations on where their distribution can go, and is typical and appropriate for a niche brand.
 
In the conference call, management noted that they had run out of snow goggles by the end of 2013 and that it was their first year of running out of inventory. They also noted that they had strong orders for next season. The one questioner expressed some concern that, as a result, they might have left some sales on the table. CEO Michael Marckx allowed as how they probably had.
 
I was waiting and hoping he’d suggest to the questioner that running out of inventory had something to do with next season’s strong orders, but he didn’t.
 
SPY expects its revenues in 2014 to be in the $39 to $40 million range with a “modest improvement” in gross profit. I was also interested to learn that they will start paying interest on the shareholders debt in cash, rather than accruing it as more debt.
 
It is interesting what you can do with your expenses when you are a bit cautious with your distribution. I am reluctant to draw too straight a line between controlling distribution and reducing marketing expenses (and SG&A, and inventory, and reducing working capital investment) but I’m pretty sure there’s something to it. Retailers seem to favor product that sells through at full margin for some reason, and that makes business easier and more profitable for everybody.
 
I am pretty sure SPY has also benefitted from the brand refocusing and related company reorganization. As they describe it, “…to sustain the relevancy of our brand to our target market and beyond, we reorganized our entire company, realigned our branding efforts in order to better reflect the original intent of our brand, and have continued to make improvements since then.” Sharing a focus, direction, sense of purpose matters. Sorry if that sounds a little mystical, but I suspect it’s part of the reason they could increase sales and cut expenses.
 
SPY’s business strategies in some cases don’t sound much different from their much larger and better resourced competitors and that could be a problem. I also noticed there wasn’t a word about online or direct to consumer in the whole 10K, and that’s certainly different from most brands. Finally, if they haven’t already, they are going to run out of ways to cut expenses, and bottom line improvement this year may have to come from growing sales.
 
But for now, let’s just note the continued improvement and see what happens next.

SPY’s Quarter: More of the Same. That’s Good and Bad

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To sum it all up, the good news is that sales for the quarter ended September 30.2013 rose 2.7% compared to the same quarter last year from $9.89 to $10.15 million and the net loss declined from $1.78 million to $302,000. The bad news continues to be the balance sheet, where the long term debt to stockholders is $20.86 million, up from $17.53 million a year ago. Here’s the link to the 10Q for those who might be interested, though I’m pretty sure most of you read my stuff specifically to avoid having to look at the 10Q. 

I suppose I could stop here and have the shortest article ever. But there are a few financial points that need highlighting and a big strategic issue.
 
The sales amounts are pretty much all SPY branded product except for $100,000 in last year’s quarter. However they note that there was $600,000 in SPY sales this quarter “…which were considered to be closeouts, defined as (a) older styles not in the current product offering or (b) the sales of certain excess inventory of current products sold at reduced pricing levels.” The amount in last year’s quarter was $800,000 and it’s good to see it declining. It’s about 6% of sales. Apparently, they are still clearing up some inventory issues.
 
Sunglasses and optical were 56% of sales. Goggles were 43%. The numbers in last year’s quarter were 64% and 35% respectively. North American sales were 80% of the total compared to 84% last year.
 
The reduction in the net loss was driven by two things. First was a monster improvement in the gross profit margin from 43.5% to 48.5%. 
 
“The increase in our gross profit as a percent of net sales during the three months ended September 30, 2013 compared to the same period in 2012 was primarily due to: (i) improved overall sales mix of our higher margin products; (ii) a higher percentage of lower cost inventory purchases from China; (iii) lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America; and (iv) lower sales of closeout products at reduced price levels.”
 
I would be very interested to know what their margin was on the $600,000 in closeout sales.
 
The second was a 19% decline in operating expenses from $5.53 to $4.47 million resulting in an operating profit of $454,000 compared to an operating loss of $1.22 million a year ago. Most of this was the result of a $900,000 decline in sales and marketing expense to $3 million due to “…(i) a $0.3 million decrease in advertising, public relations, marketing events, and related marketing costs; (ii) a $0.6 million decrease in sales and marketing salary and travel related expenses primarily for reductions in headcount.”
 
I’d also note that cash provided by operations over the nine months of the year so far was a positive $2.49 million compared to a negative $4.13 million in last year’s first nine months. Keep in mind that the interest on the shareholder debt is not being paid in cash but being added to principal and that has something to do with the improvement.
 
Enough on the numbers. Let’s talk about the brand’s positioning. Here’s how they describe it in the 10Q:
 
“…the Company believes it has captured the imagination of the action sports market with authentic, distinctive, performance-driven products under the SPY ® brand. Today, the Company believes the SPY ® brand, symbolized by the distinct “cross” logo, is a well-recognized eyewear brand in its segment of the action sports industry, with a reputation for its high quality products, style and innovation.”
 
Fair enough. Now, here’s some branding discussion from the press release:
 
“We have a HAPPY disrespect for the usual way of looking (at life). This mindset helps drive us to design, market and distribute premium products for people who "live" to be outdoors, doing intense action sports, motorsports, snow sports, cycling and multi-sports-the things that make them HAPPY. We actively support the lifestyle subcultures that surround these pursuits, and as a result our products serve the broader fashion, music and entertainment markets of the youth culture.”
 
I think the happy disrespect approach is great as long as they can keep it up. It really can supply some differentiation. Irreverence works in this industry. But note that the second quote talks about the broader youth culture market, and the first does not.
 
Maybe I’m reading too much into this. It seems symptomatic of a problem I’ve been highlighting for a while. How does a company maintain its positioning in the historical action sports industry while expanding into the broader youth culture business? It’s proven to be difficult (Burton? Volcom? Skullcandy? Sanuk?).
 
Long term, SPY’s challenge is exactly to do that. I think it has to if it’s going to find enough growth and profitability to get out from under its debt to shareholders. Strategically, that’s what I’ll be watching for.

 

 

Spy’s June 30 Quarter; Things Are Getting Happier

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There are two things that really struck me in reading Spy’s June 30 10Q (which you can read here). You may not have seen them because, unlike you, I delight in reading small print and conference call transcripts. Perhaps “delight” is too strong a word. 

Anyway, the first thing I saw was that they had no (as in zero, zip, nada) sales of the “licensed products,” which, if you’ve been following the continuing adventures of Spy, you know was a distraction and cash flow problem for a couple of years. It hasn’t been a big deal for a quarter or so, but I look at this as the official end of all the crap Spy has had inflicted or has inflicted on itself in recent years. Now they just have to run the business.
 
Speaking of running the business, the second thing I noticed was that the cash flow from operations for the six months ended June 30 was a positive $1,077,000. In the first six months last year they used $3,860,000 in cash. I like positive operating cash flow. Sometimes, I like it more than an accounting profit because you can only pay your bills with cash- not with accounting based profit.
 
There’s still the small issue of the company not making any money, but the loss fell from $1.6 million in last year’s quarter to $574,000 in this year’s June 30 quarter. They accomplished that by increasing sales 5.6% to $9.96 million, improving the gross margin to 52.8% from 50.3% and reducing operation expenses by 15% from $5.83 million to $4.95 million.
 
Unsurprisingly, sunglass sales were 95% of total revenues during the quarter, with goggles being 4% and apparel 1%. North American sales (including Canada) were 88% of the total. What they define as closeouts of Spy product were $800,000 during the quarter compared to $500,000 last year. “A significant portion of the SPY ® sales growth was from sales of sunglasses into our North American optical and international channels, and from our optical frame product line and Happy Lens™ collection.”
 
The higher gross margin resulted from “(i) improved overall sales mix of our higher margin products partially due to increased levels of sales into optical channels; (ii) a higher percentage of lower cost inventory purchases from China; (iii) lower overhead as a percentage of sales partially due to the consolidation of our European distribution center to North America…” But they also had to increase inventory reserves, and that reduced the margin a bit. I’d really like more information on the composition of Spy’s inventory.
 
The reduction in operating expenses included sales and marketing that declined by 22% or $800,000 to $3 million. This came from “…(i) a $0.6 million decrease in advertising, public relations, marketing events, and related marketing costs; (ii) a $0.3 million decrease in sales and marketing salary and travel related expenses primarily for reductions in headcount. These decreases were partially offset by a $0.1 million increase in sales incentives and commissions…”
 
The balance sheet reflects both the improvement in operating performance and the continuing issue of too much debt. Over a year, cash rose from $821,000 to $948,000. Receivables were up from $6.39 to $6.45 million. Of course you expect some growth in receivables with sales growth, but I’d really need to see the composition of receivables last years and now to know how I feel about the change and current level. Specifically, I’d want to know how much was related to Spy brand product at both dates.
 
Inventory fell a bunch from $7.7 million to $5.5 million. That reduction is good to see, but some of that is due not only to liquidating the licensed brand product, but to getting rid of some old Spy inventory as well. Is the inventory now “right sized” for a more normally operating Spy business? I can’t tell, but it’s a lot closer than it used to be.
 
On the lower half of the balance sheet, we’ve got negative equity of $14.5 million, up from $13.8 million a year ago. Remember that the reason Spy has had a chance to try and pull off a turnaround is due to a major shareholder who’s been willing to pump in cash. Last June 30, long term debt to shareholder was $15.1 million. This June 30, the number is $23.2 million. However, current liabilities have fallen from $12.3 to $8.5 million, and total liabilities are up just 4.9% from $27.5 to $28.9 million.
 
In the conference call, CEO Michael Marckx talked about how Spy has “…become a much more effective organization, with the idea of Super Service at the heart of our company culture. This can be summed up with the ethos of being in service to our retail partners, the people who wear our products and to one another, inside and outside of the company. Our Super Service mantra is simple: How can we make people HAPPY? This mindset is not only evident in our customer service, it is apparent in how we market our brand…”
 
I know- that sounds a little like a big old platitude, but I don’t think it is. Let me finish quoting CEO Marckx before I explain why.
 
“…our efforts this half and moving forward stem from a focus and brand ethos that will help to further strengthen our unique positioning and product offering in ways that are mutually beneficial to our retailers. With a more diverse and unique selling proposition from SPY, our retailers are able to better serve their communities with higher quality, differentiated products from SPY, and do so knowing we bring an energy, strength and point of view that our competitors are not matching.”
 
What he’s doing is bringing continuity and clarity to the way the organization functions. Everybody knows how to spend their time. They don’t have to ask so often what to do and not do. They know how every stakeholder should feel after dealing with Spy- Happy.
 
They don’t focus so much on what the competition is doing as on how they can run their own business well. Without this focus I bet they couldn’t have increased sales and gross margin while cutting expenses.
 
Financially, Spy isn’t out of the woods. They are still losing money and their balance sheet, though showing operating improvement, is burdened with way too much debt. Solving that problem requires not just that they make a profit but that they grow that profit through increasing sales. I hope there isn’t pressure to grow sales faster than their market position permits. Our industry is littered with damaged brands who tried to pull that off.

 

 

SPY’s March 31 Quarter: Really Good News

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This is a little weird for me, but I’m not going to start with the numbers. Rather, I want to start with some of CEO Michael Marckx’s comments in the conference call. 

I may not have these quotes exactly right because I can’t type as fast as he talks. He said things like:
 
·         “Super service is at the heart of the company’s culture.” “How can we make people happy?”  
·         “The mission and vision are universally understood in the company.”
·         “Improved product mix with higher quality and prices.”
·         “Reinvigorated brand profile.”
·         “An organization that is firing on all cylinders.”
 
This is backed up by the numbers, and it’s a transformation process SPY has described and pursued over some quarters now. They’ve been consistent in their approach and goals.
 
Basically, they are doing a lot more with less and I think it’s because, “The mission and vision are universally understood in the company.” That’s not voodoo. It’s common sense. When you are running a business there are endless invitations to be distracted. That will never go away, but when there is consensus on mission and vision, you have a shield to reduce the impact. Ideas and opportunities either fit the mission and vision or they do not. Okay, it’s not always that clear cut, but the consensus motivates everybody to focus on the right stuff and to not waste time and resources. Everybody in the organization is empowered to say, “Nope, doesn’t fit. We’re not going that way.” Think of the improvement in organizational efficiency created by that common knowledge and consensus.
 
The other thing I like, of course, is that SPY’s strategy is pretty consistent with the one I’ve been proselytizing about recently. It’s where you focus on gross margin dollars and cautious distribution as part of your strategy to create brand distinctiveness and recognize the tie in between marketing and operations. To make a long story short, I think it’s a way for some brands and retailers to improve their operating income line with less risk.
 
SPY’s revenues rose 10.6% to $9 million from $8.1 million in the same quarter the previous year. But SPY branded products were up 14% or $1.1 million and represent essentially all sales in this year’s March 31 quarter. Remember in last year’s quarter they were still getting rid of their discontinued licensed product inventory and sold $300,000 of it. That’s all gone.
 
We should take a moment and pause to recognize that as far as I can tell SPY is officially no longer dealing with any of the self-inflicted problems it had over the last six plus years. Being out from under all that is one of the things that makes their strategy viable. Gee, I had a lot of fun writing about that stuff and am kind of going to miss it.
 
The gross profit percentage was 51% compared with 47% for last year’s quarter. Apparently the leading cause of that increase is that they are no longer selling the closeout licensed products which had a lousy margin. However, they also note that they are getting lower costs from more Chinese made product, that their international business is more cost efficient, and that they are selling higher margin products “…due to increased levels of sales to specialized core accounts and optical channels.”
 
Selling and marketing expense fell 21% or $800,000 to $2.9 million. They restructured and cut stuff. But they also had to spend $100,000 more in sales incentives and commissions. You know, I always loved signing big commission checks. The bigger the better, because that meant the company was doing better.
 
Okay, so they cut marketing costs by $600,000, but increased SPY branded sales by 14%. That’s pretty good. I guess some of those marketing costs weren’t quite as necessary as everybody thought. There’s a lesson there somewhere.
 
I want to hypothesize that if they didn’t have an organization with consensus on vision and mission they couldn’t have gotten that increase while making the cuts. I think their brand positioning and distribution strategy allowed them to accomplish more with less. Think about that.
 
General and administrative expense was down $600,000 or 28% to $1.4 million. There were some headcount reductions, but also less in legal, professional services and general corporate matters. I suspect some of that decline is the result of getting past old problems.
 
Overall, operating expenses fell from $5.95 million to $4.57 million, a 23.2% decline. That left us (drumroll please) with an operating profit of $29,000 compared to an operating loss of $2.16 million a year ago.
 
Interest expense rose from $0.4 million to $0.8 million. Some of that is non-cash. We’ll get to the balance sheet in a minute. There was still a net loss of $721,000 but that compares to a loss of $2.6 million in the same quarter last year. Net cash provided by operations was $1.55 million compared to operations using $363,000 of cash last year.
 
On the balance sheet, cash is up from $416,000 a year ago to $1.4 million. Receivables are unchanged. Inventories have fallen from $6.3 million to $5.9 million. All that’s good. The continuing problem of course is the notes payable to shareholders of $19.6 million and the negative equity of $14.3 million. A year ago, those numbers were $13.7 million and negative $9.8 million respectively. As I think everybody knows, if it wasn’t for shareholders with deep pockets, SPY would have closed or been sold long ago. It looks, however, like those shareholder contributions might be coming to an end.
 
I don’t really have any criticism of SPY operationally. It appears that they’ve got some well positioned, distinctive product offerings, a focused organization, financial discipline and (which I really love) an awareness of the connection between how you operate and how your offerings are received.
 
I love it when a plan comes together.

 

 

SPY’s Sales Up, Loss Reduced; But There’s Still That Pesky Balance Sheet

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It’s been years since we’ve had an annual or quarterly report from SPY so focused on growing the brand and with so little mention of managing past problems. Remember, though, that all I know and write about is what I hear in the conference call or read in the public documents. Speaking of which, here’s the link to the 10K. 

Strategy and Market Positioning
 
SPY’s presentation is about new, innovative product, expense management and reduction, their “specialized athlete consultants,” (which I guess some people might call team riders), the brand’s irreverent attitude as a positioning statement, a stabilized and focused organization, a rationalized structure in Europe (going direct never made sense with just $6 million in revenue there), and the focus on and growth of the SPY brand.
 
SPY characterizes itself as a “…creative, performance-driven brand,” and divides its eyewear products into three groups:
 
“(i) sunglasses, which includes fashion, Happy Lens™, performance sport and women specific sunglasses; (ii) goggles, which includes snow sport and motocross goggles created for our core demographics, and a new goggle line extension for the SPY ® brand that targets new distribution opportunities and customers; and (iii) optical, which includes optical-quality frames and sunglasses for persons in a slightly older, but still youthful, demographic.”
 
“We design, market and distribute premium products for people who are happy to be outside, especially youthful people who love action sports, motorsports, snow sports, cycling and multi-sports markets. Our products embrace their attendant lifestyle subcultures, crossing over into more mainstream fashion, music and entertainment markets. We believe a primary strength is our ability to create distinctive products for young minded, active people with a very different and irreverent point of view.”
 
They talk a lot more about their business strategy and products in the first couple of pages of the 10K and it’s worth a quick read. Here are their product categories and retail price ranges for each.
 
Fashion Sunglasses                                                         $75 to $180
Happy Lens Sunglasses                                                 $140 to $200
Women-Specific Sunglasses                                       $$85 to $135
Performance Sport Sunglasses                                  $85 to $160
Prescription Frames                                                       $180 to $210
Snow Sport Goggles                                                       $40 to $160
Motocross Goggles                                                         $30 to $75
 
The management challenge is pretty clear. SPY’s a smaller company whose product categories range from core to broad fashion. Its description of its market and customers would seem to position it as a niche brand but, as noted above, it crosses over into much larger markets with much bigger competitors. It would be a really interesting exercise (I’m sure SPY’s team has done it) to look at competitor price points for each of SPY’s categories and see who they define as competitors. SPY looks like it’s created some innovative products to differentiate itself, but many to most of its competitors have a lot more money to throw at product development (SPY spend $600,000 in 2012). How do you succeed as a small company in both the core and larger fashion market?
 
Hardly a new question, is it? I’ve recently noted that Skullcandy has some of the same issues, and wondered how Quiksilver can be focused on performance products but sell them in very broad distribution (JC Penney for example) to people who may not really understand or care so much about performance. Bluntly, I think every action sports/youth culture brand has to address the issue. How?
 
You do it by building a solid brand identity with patience over a period of time that I think is measured in years. You develop a consumer base that identifies with your brand and supports it. You watch your distribution. You don’t push into the broader market; you wait until you are pulled into it. 
 
SPY, in spite of all its past issues, has done that if only by virtue of the brand having survived this long. The brand has some strength in spite of those past issues. But the balance sheet limits options, as we’ll discuss after reviewing the numbers. 
 
The Results
 
Starting with the GAP numbers, sales for the year ending December 31, 2012 grew 6.8% to $35.6 million from $33.4 million the previous year. Sunglasses represented 77% of sales. Goggles were 22%. The gross profit margin rose from 43% to 46.1%. This was due to sourcing more product from China (the impact of the Italian factory is declining), and selling less closeout product of both the SPY and the licensed brands (discussed below).   
 
Operating expenses fell 9.8% from $23.8 to $21.5 million. Most of that decline was in general and administrative expenses. The sales and marketing spend rose, which you’d expect given their strategy. Advertising rose from $721,000 to $819,000.
 
The loss from operations fell for the year from $9.4 million to $5 million. Total other expense (mostly interest) rose from $1.5 to $2.2 million. The net loss was $7.2 million compared to a loss of $10.9 million the previous year.
 
Now for some important clarifications. Remembered all those licensed brands they tried to market and gave up on? They sold $2.2 million of that during 2011 but only $500,000 of it during 2012. Further good news is that they expect to sell $50,000 of that stuff during the current quarter, but then they will be done. It’s all gone!
 
Anyway, their sales were up 6.8% in 2012 even though they sold $1.7 million less of those licensed brands. Sale of the SPY brand product actually increased in 2012 by 13% to $35.1 million from $31.1 million the prior year. Sales of SPY brand closeout product fell to $2.6 million from $3 million in the prior year.
 
Past reports from SPY have spent way too much time describing money they had to spend for one thing or another that hadn’t worked out. If we aren’t completely over those, we’re certainly getting damned close. Not only don’t they have to spend money on those various inconveniences anymore, but they don’t have to waste time on them when it could be better spent building the SPY brand.
 
Sales during the last quarter of the year fell by 4.3% from $8.5 to $8.1 million. But the gross profit margin rose from 33.1% to 44%. The net loss in the quarter dropped from $3.4 million to $1.2 million.
 
SPY expects one-third of its 2013 sales to come from its new products. They are targeting operating expenses of under $18 million and believe if they could get revenues to the $37 to $38 million level, they can break even at the operating profit level. To put things in perspective, an increase to $37 million would be a 3.9% revenue increase over 2012.
 
Be aware, however, that their definition of operating profit excludes the noncash interest that is being added to the principal of their debt rather than paid in cash. It was $700,000 in 2012 and I expect it to be higher in 2013. And that brings us back to-
 
The Balance Sheet and Strategy
 
As you recall, SPY’s major shareholder has put a whole bunch of money into the company. If he hadn’t, the company would have gone belly up or been sold for not much. As of the end of 2012, notes payable to stockholder on the balance sheet was $19 million. Total indebtedness, including those notes, lines of credit and capital leases was $23.9 million.
 
Where the balance sheet and strategy come together (or maybe where they conflict, actually) is in creating a company and brand with a value that would permit the shareholder to get his $19 million back as well as pay off the other debt. That requires not only that the company make money at an income before interest line, but that it demonstrate some solid growth potential.
 
When you look at their product categories (above) you see they are placing bets in quite a number of markets (though there’s some obvious overlap among them). I hope SPY, as a $36 million dollar company, has the resources to pursue them all. In a perfect world, you’d sell the company to a larger player with the resources to insure they could, but the circumstances of the balance sheet make that difficult.       
 
I like the operating and marketing actions SPY is taking. I just hope there isn’t urgency around growth that leads to them trying to push the brand too fast in too many categories.

 

 

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

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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. 

 

 

Spy’s Expense Cuts

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Spy announced on August 27 that they were reducing their North American and European employment by 20 positions, going to a distribution model in Europe (they had been direct previously), and spending less on marketing. They think these changes will cost them  $1.2 million in the quarter ($1.0 million in cash) during their 3rd quarter, but that they “…could result in annual operating cost savings of up to $6.0 million in 2013.”
 
Back on July 2nd, Spy filed an 8K announcing, among other things that they expected to raise some form of equity capital by August 31st. There has been no announcement that any equity has been raised.
 
When I wrote about Spy’s June 30 quarter, I pointed out that their majority shareholder had increased the line of credit to the company to $10 million (and that Spy owed him $15 million). I said (and had said before) that Spy’s brand focus was correct. I also said, “As long as Costa Brava is willing to fund them, they can continue to pursue their strategy.”
 
I feel strongly both ways about what Spy is doing. On the one hand, the balance sheet and cash run rate certainly seems to require expense reduction. On the other hand, their strategy has been to invest in the brand to get revenues to a level that could support the required marketing effort. For all the progress Spy has made in increasing brand sales, it looks like somebody think it hasn’t happened fast enough to justify the continuing required cash investment.
 
They don’t give a breakdown of exactly where the personnel and expense reductions happened. I’d be very interested to know that so I could better judge if this was a tactical decision to increase the U.S. focus or a more fundamental strategic decisions by funding source Costa Brava that that they couldn’t just keep pouring cash in.
 
What we do know from their 10Q is that in the quarter ended June 30, North American sales were $8.73 million and international only $740,000. You wonder how much expense there could be in Europe given the level of revenues there.  
 
Going from a direct to a distribution model in Europe does indeed reduce expenses. But it also reduces revenues since you aren’t going to be selling direct and your distributors will want to make a few Euros too. They didn’t indicate how much that reduction might be. Depends, I suppose, on the distributors and how quickly they can be up and running. 
 
I’ll look forward to their filling us in on how that transition is going. For all I know, this is a really positive development, but they haven’t supplied us with enough details to know that.

 

 

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

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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.
 

 

 

Spy to Raise Capital by End of August- But That’s All We Know

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Spy filed an 8K on July 2 that announced they had increased the amount of the note due to Costa Brava from $6 million to $7 million, and that the full amount of $7 million was already outstanding. They also said they expected to raise some form of equity by August 31. As you may recall, Costa Brava owns 48.4% of Spy’s common stock (52.1% on an as converted basis). Mr. Seth Hamot is the Chairman of the Board of Spy, and “…sole member of the sole general partner of Costa Brava.”

You may also recall, or you may not, that interest on the loan to Costa Brava was being accrued as additional debt by Spy rather than paid in cash. That’s at least part of the reason why the loan amount had to be increased.

We also learn that, “SPY North America must prepay $1 million of the principal amount outstanding under the line of credit within five business days of our proposed sale of equity (preferred stock, common stock, warrants to purchase common stock, or any combination thereof) with proceeds to us of at least $4 million prior to payment of any transaction expenses. The amount so paid will reduce dollar-for-dollar Costa Brava’s commitment to make advances under the line of credit. We expect to sell such amount of equity by August 31, 2012.”
 
That Spy would want to raise equity is hardly a surprise. Their filings have noted the potential need for additional working capital, and Mr. Hamot, understandably, doesn’t want to continue to lend money to Spy.
 
But that suggests he expects the money to come from somewhere besides Costa Brava. We don’t, however, know what form the equity will take or how much it will be though the deal is supposed to be done by August 31. That makes me think the discussions are already ongoing if only because they felt obligated to mention it in this filing.
 
Spy’s stock closed on July 3 at $1.40 a share. But it doesn’t trade much volume and there’s a big bid/ask spread so that doesn’t mean all that much. It’s only averaged 2,457 shares a day over the last 90 trading days and some days there are no trades at all.
 
You will also note from the quote above that Spy has to pay back a chunk of any money it raises to Costs Brava to reduce the loan outstanding. While that improves the balance sheet by reducing debt and increasing equity (depending on the form of the capital raise), it doesn’t generate any working capital for Spy unless the amount raised is more than what’s paid back to Costa Brava.
 
Well, that’s not quite true. It reduces interest expense. But interest expense to Costa Brava hasn’t been paid in cash anyway.  It’s also made clear that the line of credit available from Costa Brava will be reduced by the amount of the repayment. That is, they can’t borrow it again.
 
So who exactly, is going to step in and invest money in Spy and at what price that goes right out the door to Costa Brava and Mr. Hamot? Other existing shareholders?
 
It should be interesting to watch. Hope you have a long and pleasant holiday weekend.