Item 1. Business.
This Annual Report on Form 10-K, including the following discussion, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve substantial risks and uncertainties. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, the words “projected”, “anticipated”, “planned”, “expected”, and similar expressions are intended to identify forward-looking statements. In particular, statements regarding retail store expansion and business growth are forward-looking statements. Forward-looking statements are not guarantees of our future financial performance, and undue reliance should not be placed on them. Our actual results, performance or achievements may differ significantly from the results, performance and achievements discussed in or implied by the forward-looking statements. Factors that could cause such a difference include material changes to Dover Saddlery, Inc.’s business or prospects, in consumer spending, fashion trends or consumer preferences, or in general political, economic, business or capital market conditions and other risks and uncertainties, including but not limited to the other factors that are detailed in “Item 1A.
Item 1A. Risk Factors.
An investment in our common stock involves a high degree of risk. You should carefully consider these risk factors before buying or trading shares of our common stock. Any such risks may materialize, and additional risks not known to us, or that we now deem immaterial, may arise. In such event, our business, financial condition, results of operations or prospects could be materially adversely affected. If that occurs, the market price of our common stock could fall, and you could lose all or part of your investment.
This Annual Report on Form 10-K includes or incorporates forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can identify these forward-looking statements by the use of the words “believes”, “anticipates”, “plans”, “expects”, “may”, “will”, “would”, “intends”, “estimates”, and other similar expressions, whether in the negative or affirmative. We cannot guarantee that we actually will achieve the plans, intentions or expectations disclosed in the forward-looking statements made. We have included important factors in the cautionary statements below that we believe could cause actual results to differ materially from the forward-looking statements contained herein. The forward-looking statements do not reflect the potential impact of any future acquisitions, mergers or dispositions. We do not assume any obligation to update any forward-looking statements contained herein.
A decline in discretionary consumer spending and related externalities could reduce our revenues.
The Company’s revenues depend to a degree on discretionary consumer spending, which may decrease due to a variety of factors beyond our control. These include unfavorable general business, financial and economic conditions, increases in interest rates, increases in inflation, stock market uncertainty, war, terrorism, fears of war or terrorism, increases in consumer debt levels and decreases in the availability of consumer credit, adverse or unseasonable weather conditions, adverse changes in applicable laws and regulations, increases in taxation, adverse unemployment trends and other factors that adversely
influence consumer confidence and spending. Any one of these factors could result in adverse fluctuations in our revenues generally. Our revenues also depend on the extent to which discretionary consumer spending is directed towards recreational activities generally and equestrian activities and products in particular. Reductions in the amounts of discretionary spending directed to such activities would reduce our revenues.
The Company’s customers’ purchases of discretionary items, including our products, may decline during periods when disposable income is lower, or periods of actual or perceived unfavorable economic conditions. If this occurs, our revenues would decline, which may have a material adverse effect on our business.
Material changes in cash flow and debt levels may adversely affect our growth and credit facilities, require the immediate repayment of all our loans, and limit the ability to open new stores.
During seasonal and cyclical changes in our revenue levels, to fund our retail growth strategy, and to fund increases in our direct business, we make use of our credit facilities, which are subject to EBITDA, fixed charge ratio, maximum capital expenditure limitations, total debt and related covenants. In the third quarter of fiscal 2012, prior to a covenant waiver by the Bank, we failed to comply with one of these covenants. If we are out of compliance with our covenants at the end of a fiscal period, it may adversely affect our growth prospects, require the consent of our lender to open new stores or in the worst case, trigger a loan default and require the repayments of all amounts then outstanding on our loans. In the event of our insolvency, liquidation, dissolution or reorganization, the lender under our revolving credit facility and term note would be entitled to payment in full from our assets before distributions, if any, were made to our stockholders.
In order to execute our retail store expansion strategy, we may need to borrow additional funds, raise additional equity financing or finance our planned expansion from profits. Our borrowings may be restricted by financial covenants; or we may also need to raise additional capital in the future to respond to competitive pressures or unanticipated financial requirements. We may not be able to obtain additional financing, including the extension or refinancing of our revolving credit facility, on commercially reasonable terms or at all. A failure to obtain additional financing or an inability to obtain financing on acceptable terms could require us to incur indebtedness at high rates of interest or with substantial restrictive covenants, including prohibitions on payment of dividends.
We may obtain additional financing by issuing equity securities that will dilute the ownership interests of existing shareholders. If we are unable to obtain additional financing, we may be forced to scale back operations or be unable to address opportunities for expansion or enhancement of our operations.
The Company’s market is highly competitive, and we may not continue to compete successfully.
The Company competes in a highly competitive marketplace with a variety of retailers, dealers and distributors. The equestrian products market is highly fragmented with approximately 10,000 retail store locations nationwide. Many of these are small businesses that have a loyal customer base that compete very effectively in their local markets. We plan to apply our historic disciplines to confront the significant competition that we face in each of our local markets. We may, therefore, not be able to generate sufficient sales to support our new retail store locations. There are also a significant number of sporting goods stores, mass merchandisers and other better funded companies that could decide to enter into or expand their equestrian products offerings. Liquidating inventory sales by our former competitors may cause us temporarily to lose business and perhaps even to lose customers. In addition, if our continuing competitors reduce their prices and continue free shipping practices, we may have to reduce our prices in order to compete. Our cost cutting and overhead efficiency measures in fiscal 2010 may also have had some negative effect on our market share in the short run. We may be forced to increase our advertising or mail a greater number of catalogs in order to generate the same or even lower level of sales. Any one of these competitive factors could adversely affect our revenues and profitability. It is possible that increased competition or improved performance by our competitors may reduce our market share, may reduce our profit margin, and may adversely affect our business and financial performance in other ways.
If the economy experiences a recession or the Company cannot successfully execute our planned retail store expansion, our growth and profitability would be adversely impacted.
As of December 31, 2012, the Company had eighteen retail stores. In response to the recent economic recession, we placed on hold for part of 2009 and in 2010 our plan to rapidly increase the number of retail stores and opened only two stores in 2011 and three stores in 2012. A significant percentage of our projected future growth had been expected to be generated from new locations. If we experience continued delays in opening new stores, fail to select appropriate sites, encounter problems in opening new locations, or have trouble achieving anticipated sales volume in new locations, our growth and profitability will be adversely impacted. Furthermore, any one or more of the new stores we intend to open may not be profitable, in which event our operating results may suffer.
As the economy recovers, our subsequent ability to expand our retail presence depends in part on the following factors:
•
favorable economic conditions;
•
our ability to identify suitable locations in key markets with attractive demographics and which offer attractive returns on our investments;
•
the availability of suitable locations at lease rental rates consistent with our expansion model;
•
our ability to negotiate favorable lease and construction terms for such locations;
•
our ability to execute sale/leaseback transactions on satisfactory terms, if at all;
•
competition for such locations;
•
the timely construction of such retail stores;
•
our ability to receive local and state government permits and approvals in connection with such locations;
•
our ability to attract, train, and retain skilled and knowledgeable store personnel; and
•
our ability to provide a product mix that meets the needs of our customers.
In addition, each retail store is expected to require approximately $700,000 to $1.2 million of capital, including start up costs, leasehold improvements and inventory, and excluding the cost of the real estate. If actual costs are higher than expected or if sales in such stores are lower than expected, we may not be able to open as many retail stores as anticipated or we will need to raise additional capital in order to continue our growth.
Changes in subjective assumptions, estimates and judgments by management resulting from external factors or accounting standards could significantly affect our financial results.
Generally accepted accounting principles and related accounting pronouncements, implementation guidelines and interpretations with regard to a wide range of matters that are relevant to our business, including, but not limited to, revenue recognition, sales returns reserves, gift-card breakage income, inventories, vendor rebates and other consideration, self-insurance liabilities, income taxes, litigation, and other contingent liabilities, are highly complex and involve many subjective assumptions, estimates and judgments by our management. Changes in these rules or their interpretation or changes in underlying assumptions, estimates or judgments by our management could significantly change our reported or expected financial performance. For example, our future performance might be adversely affected by variability in inflation rates of health care costs, resulting from the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, which expands health care coverage to many uninsured individuals and expands coverage to those already insured, and might cause material increases in health care costs or accruals for us and our vendors, that in turn could adversely affect our revenues, margins or both.
Current economic conditions and the global financial crisis may have an impact on our business and financial condition in ways that we currently cannot predict.
Since the recession that started in December 2007 ended in 2009, the recovery has been uneven and slow. Even though unemployment has fallen to 7.8% from 8.5% in the U.S, it is still not clear when a sustained robust economic recovery will begin. The recent historical decrease and any future decrease in economic activity in the United States or in other regions of the world in which we do business could adversely affect our financial condition and results of operations. Continued and potentially increased volatility, instability and economic weakness, together with political instability in emerging markets and potential higher energy and fuels costs and a resulting decrease in discretionary consumer and business spending may result in a reduction in our revenues. We currently cannot predict the extent to which our revenues may be impacted. In addition, financial challenges experienced by our suppliers or distributors could result in product delays and discontinuances, a lack of new products, inventory imbalances and/or cost increases, and less favorable trade credit terms.
The Company’s business may be adversely affected by pricing pressures from fluctuations in energy and/or commodity costs.
Fluctuations in the price, availability and quality of fabrics and other raw materials used to manufacture the Company’s products, as well as the price for labor and transportation have contributed to, and may continue to contribute to, ongoing pricing pressures throughout the Company’s supply chain. The price and availability of such inputs to the manufacturing process may fluctuate significantly, depending on several factors, including commodity costs (such as higher cotton prices), energy costs (such as fuel), inflationary pressures from emerging markets, increased labor costs, weather conditions and currency fluctuations. Any or all of these impacts could have a material adverse impact on the Company’s business, financial condition and results of operations. We may be unable to pass such price increases along to the Company’s customers and be unable to maintain the Company’s gross margins. In addition, the increase in energy and commodity costs could adversely affect consumer spending and demand for the Company’s products.
The Company may be unable to open new stores and enter new markets successfully.
An important part of the business plan had been to increase our number of stores and enter new geographic markets. In light of the recent economic recession, the Company placed that plan on hold in 2009 and 2010, but opened two stores in 2011 and three store in 2012. Since the IPO, we had opened ten new stores through December 31, 2012 and remodeled, expanded and converted four stores from the Dominion Saddlery acquisition. If financial and economic indicators forecast sustainable improvement, we plan to open additional stores. For our growth strategy to be successful, we must identify and lease or buy favorable store sites, hire and train associates and adapt management and operational systems to meet the needs of our expanded operations. These tasks may be difficult to accomplish successfully, and may also be restricted by covenants and conditions in our loan agreements. If we are unable to open new stores as quickly as planned, our future sales and profits could be materially adversely affected. Even if we succeed in opening new stores, these new stores may not achieve the same sales or profit levels as our existing stores. Also, our expansion strategy includes opening new stores in markets where we already have a presence so we can take advantage of economies of scale in marketing, distribution and supervision costs. However, these new stores may result in the loss of sales in existing stores in nearby areas.
The Company’s stock price may fluctuate based on market expectations.
The public trading of our stock is based in large part on market expectations that our business will continue to grow and that we will achieve certain levels of net income. If the securities analysts that regularly follow our stock lower their ratings or lower their projections for future growth and financial performance, the market price of our stock is likely to drop significantly. In addition, if our quarterly financial performance does not meet the expectations of securities analysts, our stock price would likely decline. The decrease in the stock price may be disproportionate to the shortfall in our financial performance.
The future sale of shares of the Company’s common stock and limited liquidity may negatively impact our stock price.
When the Company’s shareholders sell substantial amounts of our common stock, the market price of common stock could fall. A reduction in ownership by our controlling shareholders or any other large shareholders could cause the market price of our common stock to fall. Similarly, the market may disfavor the adoption of Rule 10b5-1 trading plans by one or more of the Company’s Officers or Directors, perceiving that such a plan represents a decline in management’s confidence about the Company’s prospects or that the parameters for and trading under a Rule 10b5-1 sales plan could cause downward pressure on the stock price. In addition, the average daily trading volume in our stock is relatively low. The lack of trading activity in our stock may lead to greater fluctuations in our stock price. Low trading volume may also make it difficult for shareholders to make transactions in a timely fashion. The four-year decline in the general trading range of the price of our common stock together with the cyclical retail sector with which we are grouped, could reduce interest in our Company and thus, continue to deflate demand for purchasing shares of our common stock.
Technology failures and privacy and security breaches could adversely affect the Company’s business.
A significant part of the Company’s overall revenues derives from website sales. The success of our online business depends in part on factors over which we have limited control. These factors include changing customer preferences, changing buying trends related to Internet usage, changes in technology interfaces, temporary outages due to bandwidth constraints, another denial of service attack, computer viruses, and other malicious activity, hardware or network failures, other technology failures or human errors, security breaches and consumer privacy concerns. Any failure to respond successfully to these risks and uncertainties might adversely affect sales through our websites, impair our reputation and increase our operating costs.
If the Company’s information technology systems fail to perform as designed or if the Company needs to make system changes in order to support the growing direct and retail store businesses, there may be disruptions in operations.
The efficient operation of our business is dependent on our information technology systems and our point of sale, or POS, systems. Our information technology systems are located in Littleton, MA, and our POS systems are located in each retail store. These systems, which our employees use to process transactions, respond to customer inquiries, manage inventory, purchase, sell and ship goods on a timely basis, and maintain cost-effective operations, are subject to damage from natural disasters, power failures, hardware and software failures, security breaches, network failures, computer viruses and operator negligence. The failure of our information technology systems and our POS systems to perform as designed, even if temporary, could adversely affect inventory levels, shipments to customers and customer service. Any such event would have a material adverse effect on our operating results.
The Company may experience operational problems with its information systems as a result of system failures, viruses, computer “hackers” or other causes. Any material disruption or slowdown of our systems could cause information, including data related to customer orders, to be lost or delayed, which could hurt our business, financial condition and results of operations. Moreover, we may not be successful in developing or acquiring technology that is competitive and responsive to the needs of our customers and might lack sufficient resources to make the necessary investments in technology to compete with our competitors. Accordingly, if changes in technology cause our information systems to become obsolete, or if our information systems are inadequate to handle our anticipated growth, we could lose customers.
While we believe that our systems are adequate to support our planned opening of additional retail stores over the next several years and the future growth of our direct sales business, we may need to upgrade and modify our information technology capabilities. Any upgrades to our information technology systems and our POS systems may not be successful or may cause substantial expenses. In addition, there are inherent risks associated with upgrading our core systems, including disruptions that affect our ability to deliver products to our customers. If we were unable to adequately handle these disruptions, it could adversely affect inventory levels, shipments to customers and customer service. Any such event would have a material adverse effect on our operating results.
The Company’s growth may strain operations, and finances, which could adversely affect our business and financial results.
The Company’s business has grown and continues to grow through organic growth and acquisitions. Accordingly, sales, number of stores, number of states in which we conduct business, and number of associates have grown and will likely continue to grow. This growth places significant demands on management and operational systems and may be limited by covenants and conditions in our loan agreements. If we are not successful in continuing to support our operational and financial systems, expanding our management team and increasing and effectively managing our associate base, or managing our finances, this growth is likely to result in operational inefficiencies and ineffective management of the business and associates, or financial constraints or, in the worst case, loan default, any one or more of which may in turn adversely affect our business and financial performance.
The Company’s quarterly operating results are subject to significant fluctuation.
The Company experiences seasonal fluctuations in our revenues and operating results. We typically realize a higher portion of our revenues and operating results during the fourth quarter. As a result of this seasonality, we believe that quarter to quarter comparisons of our operating results are not necessarily meaningful and that these comparisons cannot be relied upon as indicators of future performance. Our operating results have fluctuated from quarter to quarter in the past, and we expect that they will continue to do so in the future. Our earnings may not continue to grow at rates similar to the growth rates achieved in recent years and may fall short of either a prior fiscal period or investors’ expectations. Factors that could cause these quarterly fluctuations include the following: the extent to which sales in new stores result in the loss of sales in existing stores; our direct marketing, accrual or pre-opening store expenses in one or more new store locations, resulting in higher operating expenses without a corresponding increase in revenues; the transaction costs and goodwill associated with acquisitions; the impairment of such goodwill and the adverse effect on our profitability in the event that future performance does not occur as planned; the mix of products sold; pricing actions of competitors; the levels of and response rates and delays to; advertising and promotional expenses; and seasonality, primarily because the sales and profitability of our stores are typically slightly lower in the first and third quarters of the fiscal year than in other quarters. Most of our operating expenses, such as rent expense, advertising expense and employee salaries, do not vary directly with
the amount of sales and are difficult to adjust in the short term. As a result, if sales in a particular quarter are below expectations for that quarter, we may not proportionately reduce operating expenses for that quarter, and, therefore, this sales shortfall would have a disproportionately negative effect on our net income for the quarter.
If businesses we acquire do not perform as well as we expect or have liabilities that we are not aware of, we could suffer consequences that would substantially reduce our revenues, earnings and cash flows.
The Company’s business strategy includes growth of our retail sales channel, both through the development and opening of new Dover branded store sites and the acquisition and conversion of existing retail stores to the Dover brand. Our financial performance may be adversely affected as the result of such acquisitions by such factors as: (1) difficulty in assimilating the acquired operations and employees; (2) inability to successfully integrate the acquired inventory and operations into our business and maintain uniform standards, controls, policies, and procedures; (3) lower-than-expected loyalty of the customer base of the acquired business to Dover branded stores and products; (4) post-acquisition variations in the product mix offered by the stores of the acquired business, resulting in lower revenues and gross margins; (5) declines in revenues of stores of the acquired business from historical levels and those projected, and (6) the occurrence of any one or more of such factors might lead to the impairment of any goodwill associated with an acquisition and have an adverse effect on our profitability. Further, businesses we acquire may have unknown or contingent liabilities that are in excess of the amounts that we have estimated. Although we have obtained indemnification, we may discover liabilities greater than the contractual limits or the financial resources of the indemnifying party. In the event that we are responsible for liabilities substantially in excess of any amounts recovered through rights to indemnification, we could suffer severe consequences that would substantially reduce our revenues, earnings and cash flows.
Our shareholders may experience dilution in their ownership positions.
The Company has historically granted options to employees as a significant part of our overall compensation package. As of December 31, 2012, our employees and non-employee directors held vested options in the aggregate to acquire 518,678 shares of common stock, all of which were exercisable at a weighted average sale and exercise price of $4.30 per share. As previously reported, in September 2012, an employee purchased for cash 2,096 shares of the Company’s common stock through exercise of an incentive stock option at $1.24 per share. In addition, in November 2012 a senior executive officer purchased for cash 2,644 shares of the Company’s common stock through exercise of an incentive stock option at $1.24 per share. In October 2012 various employees and officers voluntarily forfeited options to purchase a total of 92,623 shares of the Company’s common stock that had an initial incentive stock option price of $10.00 per share. To the extent that option holders exercise other vested outstanding options to purchase common stock, there may be further dilution. Future grants of stock-based compensation to employees may also result in dilution. We may raise additional funds through future sales of our common stock. Any such financing may result in additional dilution to our shareholders.
In addition to causing dilution, stock option grants increase compensation expense and may negatively impact our stock price.
The Company is required to take a current charge for compensation expense associated with our grant of stock options. For the year ended December 31, 2012, we recognized $251,000 of non-cash, stock-based compensation expense. This charge has the effect of decreasing our net income and earnings per share, which may negatively impact our stock price. To the extent the Company makes future grants of stock-based compensation to employees, this charge will increase.
If the Company cannot continue to successfully generate demand from the direct market channel, it would negatively impact growth and profitability.
Revenues from the Company’s direct market channel generated 57.5% of our revenues in 2012, and we expect such demand to continue to generate a majority of our revenues for at least the next few years. Our success depends on our ability to market, advertise and sell our products effectively through our various catalogs and Internet sites. We believe that the success of our direct market channel depends on:
•
favorable economic conditions;
•
our ability to offer a product mix that is attractive to our customers;
•
our ability to provide enough value to offset competitors free shipping offers;
•
the price points of our products relative to our competitors;
•
our ability to achieve adequate purchase response rates to our mailings;
•
our ability to add new customers in a cost-effective manner;
•
timely delivery of catalog mailings to our customers;
•
an efficient Internet interface;
•
a seamless buying experience for our customers across both of our channels; and
•
cost effective and efficient order fulfillment.
Catalog production, mailings and paper-based packing products, such as shipping cartons, entail substantial paper, postage, human resource and other costs, including costs of catalog development. We incur most of these costs prior to the mailing of each catalog. Increases in costs of mailing, paper or printing could increase our costs and adversely affect our earnings if we are unable to pass such cost increases on to our customers. The success of our direct market channel hinges on the achievement of adequate response rates to mailings, merchandising, catalog and website presentations that appeal to our customers, and the expansion of our potential customer base in a cost-effective manner. Lack of consumer response to particular catalog mailings or Internet marketing efforts, search engine optimization, search engine marketing and comparison shopping engines may increase our costs and decrease the profitability of our business.
The re-launch of the Company’s retail store rollout could cannibalize existing sales from the direct market channel or existing retail locations.
In response to the recent economic recession, the Company placed on hold in most of 2009 and in 2010 its plan to increase the number of retail stores. In 2011 we began to re-launch the retail store rollout by opening two Dover-branded stores. The store rollout continued in 2012 by opening three additional Dover-branded store; Warrington, PA in Q2, Medina, MN in Q3 and Raleigh, NC in Q4. We are planning on opening an additional Dover-branded store in Q1 of 2013 and will also seek between three and five new store locations that can be opened in 2013. However, our strategy to increase the number of retail store locations is based on finding optimal locations where demand for equestrian products is high. When we open a retail store in an area that has a high concentration of our existing customers, we expect that such customers will purchase products in the retail location as well as through our catalogs and websites, ultimately increasing their total purchases as multi-channel customers. Demand from our direct market channel in the geographic area surrounding our Hockessin, DE store declined 4% in the first year of such store’s operation. In the future, in areas where we open retail stores, the customers located within the area of such store may not spend more than they would have from the catalog and websites and, therefore, there may be a shift in demand from our direct market channel to our retail market channel. In such case, we may incur significant costs associated with opening a store, shipping product to that store and mailing catalogs while not generating incremental revenue.
As the Company re-launches its retail store expansion plan, quarterly revenues and earnings could be variable and unpredictable and inventory levels will increase.
Over the next several years, as the economy continues to recover, we plan to continue our retail store expansion strategy. As we open new stores, (i) revenues may fluctuate, and (ii) pre-opening expenses will be incurred which may not be offset by a corresponding increase in revenues during the same financial reporting period. These factors may contribute to variable operating results.
Some of the expenses associated with openings of our new retail stores, such as labor incurred from increased headcount and store occupancy, will increase. Additionally, as we increase inventory levels to provide stores with merchandise, we may not be able to manage this inventory without incurring additional costs. If retail store sales are inadequate to support these new costs, our earnings will decrease.
The Company relies on service providers to operate our business and any disruption of space or substantial increases in the costs of their supply of services could have an adverse impact on our revenues and profitability.
The Company relies on a number of service providers to operate our business such as:
•
a printer and a database processor to produce and mail our catalogs;
•
a website hosting service provider to host and manage our websites, a search engine marketing consultant and an email service provider to send out customer emails;
•
telephone data companies to provide telephone, Internet and fax service to our customer service centers and to communicate between locations; and
•
shipping companies such as FedEx, the U.S. Postal Service, UPS, and common carriers for timely delivery of our catalogs and merchandise to our customers, merchandise from our suppliers, including foreign suppliers, to us and merchandise from our warehouse to our retail stores.
Any disruption in these services, or substantial cost increases in these services, may have a negative impact on our ability to market and sell our products and serve our customers and could result in increased costs to us.
The Company relies on merchandise suppliers to operate our business and any disruption of their supply of products could have an adverse impact on our revenues and profitability.
The Company relies on merchandise suppliers to supply our products in saleable condition, in sufficient quantities, at competitive prices and in a timely manner. We also rely on them to extend favorable sales terms for the purchase of their products and quality. In 2012, our single largest merchandise supplier accounted for significantly less than 10% of our sales. Our current merchandise suppliers may not be able to accommodate our anticipated product or credit needs in a timely manner or at all. If we are unable to acquire suitable merchandise in a timely manner, obtain favorable credit terms, or lose one or more key merchandise suppliers, we may not be able to offer products that are important to our merchandise assortment, which would have a material adverse effect on our business. While we believe our merchandise supplier relationships are satisfactory, we have no contractual arrangements providing for continued supply or credit terms from our key merchandise suppliers and our merchandise suppliers may discontinue selling to us at any time or may raise the cost of merchandise, and we may be unable to pass such price increases along to our customers.
If the Company does not properly manage our inventory levels, our operating results and available funds for future growth will be adversely affected.
The Company currently maintains a high level of inventory and a broad depth of products for our customers. The investment associated with this high level of inventory is substantial. If we fail to adequately predict the quantity or mix of our inventory, we will incur costs associated with stocking inventory that is not being sold or fails to meet the demands of our customers or we may be required to write off or write down inventory which would lower our operating results. If we do not meet the needs of our customers, they may purchase products from our competitors. Although we have some ability to return merchandise to our suppliers, we incur additional costs in doing so, and we may not be able to return merchandise in the future.
A natural disaster or other disruptions at our Littleton, MA warehouse fulfillment center could cause the Company to lose merchandise and prevent delivery of products to our direct sales customers and our retail stores.
The Company currently relies on the Littleton, MA warehouse to fulfill orders shipped to customers and restocking store inventories. Any natural disaster or other serious disruption to this warehouse due to fire, flood, tornado, earthquake or any other calamity could damage a significant portion of our inventory and materially impair our ability to adequately stock our retail stores, deliver merchandise to customers, and process returns to merchandise suppliers. A disruption of this type could result in lost revenues and increased costs.
If the Company loses key members of management or is unable to retain qualified staff required to operate our business, our operating results could suffer.
The Company’s future success depends to a significant degree on the skills, experience and efforts of Stephen Day, our president and chief executive officer, Jonathan Grylls, our chief strategic officer, William Schmidt, our chief operating officer and other key personnel including our senior executive management. We currently maintain two million dollars of key-man life insurance on Mr. Day, the proceeds of which are required to pay down outstanding debt. We have employment agreements with Mr. Day, Mr. Schmidt and Mr. Grylls, which contain provisions for non-competition, non-solicitation and severance. In addition, our future success depends upon our ability to attract and retain highly-skilled and motivated, full-time and temporary sales personnel with appropriate equestrian products industry knowledge and retail experience to work in management and in our retail stores. The loss of the services of any one of our executives or the inability to attract and retain qualified individuals for our key management and retail sales positions may have a material adverse effect on our operating results.
The Company may need additional financing to execute our growth strategy, which may not be available on favorable terms or at all. The inability to raise financing could increase our costs, limit our ability to grow and dilute the ownership interests of existing shareholders.
As of March 29, 2013, the Company amended its current revolving credit facility. The amended credit facility is due in full on March 29, 2015 and its borrowing limit may be increased to $20,000,000 from $13,000,000 at the sole discretion of the bank, both of which conditions may limit our ability to finance the opening of all of our planned additional stores over the next several years. In order to satisfy our revolving credit facility when due and to execute our retail store expansion strategy, we may need to borrow additional funds, raise additional equity financing or finance our planned expansion from profits, but such borrowings or new financings might be limited by the covenants and other terms in other loan agreements. We may also need to raise additional capital in the future to respond to competitive pressures or unanticipated financial requirements. We may not be able to obtain additional financing, including the extension or refinancing of our revolving credit facility, on commercially reasonable terms or at all. A failure to obtain additional financing or an inability to obtain financing on acceptable terms could require us to incur indebtedness at high rates of interest or with substantial restrictive covenants, including prohibitions on payment of dividends.
The Company may obtain additional financing by issuing equity securities that will dilute the ownership interests of existing shareholders. If we are unable to obtain additional financing, we may be forced to scale back operations or be unable to address opportunities for expansion or enhancement of our operations.
The Company relies on foreign sources for many of our products, which subjects us to various risks.
The Company currently direct sources less than one quarter of our products from foreign manufacturers located in Europe, Asia and South America and buys a majority of its products from distributors and manufacturers that also source products from foreign manufacturers. As such, we are subject to risks and uncertainties associated with changing economic and political conditions in foreign countries. These risks and uncertainties include currency rate fluctuations, manufacturing quality control risks, import duties and quotas, work stoppages, economic uncertainties including inflation, foreign government regulations, wars and fears of war, acts of terrorism and fear of acts of terrorism, political unrest and trade restrictions. Additionally, countries in which our products are currently manufactured or may be manufactured may become subject to trade restrictions imposed by the U.S. or foreign governments. Any event affecting prices or causing a disruption or delay of imports from foreign merchandise suppliers, including the imposition of additional import restrictions, currency rate fluctuations, restrictions on the transfer of funds or increased tariffs or quotas, or both, could increase the cost or reduce the supply of merchandise available to us and adversely affect our operating results.
The Company does not currently, and does not plan to, hedge against increases or decreases in the value of the U.S. dollar against any foreign currencies. Our product sourcing from foreign merchandise suppliers means, in part, that we may be affected by declines in the value of the U.S. dollar relative to other foreign currencies. Specifically, as the value of the U.S. dollar declines relative to other currencies, our effective cost of products increases. As a result, declines in the value of the U.S. dollar relative to foreign currencies would adversely affect our operating results.
As the Company continues its retail store expansion strategy, it may result in state governments asserting that the direct market channel has established state tax nexus with that state, which may cause our business to pay additional income and sales tax and have an adverse effect on the demand and related cash flows from our direct market channel.
As the Company continues its retail store expansion strategy and opens retail stores in additional states, the necessary relationship between the retail stores and the direct market channel may be deemed by certain state tax authorities to create a nexus for state income and sales taxation of our business in those states. This could result in an increase in the tax collection and payment obligations of our business, which would have an adverse effect on the sales demand and related cash flows from our direct market channel and our overall business. Such sales tax collection obligations, if any, would increase the total cost of our products to our customers. This increased cost to our customers could negatively affect the revenues of our direct market channel if we are required to reduce the underlying prices to maintain unit sales volumes for the products marketed through our direct market channel. The occurrence of either of these events would have an adverse effect on demand and related net cash flows from our direct market channel. This area of law is uncertain and changing, and we could be subject to paying back taxes and penalties.
If the Company fails to adequately protect our trademarks, our brand and reputation could be impaired or diluted, and we could lose customers.
The Company has, or has rights to, three trademarks that are considered to be material to the successful operation of our business. These trademarks are: Dover Saddlery, Smith Brothers, and The Source. We currently use all of these marks in our direct channel business. We also have several additional pending trademark applications. We regard our copyrights, service marks, trade dress, trade secrets and similar intellectual property as critical to our success. In addition to our registered marks and pending applications, our principal intellectual property rights include copyrights in our catalogs, rights to our domain names and our databases and information management systems. As such, we rely on trademark and copyright law, trade secret protection and confidentiality agreements to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights may be inadequate. Our trademark applications may not be granted, and we may not be able to secure significant protection for our marks. Our competitors or others may adopt trademarks or service marks similar to our marks or try to prevent us from using our marks, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets or other proprietary rights for any reason, our brand and reputation could be impaired or diluted, and we may lose customers.
The Company may have disputes with, or be sued by, third parties for infringement or misappropriation of their proprietary rights, which could have a negative impact on our business.
Other parties may assert claims with respect to patent, trademark, copyright or other intellectual property rights that are important to our business, such as our Dover Saddlery, Smith Brothers and The Source trademarks. Other parties might seek to block the use of, or seek monetary damages or other remedies for the prior use of, our intellectual property or the sale of our products as a violation of their trademark, patent or other proprietary rights. Defending any claims, even claims without merit, could be time-consuming, result in costly settlements, litigation or restrictions on our business and could damage our reputation.
In addition, there may be prior registrations or use of intellectual property in the U.S. or foreign countries (including, but not limited to, similar or competing marks or other proprietary rights) of which we are not aware. In all such countries, it may be possible for any third-party owner of a trademark registration in that country or other proprietary right to enjoin or limit our expansion into those countries or to seek damages for our use of such intellectual property in such countries. In the event a claim against us was successful and we could not obtain a license to the relevant intellectual property or redesign or rename our products or operations to avoid infringement, our business, financial condition or results of operations could be harmed. In addition, securing registrations does not fully insulate us against intellectual property claims, as another party may have rights superior to our registration or our registration may be vulnerable to attack on various other grounds.
Any such claims of infringement or misappropriation, whether meritorious or not, could:
•
be expensive and time consuming to defend;
•
prevent us from operating our business, or portions of our business;
•
cause us to cease selling certain products;
•
result in the loss of customers;
•
require us to re-label or re-design certain products, if feasible;
•
result in significant monetary liability;
•
divert management’s attention and resources;
•
potentially require us to enter into royalty or licensing agreements in order to obtain the right to use necessary intellectual property; and
•
force us to stop using valuable trademarks under which we market our products.
Third parties might assert infringement claims against us in the future with respect to any of our products. Any such assertion might require us to enter into royalty arrangements or litigation that could be costly to us. Any of these events could have a material adverse effect on our business.
The Company is subject to numerous regulations and regulatory changes that could impact the business or require us to modify our current business practices.
The Company is subject to numerous regulations governing the Internet and e-commerce, retailers generally, the importation, promotion and sale of merchandise, and the operation of retail stores and warehouse facilities. These regulations include customs, privacy, truth-in-advertising, consumer protection, shipping and zoning and occupancy laws and ordinances. Many of these laws and regulations may specifically impede the growth of the Internet or other online services. If these laws were to change, or are violated by our management, employees, suppliers, buying agents or trading companies, we could experience delays in shipments of our goods or be subject to fines or other penalties which could hurt our business, financial condition and results of operations.
The growth and demand for online commerce has resulted, and may continue to result, in more stringent consumer compliance burdens on companies that operate in the e-commerce segment. Specifically, certain states have enacted various legislation with respect to consumer privacy. In addition, the Federal Trade Commission and certain state agencies have been investigating various Internet companies regarding their use of personal information. The costs of compliance with federal and state privacy laws and the costs that might be incurred in connection with any federal or state investigations could have a material adverse affect on our business and operating results. Our direct market channel procedures are subject to regulation by the U.S. Postal Service, the Federal Trade Commission and various state, local and private consumer protection and other regulatory authorities. In general, these regulations govern the manner in which orders may be solicited, the form and content of advertisements, information which must be provided to prospective customers, the time within which orders must be filled, obligations to customers if orders are not shipped within a specified period of time and the time within which refunds must be paid if the ordered merchandise is unavailable or returned. From time to time, we have modified our methods of doing business and our marketing procedures in response to such regulation. To date, such regulation has not had a material adverse effect on our business or operating results. However, future regulatory requirements or actions may have a material adverse effect on our business or operating results.
Legal requirements are frequently changed and subject to interpretation, and we are unable to predict the ultimate cost of compliance with these requirements or their effect on our operations. We may be required to make significant expenditures or modify our business practices to comply with laws and regulations. Compliance with existing or future laws and regulations may materially limit our ability to operate our business and increase our costs.
The Company’s 100% satisfaction guarantee exposes us to the risk of an increase in our return rates which could adversely affect our profitability.
Part of the Company’s marketing and advertising strategy focuses on allowing customers to return products ordered from our catalogs or retail stores at any time if they are not satisfied and obtain a refund of the purchase price. As we expand our sales, our return rates may not remain within our historically low levels and could significantly impair our profitability.
The Company’s marketing expenditures may not result in increased sales or generate the levels of product and brand name awareness we desire, and we may not be able to manage our marketing expenditures on a cost-effective basis.
A significant component of the Company’s marketing strategy involves the use of direct marketing to generate sales, from both our direct and retail market channels. Future growth and profitability will depend in part on the effectiveness and efficiency of our marketing expenditures, including our ability to:
•
create greater awareness of our products and brand name;
•
determine the appropriate creative message and media mix for future marketing expenditures;
•
effectively manage marketing costs, including creative and media, to maintain acceptable costs per inquiry, costs per order and operating margins; and grow revenue when the economy rebounds; and
•
convert inquiries into actual orders.
Our marketing expenditures may not result in increased sales or generate sufficient levels of product and brand name awareness and we may not be able to maintain market share in the short run or manage such marketing expenditures on a cost effective basis.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
The Company currently leases an approximately 100,000 square foot facility in Littleton, MA for the corporate headquarters, main call center, warehouse, and fulfillment center. The Company uses approximately 92,000 square feet for warehouse space and the remaining space is used as office space. The Littleton lease was amended October 1, 2010 and expires September 30, 2020. We have one five-year option to renew thereafter.
The Company leases approximately 2,000 square feet of space in North Conway, NH for use as a satellite call center and for our creative design offices. We lease approximately 5,100 square feet of space in Denton, TX for use as a satellite call center and additional offices.
As of December 31, 2012, the Company leased approximately 153,000 square feet of space for our eighteen retail stores located in Massachusetts (1), Virginia (3), New Hampshire (1), Maryland (2), Delaware (1), Texas (2), New Jersey (1), Georgia (1), Colorado (1), Illinois (1), Pennsylvania (1), Minnesota (1), North Carolina (1) and Rhode Island (1).
Item 3.
Item 3. Legal Proceedings.
From time to time, the Company is exposed to litigation relating to our products and operations. The Company is not currently engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material, adverse affect on our financial condition or results of operations.
Item 4.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market Information.
The Company’s common stock trades on The NASDAQ Stock Market LLC under the symbol “DOVR”. As of March 5, 2013, the record date for our 2013 Annual Meeting of Stockholders, the number of holders of record of our common stock was 26 and the approximate number of beneficial owners was 1,150.
The following table sets forth, for the periods indicated, the high and low sales prices for our common stock for each full quarterly period within the two most recent fiscal years, as reported on the NASDAQ Stock Market LLC:
The Company has never declared or paid any cash dividends on our common stock. We currently intend to retain any earnings for use in the operation and expansion of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future. Moreover, our current revolving credit facility and term note contains provisions which restrict our ability to pay dividends.
The information required to be disclosed by Item 201(d) of Regulation S-K, “Securities Authorized for Issuance Under Equity Compensation Plans,” is included under Item 12 of Part III of this Annual Report on Form 10-K.
Recent Sales of Unregistered Securities; Uses of Proceeds from Registered Securities.
The Company did not issue or sell any equity securities in the twelve months ended December 31, 2012, other than (as previously reported) as the result of exercise in September and November 2012 of certain vested stock options to purchase a total of 4,740 shares of our common stock, resulting in $2,599 and $3,279, respectively, of proceeds, which the Company applied in full for general working capital purposes during the respective three month periods ended September 30, 2012 and December 31, 2012. In the fourth quarter of 2012, options to purchase 92,643 shares of the Company’s common stock were voluntarily forfeited by holders of those options. The Company continues to reserve that numbers of shares to cover the potential future award of options and their possible exercise.
For history of the Company’s debt and equity financing activity prior to January 1, 2012, see Part II, Items 5 and 9B of the Company’s Annual Report on Form 10-K for the fiscal year ending December 31, 2011, as filed with the SEC on March 29, 2012.
Issuer Purchases of Equity Securities
During the fiscal year ended December 31, 2012, there were no repurchases made by us or on our behalf, or by any “affiliated purchasers” of shares of our common stock.
Item 6.
Item 6. Selected Financial Data
Not Applicable to Smaller Reporting Company.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
This Annual Report on Form 10-K, including the following discussion, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve substantial risks and uncertainties. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, the words “projected”, “anticipated”, “planned”, “expected”, and similar expressions are intended to identify forward-looking statements. In particular, statements regarding a rebounding economy, retail store expansion and business growth are forward-looking statements. Forward-looking statements are not guarantees of our future financial performance, and undue reliance should not be placed on them; our actual results, performance or achievements may differ significantly from the results, performance and achievements discussed in or implied by the forward-looking statements. Factors that could cause such a difference include material changes to Dover Saddlery, Inc.’s business or prospects, in consumer spending, fashion trends or consumer preferences, or in general political, economic, business or capital market conditions and other risks and uncertainties, including but not limited to the other factors that are detailed in “Item 1A. Risk Factors.” We disclaim any intent or obligation to update any forward-looking statements.
Overview
The Company is the leading, specialty retailer and the largest multi-channel marketer of equestrian products in the U.S. For over 35 years, Dover Saddlery has been a premier upscale marketing brand in the English-style riding industry. We sell our products through a multi-channel strategy. This multi-channel strategy has allowed us to use catalogs and our proprietary database of over two million names of equestrian enthusiasts as a primary marketing tool to increase catalog sales and to drive additional business to our e-commerce websites and retail stores.
In November of 2005, Dover Saddlery was taken public using the Open IPO ® process. The proceeds of that offering were used to retire debt and launch our retail rollout.
The Company’s strategy for growth has been to open additional retail stores using the proprietary, mathematical, store optimization model to select the sites. Our initial target of opening 50 retail locations in addition to the 3 stores operating at the IPO, is now 30% complete, with 15 new locations since our IPO. For 2013 through 2017, the Company estimates that it could open on average four stores annually from cash flow and borrowing under its line of credit from its bank and may proceed under that plan if and as the economy improves. In order to open more than four stores per year, the Company may need to raise additional debt and/or equity capital. Depending on the store size in terms of area, the local lease and construction rates which vary widely across the country, the Company estimates that it would need to invest between $700,000 to $1,200,000 to pay for fixtures, equipment, leasehold improvements, inventory and pre-opening expenses for each store opened. The Company makes no representation that it will open any new stores in the next few years or what each store shall cost to open.
The recovery in 2010 and 2011 from the recession that ended in 2009 has been uneven and slow and created a difficult operating environment for our industry as a result of numerous external factors that led to all time historical lows in consumer confidence which resulted in a contraction in specialty retail consumer spending. In 2012, our prior investment in our retail expansion and the opening of three additional retail stores generated a 19.9% increase in retail market channel revenues, to partially offset the economic drop in direct channel revenues, resulting in $86.0 million in total revenues. Although our overall sales increased over 2011, increased cost of goods sold and expenses in marketing and salaries, generated an Adjusted EBITDA* of $4.6 million, a decrease of 3.1% over the 2011 results. The resulting net income was $1,589,000 or $0.29 per diluted share. The Company utilized the resulting operating cash flow to fund inventory growth, strengthen our balance sheet and open three additional retail stores, which places the Company in a strategic position for further growth as the retail economy improves.
In 2010 the Company developed several short-term strategies to maintain or expand market share, reduce operating costs and reduce capital expenditures, which included the suspension of new store openings. In 2011, our retail expansion was resumed but on a conservative basis by opening just two stores. Our retail expansion continued in 2012, with opening an additional three stores with our 19th store scheduled to open in Q1 of 2013, and we will continue to be extremely opportunistic in renegotiating existing leases and negotiating new leases. Management believes new retail lease costs should drop resulting in enhanced store profitability for new stores opened with a lower lease cost.
The Company believes that the following strategic actions, initiated in 2009, allowed us to successfully weather the recent recession and slow recovery and generate positive growth in sales and earnings as consumer confidence improved and the economy turned around. These are:
•
Cost control particularly in the area of targeted marketing, direct labor in the warehouse, call center and retail stores, and management salaries.
•
Reduction in capital expenditures by curtailing store expansion and being extremely opportunistic in present and future lease negotiations.
•
Careful monitoring of same store sales growth and direct marketing response rates in order to determine when the Company’s customers have returned to normal spending behavior, which will allow Dover to increase its marketing activities.
•
Slowly re-launching our retail store expansion strategy by opening two stores in 2011 and three stores in 2012.
In this time of economic uncertainty, it is very difficult to accurately predict economic trends; however, improving economic indicators such as falling unemployment rates and expanding GDP and increased buying from our customer base, gives us the confidence to continue the store expansion strategy in 2013.
* We reference Adjusted EBITDA in this Overview because we consider it an important supplemental measure of our performance; indeed, the Company ties its executive and employee bonus pools directly to this measure. Also, we believe it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry. Its definition and limitations are set forth in this section under “Results of Operations”, Management’s Discussion and of Analysis and Financial Condition and Results of Operations, of Item 7 of this Annual Report on Form 10-K.
Consolidated Performance and Trends
The Company reported consolidated net income for the year ended December 31, 2012 of $1,589,000 or $0.29 per diluted share. This is compared to net income of $1,724,000 or $0.31 per diluted share for the corresponding period in 2011.
The 2012 results reflect our continuing efforts to execute our growth strategy in the retail market channel where revenues increased 19.9% to $36.6 million for the year. This trend of increased revenue in the retail market channel may be slowed or eroded by delays in the execution of our new store expansion strategy, constraints in available capital, and interim declines in consumer demand at our retail stores impacted by lingering effects of the recent global financial and credit crisis. The Company responds to fluctuations in revenues primarily by delaying the opening of new stores, adjusting marketing efforts and operations to support our retail stores and managing costs. The success of our new store growth plan is dependent upon the response of our customers to these marketing strategies and evolving market conditions. Our direct market channel revenues decreased 1.7%, to $49.5 million for the year ended 2012, due to more aggressive posture of online retailers and our customer’s temporarily shifting to retail as the Company opens new stores. We anticipate and respond to fluctuations in our direct customers’ response by adjusting the quantities of catalogs mailed and other Internet marketing and customer-related strategies and tactics in order to maximize revenues and manage costs.
Revenues
The Company markets and sells the most comprehensive selection of products in the equestrian industry. We currently derive our revenues from product sales from two integrated market channels: direct and retail. Our direct market channel generates product sales from both catalog mailings and Internet marketing, and our retail store sales consist of product sales generated by our retail market channel. We sell to the English-style riding market through our Dover Saddlery brand and to the Western-style riding market through our Smith Brothers brand.
In 2012, approximately 57.5% of our revenues were generated by our direct market channel and 42.5% were generated by our eighteen retail stores, which increased from the 37.7% of retail sales in 2011, due primarily from gains achieved from strong sales growth from our newer stores as they mature, three additional retail stores and promotions. All revenues are recorded net of product returns. In addition, beginning in the first quarter of 2012, the Company began to recognize revenue from the breakage of gift cards when the likelihood of redemption of the gift card is remote and there is no legal obligation for the Company to remit the value of such unredeemed gift cards to any relevant jurisdiction. Revenue was recognized in both retail and direct market channels based on where the gift card was issued.
Revenues from our product sales are seasonal. In addition, our revenues can be affected by the timing of our catalog mailings. In 2012, 30.7% of our annual revenues were generated in the fourth quarter.
Cost of Revenues
The most significant components of the Company’s cost of revenues are product, purchasing, handling and transportation costs to obtain the products and ship them to our customers and stores. We manage our integrated merchandising efforts by forming positive relationships with over 500 suppliers to ensure competitive costs and the most up-to-date and complete product offering for our customers. We have implemented procedures to promote labor efficiencies in the handling of our products. In addition, we work closely with transportation companies in negotiating competitive rate structures to minimize our freight costs.
Gross Profit
The Company’s gross profit as a percentage of revenues varies according to the season of the year and the mix of products sold. Our gross profit may not be comparable to other specialty retailers, as some companies include all of the costs related to distribution in cost of revenues while others, like us, exclude all or a portion of the costs related to distribution from cost of revenues and include them in selling, general and administrative expenses.
Selling, General and Administrative Expenses
The Company’s selling, general and administrative expenses consist primarily of:
•
advertising, marketing and other brand-building costs, primarily associated with developing, printing and distributing our catalogs and purchasing internet advertising;
•
labor and related costs for order processing, and salaries and related costs for marketing, creative, administrative and executive personnel;
•
infrastructure costs, insurance, utilities and information system costs;
•
credit card processing fees;
•
occupancy and other overhead costs;
•
store pre-opening costs;
•
public company, professional fees and other legal, accounting and related costs; and
•
non-cash, stock-based compensation, depreciation and amortization.
As the long-term strategy will continue to focus on increasing our market penetration and continuing to build brand awareness, we anticipate that selling, general and administrative expenses will continue to increase in absolute dollars for the foreseeable future. Total selling, general and administrative costs as a percentage of our revenues are not likely to decrease in the foreseeable future as we intend to continue to take advantage of our market-leading position in the equestrian industry by building on the Dover Saddlery and Smith Brothers brands. We also expect our general and administrative expenses will remain high due to our operations as a public company.
Fiscal Periods
Our fiscal year ends on December 31, and our fiscal quarters end on March 31, June 30, September 30 and December 31.
Results of Operations
The following table sets forth results of operations for the periods shown (dollars in thousands):
(1) Includes seventeen Dover-branded stores and one Smith Brothers store. The Warrington, PA Dover-branded store opened in Q2 of 2012, Medina, MN store opened in Q3 of 2012 and the Raleigh, NC store opened in Q4 of 2012.
(2) When we use the term “Adjusted EBITDA”, we are referring to net income minus interest income and other income plus interest expense, income taxes, non-cash stock-based compensation, depreciation, amortization and other investment (income) loss, net. We present Adjusted EBITDA because we consider it an important supplemental measure of our performance and believe it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry.
Adjusted EBITDA has some limitations as an analytical tool and you should not consider it in isolation or as a substitute for net income, operating income, cash flows from operating, investing or financing activities or any other measure calculated in accordance with U.S. generally accepted accounting principles. Some of the limitations are:
•
Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or capital commitments;
•
Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;
•
Adjusted EBITDA does not reflect the impact of an impairment charge that might be taken, when future results are not achieved as planned, in respect of goodwill resulting from any premium that the Company might pay in the future in connection with potential acquisitions;
•
Adjusted EBITDA does not reflect the interest expense or cash requirements necessary to service interest or principal payments on our debt;
•
Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements;
•
Although stock-based compensation is a non-cash charge, stock options previously awarded, together with additional stock options that might be granted in the future, might have a future dilutive effect on earnings and EPS;
•
Other companies in our industry may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.
The following table reconciles net income to Adjusted EBITDA (in thousands):
(*) Includes the cumulative impact of the change in gift card breakage income of $684,007 recorded in the first quarter of 2012 and current breakage income for year ended December 31, 2012 of $172,350. There was no breakage recorded for the same period in 2011.
The following table sets forth our results of operations as a percentage of revenues for the periods shown (1):
(1) Some of these amounts may not sum properly due to rounding.
Comparison of Years Ended December 31, 2012 and 2011
Revenues
Total revenues increased $5.2 million, or 6.5%, to $86.0 million for the year ended December 31, 2012 from $80.8 million for the year ended December 31, 2011. Revenues in our direct market channel decreased $0.8 million, or 1.7%, to $49.5 million from $50.3 million in the corresponding period in 2011. Revenues in our retail market channel increased $6.1 million, or 19.9%, to $36.5 million from $30.5 million in 2011. The decrease in our direct market channel was due to the more aggressive posture of online retailers and our customer’s shifting to retail as the Company opens new stores. The increase in revenues from our retail market channel was due to strong sales growth from our newer stores as they mature, three additional retail stores and promotions. Same store sales for the twelve month period increased 6.0% over the prior year. In addition, gift card breakage revenue of $856,357, including a cumulative impact of $684,007, was recognized during the year ending December 31, 2012. The revenue was recognized in both retail and direct market channels based on where the gift card was issued. There was no gift card breakage recorded for the same period in 2011.
Gross Profit
Gross profit for the year ended December 31, 2012 increased $1.7 million, or 5.5%, to $32.7 million from $31.0 million for the corresponding period in 2011. Gross profit, as a percentage of revenues, for the year ended December 31, 2012 decreased 0.3% to 38.0% from 38.3% for the corresponding period in 2011. The increase in gross profit of $1.7 million was attributable to increased revenues in the retail channel and gift-card breakage income. The decrease in gross profit as a percentage of revenues was attributable to variations in our overall product mix and promotions.
Selling, General and Administrative
Selling, general and administrative expenses increased $2.0 million, or 7.5%, for the year ended December 31, 2012 to $29.2 million from $27.2 million for the corresponding period in 2011. Increased marketing costs of $683,000, lease expense of $383,000, professional fees of $148,000 and labor costs of $669,000 were the primary causes for this increase in SG&A expenses. SG&A expenses, as a percentage of revenues, increased to 34.0% of revenues from 33.7% of revenues for the corresponding period in 2011 due to increased marketing, lease expense, professional fees and labor costs. Labor and lease expense increased primarily due to the additional number of stores as compared to last year. Professional and marketing costs largely reflect our ongoing investments to improve our Internet channel.
Interest Expense
Interest expense, including amortization of financing costs, attributed primarily to our term note and revolving credit facility decreased $190,000 or 26.1% to $538,000 for the year ended December 31, 2012 from $727,000 for the same period in 2011. In the first quarter of 2011, there was an increase of $243,000 which was attributed to expensing unamortized, deferred financing costs and the debt discount upon the refinancing of the senior subordinated notes on March 28, 2011.
Other Investment Income
Net loss from investment activities consists of the Company’s share of net earnings or loss of its affiliate as they occur. The Company’s net investment loss for the year ended December 31, 2012 was $39,000, an increase of $21,000 over its net investment loss of $18,000 in 2011. The Company’s investment loss from investment activities are related to our investments in Hobby Horse Clothing Company, Inc. (“HH”) and Horsepharm, LLC.
Income Tax Provision
The provision for income taxes was $1,277,000 for the year ended December 31, 2012, reflecting an effective tax rate of 45%, compared to $1,306,000 for the corresponding period in 2011, reflecting an effective tax rate of 43%. The effective tax rate in 2012 increased due primarily to an earnings mix by state and the impact of certain permanent tax items.
Net Income
The net income for the year ended December 31, 2012 decreased $135,000 or 7.8%, to $1,589,000 from $1,724,000 for the corresponding period in 2011. This decrease in profitability of $135,000 (which is net of the after-tax gift card breakage revenue recognized for the period) was due primarily to increased SG&A expenses related to marketing, lease expense, professional fees and labor costs that increased at a higher pace than revenue and gross margin. In addition, weaker than prior-year direct sales (as explained in Revenues above) reduced the gross margin contribution. The resulting income per diluted share decreased to $0.29 for the year ended December 31, 2012 as compared to $0.31 for the corresponding period in 2011.
Non-GAAP Financial Measures and Information
From time to time, in addition to financial results determined in accordance with generally accepted accounting principles in the United States (“GAAP”), the Company provides financial information determined by methods other than in accordance with GAAP. The Company’s management uses these non-GAAP measures in its analysis of the Company’s performance and ongoing operations. For example, the Board of Directors has a long-standing policy to use Adjusted EBITDA (defined in “Results of Operations” of Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Item 7 of our Annual Report on Form 10-K) in determining the availability and amounts of bonus awards for the Company’s senior management and key employees. The Company believes that these non-GAAP operating measures supplement our GAAP financial information and provide useful information to investors for evaluating the Company’s operating results, and trends that may be affecting the Company’s business, as they allow investors to more readily compare our operations to prior financial results, and our future performance. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.
Seasonality and Quarterly Fluctuations
Since 2001, our quarterly product sales have ranged from a low of approximately 20% to a high of approximately 32% of any calendar year’s results. The beginning of the spring outdoor riding season in the northern half of the country has typically generated a slightly stronger second quarter of the year, and the holiday buying season has generated additional demand for our normal equestrian product lines in the fourth quarter of the year. Revenues for the first and third quarters of the calendar year have tended to be somewhat lower than the second and fourth quarters. We anticipate that our revenues will continue to vary somewhat by season. The timing of our new retail store openings has had, and is expected to continue to have, a significant impact on our quarterly results. We will incur one-time expenses related to the opening of each new store. As we open new stores, (i) revenues may spike and then settle, and (ii) pre-opening expenses, including occupancy and management overhead, are incurred, which may not be offset by correlating revenues during the same financial reporting period. As a result of these factors, new retail store openings may result in temporary declines in operating profit, both in dollars and as a percentage of sales.
Liquidity and Capital Resources
For the year ended December 31, 2012, our cash decreased by $14,000. Cash was utilized primarily for seasonal working capital requirements. The source for cash generated related to increased balances in our credit facility, increased balances in depreciation and amortization, and net income. On May 10, 2012, the Company amended its line of credit facility with the bank with the potential to increase the available credit from $13,000,000 up to $20,000,000 at the bank’s discretion. On March 28, 2011, the Company also refinanced the $5,000,000 Senior Subordinated Notes plus deferred interest from proceeds of a $5,500,000 term note facility from the bank at a reduced interest rate. The Company was in compliance with all covenants under both credit facilities as of December 31, 2012.
If necessary, we plan in the future to seek additional financing from banks, or through public offerings or private placements of debt or equity securities, strategic relationships, or other arrangements. In the event we fail to meet our financial covenants with our bank, we may not have access through our line of credit to sufficient working capital to pursue our growth strategy, or if our covenant non-compliance triggers a default, our loans may be called requiring the repayment of all amounts on our loans.
Operating Activities
Cash provided by our operating activities for the year ended December 31, 2012 was $2.7 million compared to cash utilized of $1.5 million for the corresponding period in 2011. For the year ended December 31, 2012, cash outflows consisted primarily of an increase in accounts receivable of $1.0 million, increase in inventory of $0.5 million, increase in deferred taxes of $0.5 million and reductions in gift certificate liability and accounts payable of $1.2 million. Cash inflows were attributable to the results of operations which consisted of net income, non-cash expenses of depreciation, amortization, accrued expenses, stock based compensation and other expenses, which totaled $5.9 million. For the year ended December 31, 2011, cash outflows consisted primarily of an increase in inventory of $3.5 million, payment of deferred finance of $0.4 million, reduction in accounts receivable of $0.3 million, reduction in prepaid expenses of $0.3 million, reduction in deferred taxes of $0.2 million and reductions in income taxes payable of $0.1 million. Cash inflows were attributable to the results of operations which consisted of net income, non-cash expenses of depreciation, amortization, non-cash interest, accrued expenses, stock based compensation and other expenses, which totaled $3.3 million.
Investing Activities
Cash utilized from our investing activities was $2.4 million for the year ended December 31, 2012 compared to $1.4 million for the corresponding period in 2011. Investing activities consisted primarily of retail store improvement costs and new store equipment and fixtures. As additional stores are opened, the Company invests in inventory in order to initially stock the store with product.
Financing Activities
Net cash utilized by our financing activities was $0.3 million for the year ended December 31, 2012, compared to cash of $2.4 million provided in the corresponding period in 2011. We funded our seasonal operating activities with net borrowings of $0.5 million under our revolving credit.
Revolving Credit Facility
On March 28, 2011, the Company and its bank, RBS Citizens, N.A., amended the revolving line of credit agreement in connection with the refinancing of the $5,000,000 senior subordinated notes. On May 10, 2012, the Company extended the revolving line of credit to April 30, 2014. Under the amended revolving line of credit, the Company can borrow up to $13,000,000, of which up to $1,000,000 can be in the form of letters of credit, and increase this amount up to $20,000,000 at the discretion of the bank. Any outstanding balances borrowed under the credit facility are due April 30, 2014. The credit facility bears interest at the base rate, announced from time to time by the bank, plus an applicable margin determined by the Company’s funded debt ratio. As of December 31, 2012, the LIBOR rate (base rate) was 0.21%, plus the applicable margin of 2.50%. Interest is payable monthly. At its option, the Company may have all or a portion of the unpaid principal under the credit facility bear interest at a base rate using either LIBOR or the prime rate.
On March 29, 2013, the Company and the bank amended the revolving line of credit so that the Company can borrow three term loans for capital expenditures used to open new stores. Under the amended revolving line of credit, the Company can borrow up to $13,000,000, of which up to $1,000,000 can be in the form of letters of credit and up to $8,000,000 can be advanced as term loans, and increase the $13,000,000 maximum up to $20,000,000 at the discretion of the bank. Funds available under the revolving portion of the line shall be reduced by the outstanding balance of the letters of credit and term loans. The Company borrowed $2,340,000 as a term loan on March 29, 2013 with equal principal repayments over 60 months. The Company may also borrow an additional $2,500,000 by December 31, 2013 and $3,000,000 by December 31, 2014 to fund capital expenditures for store openings. The term loan to be funded in 2014 and 2015 will be interest only for 6 months followed by equal principal repayments over 54 months. Any outstanding balances borrowed under the credit facility are due in full on March 29, 2015 unless the revolving line of credit is renewed in 2014 for another year. The credit facility bears interest at the base rate, announced from time to time by the bank, plus an
applicable margin determined by the Company’s funded debt ratio. As of March 29, 2013 the LIBOR (base rate) was 0.21%, plus the applicable margin of 2.50%. Interest is payable monthly. At its option the Company may have all or a portion of the unpaid principal under the credit facility bear interest at various LIBOR or prime rate options.
The Company is obligated to pay commitment fees of 0.25% per annum on the average daily, unused amount of the line of credit during the preceding quarter. All assets of the Company collateralize the senior revolving credit facility. Under the terms of the credit facility, the Company is subject to certain covenants including, among others, maximum funded debt ratios, minimum fixed charge ratios, current asset ratios, and capital expenditures.
Under the terms of this credit facility, the Company is subject to various covenants. For the period ending September 30, 2012, the Company obtained a waiver for non-compliance with its Fixed Charge Coverage Ratio covenant under the credit facility. At December 31, 2012, the Company was in compliance with all of the covenants under the credit facility.
Term Notes, Senior Subordinated Notes Payable and Warrants
On March 28, 2011, the Company borrowed $5,500,000 in the form of a 7-year term note from the bank to refinance the $5,000,000 senior subordinated notes and deferred interest on those notes. The initial floating rate interest on the $1,600,000 of principal (the variable interest rate portion of the term note) was 5.4% consisting of a 1.0% LIBOR floor plus a 4.4% margin. The initial floating rate interest on the $3,900,000 of principal (fixed portion of the term note with the interest rate swap discussed below) was LIBOR plus 4.4%. On April 1, 2011, the Company entered into an interest rate swap contract to fix the interest rate at 7.4% on $3,900,000 of the term note principal. The remaining $1,600,000 of the principal bears interest at a floating rate based on a base rate, with a minimum of 1.0% as announced from time to time by the bank, plus a 4.4% margin. As of December 31, 2012, the LIBOR rate (base rate) was 0.21%. Interest is payable monthly. The Company is obligated to repay $786,000 of principal annually commencing in April 2013 and extending to March 2018. The Company is further obligated to accelerate repayment of up to $1,600,000 in principal in the event it has excess cash flow determined by a cash flow recapture formula. All assets of the Company collateralize the term note facility. Under the terms of the term note facility, the Company is subject to certain covenants including, among others, maximum funded debt ratios, minimum fixed charge ratios, minimum current asset ratios, and maximum capital expenditures. The Company has realized significant interest savings as a result of refinancing the senior subordinated notes.
In connection with the issuance of the prior subordinated notes, the Company issued warrants to the note holders, exercisable at any time after December 11, 2007 for an initial 118,170 shares of its common stock at a revised exercise price of $2.75 per share. The number of shares to be received for the warrants, upon exercise, is subject to change in the event of additional equity issuances and/or stock splits. The warrants were estimated to have a fair value of $272,000, which was reflected as a discount of the proceeds. The discount was amortized through interest expense while the notes were outstanding and the unamortized discount was fully expensed at refinancing. The warrants issued in connection with the subordinated notes are still outstanding and terminate on December 10, 2016.
Working Capital and Capital Expenditure Needs
The Company believes our existing cash, cash equivalents, expected cash to be provided by our operating activities, and funds available through our revolving credit facility will be sufficient to meet our currently planned working capital and capital expenditure needs over at least the next twelve months. We anticipate increasing capital expenditures by adding stores in 2013 and beyond. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our marketing and sales activities, the expansion of our retail stores, the acquisition of new capabilities or technologies and the continuing market acceptance of our products. To the extent that existing cash, cash equivalents, cash from operations and cash from our revolving credit facility under the conditions and covenants of our credit facilities are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. Although we are currently not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, businesses, services or technologies which we anticipate would require us to seek additional equity or debt financing, we may enter into these types of arrangements in the future. There is no assurance that additional funds would be available on terms favorable to us or at all. Funds from our revolving credit facility may not be available if we fail to meet the financial covenants contained in the loan agreements with our lender. For the period ending September 30, 2012, the Company obtained a waiver for non-compliance with its Fixed Charge Coverage Ratio covenant under the credit facility. At December 31, 2012, the Company was in compliance with all of its covenants under the credit facility.
Off-Balance Sheet Arrangement
As of December 31, 2012, we had no off-balance sheet arrangements as defined in Item 303(a) (4) of the Securities and Exchange Commission’s Regulation S-K.
Critical Accounting Policies and Estimates
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses, and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates.
The Company believes that of our significant accounting policies, which are described in the notes to our consolidated financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, we believe that the following accounting policies are the most critical to fully understanding and evaluating our consolidated financial condition and results of operations. In addition, we define our same store sales to include sales from all stores open for a full fifteen months following a grand opening, or a conversion to a Dover-branded store.
Revenue Recognition
Revenues are recognized when payment is reasonably assured, the product is shipped and title and risk of loss have transferred to the customer. For direct merchandise sales, this occurs when product is delivered to the common carrier at the Company’s warehouse. For retail sales, this occurs at the point of sale. For the periods presented, the merchandise returns reserve has been decreased from 15.0% to 13.5% to reflect recent trends; resulting in reserves of $815,000 and $877,000 for the years ended December 31, 2012 and 2011, respectively. We do not anticipate additional changes to the future trends of our merchandise returns.
Shipping and handling fees charged to the customer are recognized at the time the products are shipped to the customer and are included in net revenues. Shipping costs are included in cost of goods sold.
Gift Card and Gift Card Breakage
The Company’s proceeds from the sale of gift cards are recorded as a liability and are recognized as revenue when the cards are redeemed for merchandise. Through the year ending December 31, 2011, all unredeemed gift card proceeds were reflected as a liability until redeemed. During the first quarter of 2012, the Company identified a history of redemption and breakage patterns associated with its gift cards, which support a change in the estimate of the term over which the Company recognizes income on gift card breakage. Accordingly, beginning with the first quarter of 2012, the Company began to recognize revenue from the breakage of gift cards when the likelihood of redemption of the gift card is remote and there is no legal obligation for the Company to remit the value of such unredeemed gift cards to any relevant jurisdiction.
The Company determines its gift card breakage rate based upon historical redemption patterns. Based on this historical information, the likelihood of a gift card remaining unredeemed can be reasonably estimated at the time of gift card issuance. From the point which the likelihood of redemption is deemed to be remote (gift cards that were issued three years prior and remain unredeemed) and for which there is no legal obligation to remit the value of such unredeemed gift cards to any relevant jurisdictions, breakage income is recognized over a two year period. Breakage revenue for the year ending December 31, 2012 of $856,357 was recognized as revenue, net, in the accompanying condensed consolidated statement of income and comprehensive income, which included the cumulative impact of the change of $684,007. There was no breakage recorded for the same period in 2011. The gift certificate liability balance was $2.4 million and $2.2 million for the years ending December 31, 2012 and 2011, respectively.
Inventory Valuation
Inventory consists of finished goods in the Company’s mail-order warehouse and retail stores. The Company’s inventory is stated at the lower of cost, with cost determined by the first-in, first-out (FIFO) method, or net realizable value. The Company maintains a reserve for excess and obsolete inventory. This reserve was $120,000 for the years ended December 31, 2012 and 2011. The Company continuously monitors the salability of its inventories to ensure adequate valuation of the related merchandise. Inventory valuation charges have remained consistent throughout each period presented.
Advertising Costs and Catalog Expenses
The costs of direct-response advertising materials, primarily catalog production and distribution costs, are deferred. These costs are recognized over the period of expected future revenue, which is less than one year. Advertising costs not related to our direct response catalogs and marketing activities are expensed as incurred.
Income Taxes
The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial statement and tax basis of assets and liabilities and net operating loss and credit carry forwards using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when it is more likely than not that some portion of the deferred tax assets will not be realized.
The Company has reviewed its tax positions to determine whether the positions are more likely than not to be sustained upon examination by regulatory authorities. If a tax position meets the more-likely-than-not standard, then the related tax benefit is measured based on a cumulative probability analysis of the amount that is more-likely-than-not to be realized upon ultimate settlement or disposition of the underlying issue. At December 31, 2012 the Company’s tax liability was $3,000 for unrecognized tax benefits compared $33,000 in 2011. The tax liability was reduced by $30,000 due to the expiration of the statutory examination period for certain tax positions taken in 2007.
Stock-based Compensation
The Company accounts for share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the statements of income and comprehensive income based on their fair values. Refer to Note 7 for further discussion of stock-based compensation recognized for periods presented.
Impairment of Long-lived Assets
The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to discounted future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. The Company does not believe that any of our long-lived assets were impaired as of December 31, 2012 and 2011.
Recent Accounting Pronouncements
In May 2011, the FASB issued an amendment to ASU 2011-04, Fair Value Measurement and disclosure. Among other things, the guidance expands the disclosure requirements around fair value measurements categorized in Level 3 of the fair value hierarchy and requires disclosure of the level in the fair value hierarchy of items that are not measured at fair value in the statement of financial position but whose fair value must be disclosed. It also clarifies and expands upon existing requirements for measurement of the fair value of financial assets and liabilities as well as instruments classified in shareholders’ equity. The guidance is effective for interim and annual periods beginning after December 15, 2011. The adoption of this accounting pronouncement did not have a material impact on our financial statements
ASU 2011-05, Presentation of Comprehensive Income, amends the guidance in ASC 220, Comprehensive Income, by eliminating the option to present components of other comprehensive income (OCI) in the statement of stockholders’ equity. Instead, the new guidance now requires entities to present all non-owner changes in stockholders’ equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. The components of OCI have not changed, nor has the guidance on when OCI items are reclassified to net income; however, the amendments require entities to present all reclassification adjustments from OCI to net income on the face of the statement of comprehensive income. For public entities, the amendments in the ASU are effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2011. The amended guidance must be applied retrospectively and early adoption is permitted. The Company adopted this disclosure guidance as of December 31, 2011. The Company recognized no elements of OCI prior to the year ending December 31, 2011.
In February 2013, the FASB issued Accounting Standards Update 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The guidance in this ASU requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles (U.S. GAAP) to be reclassified in its entirety to net income. For other amounts that are not required under U .S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is reclassified to a balance sheet account instead of directly to income or expense in the same reporting period. The amendments in this ASU do not change the current requirements for reporting net income or other comprehensive income in financial statements. Public companies are required to comply with the requirements of this ASU for all reporting periods (interim and annual) beginning after December 15, 2012. The Company expects to adopt this amendment in the first quarter of 2013 and does not expect the adoption to have a material impact on its consolidated financial statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
Foreign Currency Risk
All of the Company’s revenues are derived from transactions denominated in U.S. dollars. We purchase products in the normal course of business from foreign manufacturers. As such, we have exposure to adverse changes in exchange rates associated with those product purchases, but this exposure has not been significant.
Impact of Inflation
The Company believes the effects of inflation, if any, on our results of operations and financial condition have not been material in recent years.
Interest Rate Sensitivity
The Company had cash and cash equivalents totaling $0.3 million at December 31, 2012. The unrestricted cash and cash equivalents were held for working capital purposes. We do not enter into investments for trading or speculative purposes. We intend to maintain our portfolio of cash equivalents, including money market funds and certificates of deposit. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value as a result of changes in interest rates. As of December 31, 2012, all of our investments were held in money market funds.
The Company’s exposure to market risk also relates to the increase or decrease in the amount of interest expense we must pay our outstanding debt instruments, primarily certain borrowings under our revolving credit facility and on the $1,600,000 of the term notes that bear interest at a floating rate. The advances under this revolving credit facility and the $1,600,000 of principal of the term note bear a variable rate of interest determined as a function of the prime rate or the published LIBOR rate at the time of the borrowing. If interest rates were to increase by two percent, the additional interest expense during the year ended December 31, 2012 would have been approximately $62,000. At December 31, 2012, $1,515,000 was outstanding under our revolving credit facility.
The Company uses an interest rate swap contract as a cash flow hedge to eliminate the cash flow exposure of interest rate movements on variable rate debt. The Company’s term note is a variable rate instrument. On April 1, 2011 the Company entered into a 7-year interest rate swap contract on the notional value of $3,900,000 of the term note which requires payment of a fixed interest rate of interest (7.4%) and the receipt of a variable rate of interest, based on one month LIBOR rate, on the $3,900,000.
The Company designated this interest rate swap contract as an effective cash flow hedge. The Company anticipates that this contract will continue to be effective. The Company does not hold any derivative instruments that are not designated as a hedging instrument.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The Company has elected as a smaller reporting company not to furnish certain quarterly financial data and other supplementary data.
DOVER SADDLERY, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income and Comprehensive Income
Consolidated Statements of Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of Dover Saddlery, Inc.
Littleton, Massachusetts
We have audited the accompanying consolidated balance sheets of Dover Saddlery, Inc. and subsidiaries (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of income and comprehensive income, stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Dover Saddlery, Inc. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
/s/ McGladrey LLP
Boston, Massachusetts
April 1, 2013
DOVER SADDLERY, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
DOVER SADDLERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
DOVER SADDLERY, INC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes.
DOVER SADDLERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
See accompanying notes.
DOVER SADDLERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Operations and Organization
Dover Saddlery, Inc., a Delaware corporation (the “Company”), is a leading specialty retailer and the largest multi-channel marketer of equestrian products in the United States. The Company sells products through a multi-channel strategy, including direct and retail, with stores located in Massachusetts, New Hampshire, Delaware, Texas, Virginia, Maryland, New Jersey, Rhode Island, Georgia, Colorado, Illinois, Pennsylvania, Minnesota and North Carolina. The Company provides a complete line of products, as well as specially developed, private label offerings from its direct marketing headquarters, warehouse, and call center facility in Littleton, Massachusetts.
The accompanying consolidated financial statements comprise those of the Company, investment in affiliates and its wholly-owned subsidiaries, Dover Saddlery, Inc., a Massachusetts corporation, Smith Brothers, Inc., a Texas corporation, Dover Saddlery Retail, Inc., a Massachusetts corporation, Old Dominion Enterprises, Inc., a Virginia corporation, and Dover Saddlery Direct, Inc., a Massachusetts corporation. All inter-company accounts and transactions have been eliminated in consolidation.
2. Summary of Significant Accounting Policies
The accompanying consolidated financial statements reflect the application of certain accounting policies described in this note and elsewhere in the accompanying notes to the consolidated financial statements.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Segment Information
Operating segments are identified as components of an enterprise about which separate, discrete financial information is available for evaluation by the chief operating decision-maker, or decision-making group, in making decisions on how to allocate resources and assess performance. The Company views its operations and manages its business as one operating segment utilizing a multi-channel distribution strategy. Additionally, it is not practical for the Company to disclose product revenues by discrete product categories.
The following table presents certain selected operating data from both the direct and retail market channels (dollars in thousands):
Revenue Recognition
Revenues from merchandise sales, including shipping and handling, are recognized when payment is reasonably assured, the product is shipped and title and risk of loss have transferred to the customer. For direct sales, this occurs when product is delivered to the common carrier at the Company’s warehouse. For retail sales, this occurs at the point of sale. Revenues are recorded net of local sales tax collected. At the time of recognition, the Company provides a reserve for estimated merchandise returns. The reserve, which is based on prior return experience, is recorded in accrued expenses and other current liabilities (see Note 9).
Gift Card and Gift Card Breakage
The Company’s proceeds from the sale of gift cards are recorded as a liability and are recognized as revenue when the cards are redeemed for merchandise. Through the year ending December 31, 2011, all unredeemed gift card proceeds were reflected as a liability until redeemed. During the first quarter of 2012, the Company identified a history of redemption and breakage patterns associated with its gift cards, which support a change in the estimate of the term over which the Company should recognize income on gift card breakage. Accordingly, beginning with the first quarter of 2012, the Company began to recognize revenue from the breakage of gift cards when the likelihood of redemption of the gift card is remote and there is no legal obligation for the Company to remit the value of such unredeemed gift cards to any relevant jurisdiction.
The Company determines its gift card breakage rate based upon historical redemption patterns. Based on this historical information, the likelihood of a gift card remaining unredeemed can be reasonably estimated at the time of gift card issuance. From the point which the likelihood of redemption is deemed to be remote (gift cards that were issued three years prior and remain unredeemed) and for which there is no legal obligation to remit the value of such unredeemed gift cards to any relevant jurisdictions, breakage income is recognized over a two year period. Breakage revenue for the year ending December 31, 2012 of $856,357, which included the cumulative impact of the change of $684,007, was recognized as revenue, net, in the accompanying consolidated statement of income and comprehensive income. There was no breakage recorded in 2011. The gift certificate liability balance was $2.4 million and $2.2 million for the years ending December 31, 2012 and 2011, respectively.
Shipping and Handling Costs
The Company has classified amounts billed to customers for shipping and handling as revenue, and shipping and handling costs as cost of revenues, in the accompanying consolidated statements of income and comprehensive income.
Cost of Revenues and Selling, General and Administrative Expenses
The Company’s consolidated cost of revenues primarily consists of merchandise costs, purchasing, handling and transportation costs to obtain the merchandise and ship it to customers or its stores. The Company’s consolidated selling, general and administrative expenses primarily consist of selling and marketing expenses, including amortization of deferred catalog costs, retail occupancy cost, depreciation, amortization, and general and administrative expenses.
Cash and Cash Equivalents
The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.
Property, Equipment and Depreciation
Property and equipment are recorded at cost. Expenditures for additions, renewals, and betterments of property are capitalized and depreciated over the estimated useful life. Expenditures for repairs and maintenance are charged to expense as incurred.
The Company provides for depreciation of assets recorded, including those under capitalized leases, using the straight-line method by charges to operations in amounts that allocate the cost of the assets over their estimated useful lives as follows:
Depreciation of property and equipment was approximately $873,000 and $747,000 for the years ended December 31, 2012 and 2011, respectively.
Inventory
Inventory consists of prepaid, finished goods in the Company’s mail-order warehouse and retail stores. The Company’s inventories are stated at the lower of cost (determined by the first-in, first-out method), or net realizable value. The Company maintains a reserve for excess and obsolete inventory. This reserve as of December 31, 2012 and 2011 was $120,000. The Company continuously monitors the salability of its inventories to ensure adequate valuation of the related merchandise.
Advertising
The Company capitalizes costs related to its direct mail advertising and recognizes these deferred costs over the period of expected future revenue, which is typically less than one year. Deferred costs as of December 31, 2012 and 2011 were $783,662 and $1,272,854, respectively, and are included as prepaid catalog costs on the accompanying consolidated balance sheets. The combined marketing and advertising costs charged to selling, general, and administrative expenses for the years ended December 31, 2012 and 2011, were approximately $8,877,000 and $8,194,000, respectively.
Accounting for Impairment of Long-Lived Assets
The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. The Company does not believe any of its long-lived assets have been impaired as of the periods presented.
Pre-opening Store Expenses
All non-capital costs associated with the opening of new retail stores are expensed as incurred.
Financial Instruments
The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, line of credit advances, capital leases and notes payable. The carrying value of cash and cash equivalents, accounts receivable, and accounts payable reflects fair value due to their short-term nature using level 3 inputs (see Note 14 for fair value disclosures).
The Company’s outstanding amounts under the unsecured revolving credit facility and term note (“Credit Facility”) are not measured at fair value on the accompanying condensed consolidated balance sheets. The Company determines the fair value of the amounts outstanding under the Credit Facility using an income approach, utilizing a discounted cash flow analysis based on current market interest rates for debt issues with similar remaining years to maturity, adjusted for applicable credit risk. Our Credit Facility is valued using level 2 inputs. The results of these calculations yield fair values that approximate carrying values. The fair value of our Credit Facility was approximately $7,015,000 and $6,487,000 as of December 31, 2012 and December 31, 2011, respectively.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk are principally cash equivalents and accounts receivable. The Company places its cash and cash equivalents in highly rated financial institutions. The Company maintains cash and cash equivalent balances with financial institutions that occasionally exceed federally insured limits. The Company has not experienced any losses related to these balances, and management believes its credit risk to be minimal. In addition, accounts receivable consists primarily of customer credit card transactions that are fully authorized with payment in transit as of period end and, therefore, no allowance for doubtful accounts is deemed necessary. For the periods presented, there were no customers that comprised more than 10% of receivables or revenues.
Other Comprehensive Income (Loss)
Other comprehensive loss is defined as the change in net assets of a business enterprise during a period from transactions generated from non-owner sources. Other comprehensive loss includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. The Company’s only item of other comprehensive income (loss), other than reported net income, was the change in fair value of an interest rate swap. The other comprehensive income (loss), net of taxes, for the year ended December 31, 2012 and 2011 was $936 and $189,916, respectively.
Income Taxes
The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial statement and tax bases of assets and liabilities and net operating loss and credit carry forwards using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when it is more likely than not that some portion of the deferred tax assets will not be realized.
The Company has reviewed its tax positions to determine whether the positions are more likely than not to be sustained upon examination by regulatory authorities. If a tax position meets the more-likely-than-not standard, then the related tax benefit is measured based on a cumulative probability analysis of the amount that is more-likely-than-not to be realized upon ultimate settlement or disposition of the underlying issue. At December 31, 2012 the Company’s tax liability was $3,000 for unrecognized tax benefits compared $33,000 in 2011. The tax liability was reduced by $30,000 due to the expiration of the statutory examination period for certain tax positions taken in 2007.
The Company records interest and penalties related to income taxes as a component of provision for income taxes. The Company recognized nominal interest and penalty expense for the years ended December 31, 2012 and 2011.
Net Income per Share
Basic net income per share is determined by dividing net income available to common stockholders by the weighted average common shares outstanding during the period. Diluted net income per share is determined by dividing net income by the dilutive weighted average common shares outstanding. The diluted weighted average common shares outstanding include the potential incremental common shares from the exercise of stock options and warrants using the treasury stock method, if dilutive.
A reconciliation of the number of shares used in the calculation of basic and diluted net income per share is as follows:
In 2012 and 2011, approximately 578,000 options and 369,000 options, respectively, to acquire common stock were excluded from the diluted weighted average shares calculation as the effect of such options is anti-dilutive.
Stock-based Compensation
The Company accounts for share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the consolidated statements of income and comprehensive income based on their fair values and related requisite service periods. Refer to Note 7 for further discussion of stock-based compensation recognized for periods presented.
Recent Accounting Pronouncements
In May 2011, the FASB issued an amendment to ASU 2011-04, Fair Value Measurement and disclosure. Among other things, the guidance expands the disclosure requirements around fair value measurements categorized in Level 3 of the fair value hierarchy and requires disclosure of the level in the fair value hierarchy of items that are not measured at fair value in the statement of financial position but whose fair value must be disclosed. It also clarifies and expands upon existing requirements for measurement of the fair value of financial assets and liabilities as well as instruments classified in shareholders’ equity. The guidance is effective for interim and annual periods beginning after December 15, 2011. The adoption of this accounting pronouncement did not have a material impact on our financial statements
ASU 2011-05, Presentation of Comprehensive Income, amends the guidance in ASC 220, Comprehensive Income, by eliminating the option to present components of other comprehensive income (OCI) in the statement of stockholders’ equity. Instead, the new guidance now requires entities to present all non-owner changes in stockholders’ equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. The components of OCI have
not changed, nor has the guidance on when OCI items are reclassified to net income; however, the amendments require entities to present all reclassification adjustments from OCI to net income on the face of the statement of comprehensive income. For public entities, the amendments in the ASU are effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2011. The amended guidance must be applied retrospectively and early adoption is permitted. The Company adopted this disclosure guidance as of December 31, 2011. The Company recognized no elements of OCI prior to the year ending December 31, 2011.
In February 2013, the FASB issued Accounting Standards Update 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The guidance in this ASU requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles (U.S. GAAP) to be reclassified in its entirety to net income. For other amounts that are not required under U .S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is reclassified to a balance sheet account instead of directly to income or expense in the same reporting period. The amendments in this ASU do not change the current requirements for reporting net income or other comprehensive income in financial statements. Public companies are required to comply with the requirements of this ASU for all reporting periods (interim and annual) beginning after December 15, 2012. The Company expects to adopt this amendment in the first quarter of 2013 and does not expect the adoption to have a material impact on its consolidated financial statements.
3. Financing Agreements
Revolving Credit Facility
On March 28, 2011, the Company and its bank, RBS Citizens, N.A., amended the revolving line of credit agreement in connection with the refinancing of the $5,000,000 senior subordinated notes. On May 10, 2012, the Company extended the revolving line of credit to April 30, 2014. Under the amended revolving line of credit, the Company can borrow up to $13,000,000, of which up to $1,000,000 can be in the form of letters of credit, and increase this amount up to $20,000,000 at the discretion of the bank. Any outstanding balances borrowed under the credit facility are due April 30, 2014. The credit facility bears interest at the base rate, announced from time to time by the bank, plus an applicable margin determined by the Company’s funded debt ratio. As of December 31, 2012, the LIBOR rate (base rate) was 0.21%, plus the applicable margin of 2.50%. Interest is payable monthly. At its option, the Company may have all or a portion of the unpaid principal under the credit facility bear interest at a base rate using either LIBOR or the prime rate. (See Note 15)
The Company is obligated to pay commitment fees of 0.25% per annum on the average daily, unused amount of the line of credit during the preceding quarter. All assets of the Company collateralize the senior revolving credit facility. Under the terms of the credit facility, the Company is subject to certain covenants including, among others, maximum funded debt ratios, minimum fixed charge ratios, current asset ratios, and capital expenditures. At December 31, 2012, the Company was in compliance with all of the covenants under the credit facility.
At December 31, 2012, the Company had the ability to borrow $13,000,000 on the revolving line of credit, subject to certain covenants, of which there was $1,515,000 outstanding, bearing interest at the net revolver rate of 2.71%. At December 31, 2011, the Company had $987,000 outstanding, bearing interest at the net revolver rate of 2.49%.
Term Notes, Senior Subordinated Notes Payable and Warrants
On March 28, 2011, the Company borrowed $5,500,000 in the form of a 7-year term note from the bank to refinance the $5,000,000 senior subordinated notes and deferred interest on those notes. The initial floating rate interest on the $1,600,000 of principal (the variable interest rate portion of the term note) was 5.4% consisting of a 1.0% LIBOR floor plus a 4.4% margin. The initial floating rate interest on the $3,900,000 of principal (fixed portion of the term note with the interest rate swap discussed below) was LIBOR plus 4.4%. On April 1, 2011, the Company entered into an interest rate swap contract to fix the interest rate at 7.4% on $3,900,000 of the term note principal. The remaining $1,600,000 of the principal bears interest at a floating rate based on a base rate, with a minimum of 1.0% as announced from time to time by the bank, plus a 4.4% margin. As of December 31, 2012, the LIBOR rate (base rate) was 0.21%. Interest is payable monthly. The Company is obligated to repay $786,000 of principal annually commencing in April 2013 and extending to March 2018. The Company is further obligated to accelerate repayment of up to $1,600,000 in principal in the event it has excess cash flow determined by a cash flow recapture formula. All assets of the Company collateralize the
term note facility. Under the terms of the term note facility, the Company is subject to certain covenants including, among others, maximum funded debt ratios, minimum fixed charge ratios, minimum current asset ratios, and maximum capital expenditures. The Company has realized significant interest savings as a result of refinancing the senior subordinated notes. At December 31, 2012, the Company was in compliance with all of the covenants under the credit facility.
In connection with the issuance of the prior subordinated notes, the Company issued warrants to the note holders, exercisable at any time after December 11, 2007 for an initial 118,170 shares of its common stock at a revised exercise price of $2.75 per share. The number of shares to be received for the warrants, upon exercise, is subject to change in the event of additional equity issuances and/or stock splits. The warrants were estimated to have a fair value of $272,000, which was reflected as a discount of the proceeds. The discount was amortized through interest expense while the notes were outstanding and the unamortized discount was fully expensed at refinancing. The warrants issued in connection with the subordinated notes are still outstanding and terminate on December 10, 2016.
As of December 31, 2012 and 2011, the $5,500,000 of term notes on the consolidated balance sheet, reflect the $5,500,000 face value.
Debt Payments
The estimated aggregate principal payments under our combined financing agreements as of December 31, 2012 for each of the next five fiscal years are as follows:
4. Investment in Affiliate
Investments are accounted for using the equity method of accounting if the investment provides the Company the ability to exercise significant influence, but not control, over an investee, as generally deemed to exist if the Company has an ownership interest in the voting stock of the investee of between 20% and 50%. The Company records its investment in equity method investees meeting these characteristics as an asset, included in intangibles and other assets, net in the accompanying consolidated balance sheets.
Under this method, the investment, originally recorded at cost, is adjusted to recognize the Company’s share of net earnings or loss of the affiliate as they occur, rather than as dividends or other distributions are received, limited to the extent of the Company’s investment in, advances to, and commitments for the investee.
On April 11, 2008, the Company acquired 40% of the common stock of Hobby Horse Clothing Company, Inc. (“HH”), a privately held company, in exchange for 81,720 shares of unregistered Dover common stock. The Company accounts for this investment using the equity method. The total acquisition costs included $380,000 in common stock, as well as $33,300 in professional fees. Based on the purchase allocation, the total acquisition cost of $413,300 was allocated to the fair value of the Company’s share of net assets acquired, including approximately $138,000 of intangible assets, which represents the difference between the costs and underlying equity in HH’s net assets at the date of acquisition.
The Company’s equity share of HH’s net income, including the intangible asset customer list amortization (resulting from the purchase price allocation) is reflected as other investment income in the accompanying consolidated statements of income and comprehensive income. The Company recorded net loss of approximately $(32,000) for the year ending December 31, 2012 compared to a loss recorded of $(7,000) for the year ending December 31, 2011. The resulting carrying values at December 31, 2012 and 2011 were approximately $248,000 and $270,000, respectively, and are included in intangibles and other assets, net, in the accompanying consolidated balance sheets.
In May 2010, the Company launched a joint venture to provide equine pharmaceuticals to the equine marketplace. The venture, HorsePharm.com, LLC (“HP”), was established as a limited liability company, and Dover has a non-controlling interest of 50%. The
Company accounts for this investment using the equity method. Thus, during the second quarter of 2010, Dover recorded its portion of the initial investment in HP of $60,000. For the year ending December 31, 2012 the Company recorded a net loss of approximately $(8,000) for its share of the joint venture’s operating results and a net loss of approximately $(10,000) for year ending December 31, 2011. The carrying values at December 31, 2012 and 2011 were approximately $22,000 and $30,000, respectively, which were included in intangibles and other assets, net, in the accompanying consolidated balance sheets. The operating agreement governing HP contains a buy/sell feature that can be exercised for a price established by the HP member who initiates the buy/sell feature. The HP member that receives the offer can elect to buy the other member’s interest or sell its interest at the offered price.
5. Commitments
The Company leases its facilities and certain fixed assets that may be purchased for a nominal amount on the expiration of the leases under non-cancelable operating and capital leases that extend through 2022. These leases, which may be renewed for periods ranging from one to five years, include fixed rental agreements as well as agreements with rent escalation clauses.
Property and equipment includes the following cost and related accumulated depreciation associated with equipment under capital lease:
Future minimum commitments for operating and capital lease obligations as of December 31, 2012 are as follows:
Total rental expense under the operating agreements included in the accompanying consolidated statements of income and comprehensive income for the years ending December 31, 2012 and 2011 were approximately $2,798,000 and $2,415,000, respectively.
In connection with retail locations, the Company enters into various operating lease agreements, with escalating rental payments. The effects of variable rent disbursements have been expensed on a straight-line basis over the life of the lease. As of December 31, 2012 and 2011, there was approximately $754,000 and $618,000, respectively, of deferred rent recorded in accrued expenses and other current liabilities on the accompanying consolidated balance sheets.
6. Income Taxes
A deferred tax asset or liability is recorded based on the differences between the financial reporting and tax bases of assets and liabilities and is measured by the enacted tax rates expected to be in effect when these differences reverse. The deferred income tax provision results from the net change during the year of deferred income tax assets and liabilities. The income tax provision is as follows:
Deferred income taxes relate to the following temporary differences as of:
The effective income tax rate varies from the amount computed using the statutory U.S. income tax rate as follows:
The Company has reviewed its tax positions to determine whether the positions are more likely than not to be sustained upon examination by regulatory authorities. If a tax position meets the more-likely-than-not standard, then the related tax benefit is measured based on a cumulative probability analysis of the amount that is more-likely-than-not to be realized upon ultimate settlement or disposition of the underlying issue. At December 31, 2012 the Company’s tax liability was $3,000 for unrecognized tax benefits compared $33,000 in 2011. Although the Company believes it has adequately reserved for its uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. The Company adjusts these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.
The Company records interest and penalties related to income taxes as a component of provision for income taxes. The Company recognized nominal interest and penalty expense for the years ended December 31, 2012 and 2011.
Tax years 2009 through 2012 remain subject to examination by the IRS, and 2007 through 2012 tax years remain subject to examination by Massachusetts, and 2006 through 2012 by various other jurisdictions.
7. Stockholders’ Equity
Preferred Stock
The Company currently has authorized 1,000,000 shares of Preferred Stock, none of which were issued or outstanding at December 31, 2012 or 2011.
Stock Option Plans
In August 2005, our Board of Directors approved the 2005 Equity Incentive Plan, which became effective on November 17, 2005, concurrent with our public offering, and was amended in 2010 with the approval of the Company’s stockholders. The amended 2005 Equity Incentive Plan provides for the grant of incentive stock options to employees and non-qualified stock options, awards of common stock and opportunities to make direct purchases of common and other stock to our employees and directors.
The aggregate number of shares of our common stock that may be issued under the amended 2005 Equity Incentive Plan is 1,123,574. The aggregate number of shares of common stock that may be granted in any calendar year to any one person pursuant to the amended 2005 Equity Incentive Plan may not exceed 50% of the aggregate number shares of our common stock that may be issued pursuant to the amended 2005 Equity Incentive Plan.
The amended 2005 Equity Incentive Plan is administered by the Compensation Committee of our Board of Directors, which has been granted the discretion to determine when awards are made, which directors or employees receive awards, whether an award will be in the form of an incentive stock option, a nonqualified stock option or restricted stock, the number of shares subject to each award, vesting, and acceleration of vesting. Generally, options granted to employees under the amended 2005 Equity Incentive Plan are expected to vest over a five-year period from the date of grant.
Stock options issued under the amended 2005 Equity Incentive Plan generally expire within ten years or, in the case of incentive stock options issued to 10% or greater shareholders, within five years.
Prior to the adoption of the 2005 Plan, the Company had issued 513,981 options under the 1999 Plan, which was the maximum the plan permitted. The Company has reserved a total of 1,123,574 shares of common stock for issuance under the 2005 Plan. As of December 31, 2012, there were 221,810 shares available for future grants, and as of December 31, 2011, 249,465 shares were available for future grants.
The following table summarizes stock option activity for the years ended December 31, 2012 and 2011.
The following table sets forth the intrinsic value at December 31, 2012 and 2011, for outstanding and exercisable options:
(1) The aggregate intrinsic value was calculated based on the difference between the fair value of the Company’s common stock on December 31, 2012 or 2011 and the weighted average exercise price of the underlying options.
Stock-based Compensation
The Company utilizes, in most cases, the Binomial Lattice option pricing model to determine the fair value of stock-based compensation. The Binomial Lattice model requires the Company to make subjective assumptions regarding the volatility of the underlying stock. The estimated volatility of the Company’s common stock price is based on the median of the fluctuations in the historical price of the Company’s common stock. The Binomial Lattice model also requires a risk-free interest rate, which is based on the U.S. Treasury yield curve in effect at the time of the grant, and the dividend yield on the Company’s common stock, which is assumed to be zero since the Company does not pay dividends and has no current plans to do so in the future. Changes in these assumptions can materially affect the estimate of fair value of stock-based compensation and, consequently, the related expense recognized in the consolidated statement of income and comprehensive income.
In November 2012 and November 2011, the Company granted 154,900 and 161,900 options, respectively, to the Company employees and directors. Using the Binomial Lattice Model (with assumptions disclosed below), the 2012 and 2011 awards had weighted average fair value of $2.88 and $2.69 per option, respectively. The stock based compensation recorded was $251,000 and $242,000 for the years ended December 31, 2012 and 2011, respectively. The fair value of these awards is recorded as stock-based compensation expense included in general and administrative expense over the requisite service period. The remaining unrecognized stock-based compensation expense related to unvested awards at December 31, 2012 was approximately $1,010,000 to be recognized on a straight-line basis over the weighted average vesting period of 4.0 years.
The following table illustrates the assumptions used in the Binomial-Lattice calculation used to value to the option awards granted during the years ended December 31, 2012 and 2011:
8. Employee Savings Plan
The Company maintains the Dover Saddlery, Inc. 401k Profit Sharing Plan (the 401k Plan). Employees of the Company may participate in the 401k Plan after three months of service, which allows employees to defer a percentage of their salary under Section 401k of the Internal Revenue Code. The 401k Plan also allows for the Company to make discretionary contributions determined annually based on a percentage of the employee’s compensation. No employer contributions were made during the periods presented.
9. Accrued Expenses and Other Current Liabilities
Accrued expenses and other current liabilities consisted of the following:
10. Intangibles and Other Assets, Net
Intangibles and other assets, net, consist of the following:
Deferred financing costs are amortized on a straight-line basis over the shorter of the contractual or estimated life of the related debt. In connection with the March 2011 debt refinancing discussed in Note 3, the Company recognized a portion of unamortized deferred financing costs associated with the modification of facilities. Purchased catalog and related assets are amortized on a straight-line basis over the estimated useful lives of the underlying assets. Amortization expense for the Company’s purchased catalog and related assets for the year ended December 31, 2011 was approximately $5,000. As of December 31, 2011, the purchased catalog and related assets were fully amortized.
In August 2012, the Company entered into a purchase agreement with Fools & Horses, LLC (“F&H”) for the purchase of its intangible assets for the price of $145,000. The asset is to be amortized on a straight-line basis over the length of the contract agreement (5 years). Amortization expense for the F&H asset for the year ended December 31, 2012 was approximately $10,000, there was no amortization expense for the same period in 2011.
11. Related Party Transactions
On October 26, 2007, the disinterested members of the Audit Committee of the Board of Directors approved a $5,000,000 subordinated debt financing facility in the form of senior subordinated notes as part of a plan to refinance the Company’s former subordinated debt with Patriot Capital. The new sub-debt facility was led by BCA Mezzanine Fund, L.P., which participated at $2,000,000 (in which Company Board member Gregory Mulligan holds a management position and indirect economic interest). The subordinated notes were consummated as of December 11, 2007. Except as noted above with respect to Mr. Mulligan, there is no relationship, arrangement or understanding between the Company and any of the subordinated holders or any of their affiliates, other than in respect of the loan agreement establishing and setting forth the terms and conditions of the subordinated notes.
On March 28, 2011, the Company repaid these subordinated notes and $423,000 of deferred interest from the proceeds of $5,500,000 in term notes. The warrants issued in connection with the subordinated notes are still outstanding and terminate on December 10, 2016. For the twelve months ended December 31, 2011, the Company recognized $175,000 in interest expense for the subordinated notes.
In October of 2004, the Company entered into a lease agreement with a minority stockholder. The agreement, which relates to the Plaistow, NH retail store, is a five-year lease with options to extend for an additional fifteen years. For the years ended December 31, 2012 and 2011, the Company expensed approximately $214,000 and $218,000, respectively, in connection with the lease.
In order to expedite the efficient build-out of leasehold improvements in its new retail stores, the Company utilizes the services of a real estate development company owned by a non-executive Company employee and minority stockholder to source construction services and retail fixtures. Total payments for the year ended December 31, 2012, consisting primarily of reimbursements for materials and outside labor, for the fit-up of stores were approximately $619,000. Reimbursements for the year ended December 31, 2011 were approximately $370,000.
12. Contingencies
From time to time, the Company is exposed to litigation relating to our products and operations. The Company is not currently engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material, adverse affect on our financial condition or results of operations.
13. Interest Rate Swap
The Company uses an interest rate swap contract as a cash flow hedge to eliminate the cash flow exposure of interest rate movements on variable rate debt. The Company accounts for its interest rate swap contract in accordance with FASB ASC 815, Derivatives and Hedging. FASB ASC 815 requires all derivatives, including interest rate swaps, to be recorded on the balance sheet at fair value. The increase or decrease in the fair value of the hedge is initially included as a component of other comprehensive income and is subsequently reclassified into earnings and recorded as interest expense, when interest on the related debt is paid. The Company values the interest rate swap contract in accordance with FASB ASC 820, Fair Value Measurement and Disclosures. The Company documents its risk management strategy and hedge effectiveness at the inception of and during the term of the hedge. The Company’s interest rate risk management strategy is to stabilize cash flow requirements by maintaining the interest rate swap contract to convert variable rate debt to fixed rate debt.
The Company is exposed to interest rate risk primarily through its borrowing activities. The Company uses an interest rate swap contract as a cash flow hedge to eliminate the cash flow exposure of interest rate movements on variable rate debt. The Company’s term note is a variable rate instrument. On April 1, 2011, the Company entered into a 7-year interest rate swap contract on the notional value of $3,900,000 of the term note which requires payment of a fixed interest rate of interest (7.4%) and the receipt of a variable rate of interest, based on one month LIBOR rate, on the $3,900,000.
The Company designated this interest rate swap contract as an effective cash flow hedge. The Company adjusts the interest rate swap to fair value with the change accounted for through other comprehensive income, as the contracts are considered effective in offsetting the interest rate exposure of the forecasted interest rate payments hedged. The Company anticipates that this contract will continue to be effective as long as there are no pre-payments of the hedged portion of the term note. The Company does not believe any of the amounts currently reported in accumulated other comprehensive loss will be reclassified into earnings in 2013. The fair value of the interest rate swap was a liability of $320,225 and $321,879 as of December 31, 2012 and 2011, respectively.
The Company does not hold any derivative instruments that are not designated as a hedging instrument. As of December 31, 2012 the following table presents information about the fair value of the Company’s derivative instruments that have been designated as hedging instruments:
The following table presents information about the effects of the Company’s derivative instruments on the Company’s results of operations:
14. Fair Value
FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value, and establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under FASB ASC 820 are described below:
Level 1 - Pricing inputs are quoted prices available in active markets for identical investments as of the reporting date. The Company does not have any investments meeting the criteria of Level 1 inputs.
Level 2 - Pricing inputs are quoted prices for similar investments, or inputs that are observable, either directly or indirectly, for substantially the full term through corroboration with observable market data. The Company’s derivatives discussed above, meet the criteria of a Level 2 input.
Level 3 - Pricing inputs include unobservable inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability, which are developed based on the best information available. Level 3 includes private investments that have no market activity. The Company does not have any investments meeting the criteria of Level 3 inputs.
The Company accounts for its interest rate swap as a derivative financial instrument in accordance with the related guidance. Under this guidance, derivatives are carried on the balance sheet at fair value. The fair value of the Company’s interest rate swap is determined based on observable market data in combination with expected cash flows. The fair value of the Company’s interest rate swap was determined using projected future cash flows, discounted at the mid-market implied forward LIBOR. The value at December 31, 2012 is included in long-term liabilities.
The following table presents the financial instruments carried at fair value as of December 31, 2012 and 2011 in accordance with the FASB ASC 820 hierarchy noted above:
15. Subsequent Events
On March 29, 2013, the Company and the bank amended the revolving line of credit so that the Company can borrow three term loans for capital expenditures used to open new stores. Under the amended revolving line of credit, the Company can borrow up to $13,000,000, of which up to $1,000,000 can be in the form of letters of credit, up to $8,000,000 can be advanced as term loans, and increase the $13,000,000 maximum up to $20,000,000 at the discretion of the bank. Funds available under the revolving portion of the line shall be reduced by the outstanding balance of the letters of credit and term loans. The Company borrowed $2,340,000 as a term loan on March 29, 2013 with equal principal repayments over 60 months. Any outstanding balances borrowed under the credit facility are due in full on March 29, 2015 unless the revolving line of credit is renewed in 2014 for another year. The credit facility bears interest at the base rate, announced from time to time by the bank, plus an applicable margin determined by the Company’s funded debt ratio. As of March 29, 2013 the LIBOR (base rate) was 0.21%, plus the applicable margin of 2.50%. Interest is payable monthly. At its option the Company may have all or a portion of the unpaid principal under the credit facility bear interest at various LIBOR or prime rate options.
The Company has evaluated all events or transactions through the date of this filing. During this period, the Company did not have any additional material subsequent events that impacted its consolidated financial statements.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures.
Not applicable.
Item 9A.
Item 9A. Controls and Procedures.
The Company’s management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2012. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
The Company’s disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and that as of December 31, 2012, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective at the reasonable assurance level.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that our internal control over financial reporting was effective appropriate as of December 31, 2012, in management’s judgment with similar cost-benefit considerations, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Management reviewed the results of its assessment with our Audit Committee. No change in our internal control over financial reporting occurred during the fiscal quarter ended December 31, 2012, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit the Company, as a smaller reporting company, to provide only management’s report in this Annual Report.
Item 9B.
Item 9B. Other Information.
On March 29, 2013, the Company and the bank amended the revolving line of credit so that the Company can borrow three term loans for capital expenditures used to open new stores. Under the amended revolving line of credit, the Company can borrow up to $13,000,000, of which up to $1,000,000 can be in the form of letters of credit, up to $8,000,000 can be advanced as term loans, and increase the $13,000,000 maximum up to $20,000,000 at the discretion of the bank. Funds available under the revolving portion of the line shall be reduced by the outstanding balance of the letters of credit and term loans. The Company borrowed $2,340,000 as a term loan on March 29, 2013 with equal principal repayments over 60 months. Any outstanding balances borrowed under the credit facility are due in full on March 29, 2015 unless the revolving line of credit is renewed in 2014 for another year. The credit facility bears interest at the base rate, announced from time to time by the bank, plus an applicable margin determined by the Company’s funded debt ratio. As of March 29, 2013 the LIBOR (base rate) was 0.21%, plus the applicable margin of 2.50%. Interest is payable monthly. At its option the Company may have all or a portion of the unpaid principal under the credit facility bear interest at various LIBOR or prime rate options.
As of December 31, 2012, 5,337,478 shares of our common stock were outstanding. Since our 2012 fiscal year end, 700 shares of our common stock were exercised resulting in 5,338,178 outstanding shares of the Registrant’s common stock as of the date of this filing.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
The information set forth under the captions “Directors, Executive Officers” and “Corporate Governance”, “Section 16(a) Beneficial Ownership Reporting Compliance” and “Code of Ethics” appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 2, 2013, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012, is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation.
The information set forth under the caption “Remuneration of Executive Officers and Directors” appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 2, 2013, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012, is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information set forth under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plans” appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 2, 2013, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012, is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information set forth under the captions “Certain Relationships and Related Transactions” and “Director Independence”, appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 2, 2013, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012, is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services.
The information set forth under the captions “Principal Accounting Fees and Services” appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 2, 2013, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012, is incorporated herein by reference.
Part IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a) Documents filed as part of this Annual Report on Form 10-K are as follows:
1. Financial Statements:
See listing of financial statements included as part of this Form 10-K in Item 8 of Part II.
2. Financial Statement Schedules:
The information required by this Item has been included in the Financial Statements and related notes as part of this Form 10-K in Item 8 of Part II above.
3. Exhibits:
Exhibit List
Set forth below is list of exhibits submitted with this Form 10-K as filed or furnished with the SEC:
Ex-10.74-Third Amendment to Revolving Credit Note with RBS Citizens dated March 29, 2013
Ex-10.75-Fifth Amendment to Loan and Security Agreement with RBS Citizens dated March 29, 2013
Ex-23.9-Consent of McGladrey LLP
Ex-31.1-Certification of Principal Executive Officer of Periodic Report Pursuant to Rule 13a-14(a) or Rule 15d-14(a)
Ex-31.2-Certification of Principal Financial Officer of Periodic Report Pursuant to Rule 13a-14(a) or Rule 15d-14(a)
Ex-32.1-Certification by Chief Executive Officer and Chief Financial Officer of Periodic Report Pursuant to 18 U.S.C. Section 1350
See the Exhibit Index immediately following the signature page of this Annual Report on Form 10-K for a complete index of exhibits, including those submitted with this Form 10-K as filed or furnished, together with those filed or furnished with the SEC incorporated by reference to other filings.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Exhibit Index
* Filed herewith.
 Furnished herewith.
 Indicates a management contract or compensatory plan or arrangement