Item 1. Business
This Annual Report contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report.
Although forward-looking statements in this Annual Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include those described in Item 1A
Item 1A. Risk Factors
Risks Related to Our Business
You should consider each of the following factors as well as the other information in this Annual Report in evaluating our business and our prospects. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations. If any of the following risks actually occur, our business and financial results could be harmed. In that case, the trading price of our common stock could decline. You should also refer to the other information set forth in this Annual Report, including our financial statements and the related notes.
Economic conditions and the resulting decline in consumer spending could continue to adversely affect our business and financial performance.
Our performance depends on general economic conditions and their impact on consumer confidence and discretionary consumer spending, which have deteriorated significantly over the past several months and may remain depressed for the foreseeable future. Our business and financial performance, including our sales and the collection of our accounts receivable, may continue to be adversely affected by the current weakness and any future weakness in economic activity and consumer spending in the United States or in other regions of the world in which we do business. Further, economic factors such as a reduction in the availability of credit, increased or continuing unemployment levels, higher fuel and energy costs, rising interest rates, adverse conditions in the housing markets, financial market volatility, recession, reduced consumer confidence, savings rates, acts of terrorism, major epidemics (including H1N1 and other influenzas) and other factors affecting consumer spending behavior could adversely affect demand for our products. If consumer spending fails to increase, we will not be able to improve our sales. In addition, reduced consumer spending may cause us to lower prices or suffer increases in product returns, which would have a negative impact on gross profit.
Current economic conditions could adversely impact our liquidity and our ability to obtain financing, including counterparty risk.
On February 26, 2007, O21NA entered into a Loan and Security Agreement (the “Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million, which was extended to $8.0 million. In addition, effective March 23, 2010, we entered into a $3.0 million Promissory Note with Costa Brava Partnership III, L.P. (“Costa Brava”). The Chairman of our Board of Directors, Seth Hamot, is the President and sole member of Roark, Rearden & Hamot, LLC, which is the sole general partner of Costa Brava. The Promissory Note is subordinated to our Loan Agreement with BFI. The proceeds from the Note are expected to be used (i) to prepay the current balance on our revolving line of credit balance with BFI in its entirety and (ii) if any proceeds remain after such prepayment, for working capital purposes. However, we may continue to re-borrow from BFI under the Loan Agreement after such prepayment is made.
We rely on this credit line with BFI and other credit arrangements to fund working capital needs. The recent unprecedented disruptions in the credit and financial markets and resulting decline in general economic and business conditions may adversely impact our access to capital through our credit line and other sources.
Under the terms of our Loan Agreement, BFI may reduce our borrowing availability in certain circumstances, including, without limitation, if in its reasonable business judgment our creditworthiness, sales or the liquidation value of our inventory have declined materially. Further, the Loan Agreement provides that BFI may declare us in default if we experience a material adverse change in our business or financial condition or if BFI determines that our ability to perform under the Loan Agreement is materially impaired.
In addition, we have a 0.6 million Euros line of credit in Italy with San Paolo IMI for LEM, which was reduced from 1.3 million Euros during 2009. We rely on this line of credit to fund working capital needs at LEM. Under the terms of this line of credit, San Paolo may further reduce the line of credit at its discretion.
The current economic environment could cause lenders to fail to extend credit to us, which would have an immediate and substantial adverse impact on our business, financial condition or results of operations. Also, if we require additional financing as a result of the foregoing or other factors, the capital markets turmoil could negatively impact our ability to obtain such financing. Our access to additional financing will depend on a variety of factors (many of which we have little or no control over) such as market conditions, the general availability of credit, the overall availability of credit to our industry, our credit ratings and credit capacity, as well as the possibility that lenders could develop a negative perception of our long-term or short-term financial prospects.
Fluctuations in foreign currency exchange rates could harm our results of operations.
We sell a majority of our products in transactions denominated in U.S. Dollars; however, we purchase a substantial portion of our products from our manufacturers in transactions denominated in Euros. As a result, the weakening of the U.S. Dollar during 2008 and 2009 caused our cost of sales to increase substantially. If the U.S. Dollar further weakens against the Euro in the future, our cost of sales could further increase. We are also exposed to gains and losses resulting from the effect that fluctuations in foreign currency exchange rates have on the reported results in our consolidated financial statements due to the translation of the operating results and financial position of our Italian subsidiaries O21 Europe and LEM, and due to net sales in Canada. Between January 1, 2008 and March 22, 2010, the Euro exchange rate has ranged from U.S. $1.23 to U.S. $1.60. Between January 1, 2008 and March 22, 2010, the Canadian Dollar exchange rate has ranged from U.S. $0.77 to U.S. $1.03. For the years ended December 31, 2009 and 2008, we had a net foreign currency gain and a net foreign currency loss of $0.3 million and $0.1 million, respectively, which represented approximately one percent and zero percent of our net sales, respectively.
The effect of foreign exchange rates on our financial results can be significant. Therefore we have engaged in the past, and may in the future engage in, certain hedging activities to mitigate over time the impact of the translation of foreign currencies on our financial results. Our hedging activities have in the past reduced, but have not eliminated, the effects of foreign currency fluctuations. Factors that could impact the effectiveness of our hedging activities include the volatility of currency markets and the availability of hedging instruments. The degree to which our financial results are affected has depended in part upon the effectiveness of our hedging activities. As of December 31, 2009, we were not engaged in any foreign currency hedging activities.
We have a history of significant losses. If we do not achieve or sustain profitability, our financial condition and stock price could suffer.
We have a history of losses and we may continue to incur losses for the foreseeable future. As of December 31, 2009, our accumulated deficit was $35.9 million and, during the year ended December 31, 2009, we incurred a net loss of $3.4 million. We have not achieved profitability for a full fiscal year since our initial public offering. If we are unable to maintain or grow our revenues, or if we are unable to reduce operating expenses sufficiently, we may not be able to achieve full fiscal year profitability in the near future or at all. Even if we do achieve full fiscal year profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If we are unable to achieve full fiscal year profitability within a short period of time, or at all, or if we are unable to sustain profitability at satisfactory levels, our financial condition and stock price could be adversely affected.
Our future capital needs are uncertain, and we may need to raise additional funds in the future which may not be available on acceptable terms or at all.
Our capital requirements will depend on many factors, including:
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acceptance of, and demand for our products;
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the costs of developing and selling new products;
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the extent to which we invest in new equipment and product development;
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the number and timing of acquisitions and other strategic transactions;
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the costs associated with the growth of our business, if any; and
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our ability to realize additional savings through streamlining our operations.
Although we believe we have sufficient funds to operate our business over the next twelve months, our existing sources of cash and cash flows may not be sufficient to fund our activities. As a result, we may need to raise additional funds, and such funds may not be available on favorable terms, or at all, particularly given current economic conditions and the recent turmoil in the capital markets. Furthermore, if we issue equity or convertible debt securities to raise additional funds, our existing stockholders may experience dilution, and the new equity or debt securities may have rights, preferences, and privileges senior to those of our existing stockholders. If we incur additional debt, it may increase our leverage relative to our earnings or to our equity capitalization. If we cannot raise funds on acceptable terms, we may need to scale back our expenditures and we may not be able to develop or enhance our products, execute our business plan, take advantage of future opportunities, or respond to competitive pressures.
If we are unable to continue to develop innovative and stylish products, demand for our products may decrease.
The action sports and lifestyle markets are subject to constantly changing consumer preferences based on fashion and performance trends. Our success depends largely on the continued strength of our brands and our ability to continue to introduce innovative and stylish products that are accepted by consumers in our target markets. We must anticipate the rapidly changing preferences of consumers and provide products that appeal to their preferences in a timely manner while preserving the relevancy and authenticity of our brand. Achieving market acceptance for new products may also require substantial marketing and product development efforts and expenditures to create consumer demand. Decisions regarding product designs must be made several months in advance of the time when consumer acceptance can be measured. If we do not continue to develop innovative and stylish products that provide greater performance and design attributes than the products of our competitors and that are accepted by our targeted consumers, we may lose customer loyalty, which could result in a decline in our net sales and market share.
We may not be able to compete effectively, which will cause our net sales and market share to decline.
The action sports and lifestyle markets in which we compete are intensely competitive. We compete with sunglass and goggle brands in various niches of the action sports market including Anon Optics, Arnette, Dragon Optical, Electric Visual, Fox, Oakley, Scott, Smith Optics and Von Zipper. We also compete with broader lifestyle brands that offer eyewear products, such as Quiksilver, and in the broader fashion sunglass sector of the eyewear market, which is fragmented and highly competitive. We compete with a number of brands in these sectors of the market, including brands such as Armani, Christian Dior, Dolce & Gabbana, Gucci, Prada and Versace. We expect that our Margaritaville eyewear will compete with other lifestyle brands. In all markets, we compete primarily on the basis of fashion trends, design, performance, value, quality, brand recognition, marketing and distribution channels.
The purchasing decisions of consumers are highly subjective and can be influenced by many factors, such as marketing programs, product design and brand image. Several of our competitors enjoy substantial competitive advantages, including greater brand recognition, a longer operating history, more comprehensive lines of products and greater financial resources for competitive activities, such as sales and marketing, research and development and strategic acquisitions. Our competitors may enter into business combinations or alliances that strengthen their competitive positions or prevent us from taking advantage of such combinations or alliances. They also may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or consumer preferences.
If our marketing efforts are not effective, our brands may not achieve the broad recognition necessary to our success.
We believe that broader recognition and favorable perception of our Spy and O’Neill brands by persons ranging in age from 17 to 35 and of our Margaritaville brand by persons ranging from 18 to 55 is essential to our future success. Accordingly, we intend to continue an aggressive brand strategy through a variety of marketing techniques designed to foster an authentic action sports and lifestyle company culture, including athlete sponsorship, sponsorship of surfing, snowboarding, skateboarding, wakeboarding, and motocross events, vehicle marketing, internet and print media, action sports industry relationships, sponsorship of concerts and music festivals and celebrity endorsements. If we are unsuccessful, these expenses may never be offset, and we may be unable to maintain or increase net sales. Successful positioning of our brand depends largely on:
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the success of our advertising and promotional efforts;
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preservation of the relevancy and authenticity of our brands in our target demographic,
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our ability to continue to provide innovative, stylish and high-quality products to our customers; and
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managing the recognition and perception of our various brands.
To increase brand recognition, we must continue to spend significant amounts of time and resources on advertising and promotions. These expenditures may not result in a sufficient increase in net sales to cover such advertising and promotional expenses. In addition, even if brand recognition increases, our customer base may decline or fail to increase and our net sales may not continue at present levels or may decline.
If we fail to develop new products that are received favorably by our target customer audience, our business may suffer.
We are continuously evaluating potential entries into or expansion of new product offerings. In expanding our product offerings, we intend to leverage our sales and marketing platform and customer base to develop these opportunities. While we have generally been successful promoting our sunglasses and goggles in our target markets, we cannot predict whether we will be successful in gaining market acceptance for any new products that we may develop. In addition, expansion of our business strategy into new product offerings will require us to incur significant sales and marketing and research and development expenses. These requirements could strain our management and financial and operational resources. Additional challenges that may affect our ability to expand our product offerings include our ability to:
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increase awareness and popularity of our existing brands;
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establish awareness of any new brands we may introduce or acquire;
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increase customer demand for our existing products and establish customer demand for any new product offering;
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attract, acquire and retain customers at a reasonable cost;
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achieve and maintain a critical mass of customers and orders across all of our product offerings;
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maintain or improve our gross margins; and
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compete effectively in highly competitive markets.
We may not be able to address successfully any or all of these challenges in a manner that will enable us to expand our business in a cost-effective or timely manner. If new products we develop are not received favorably by consumers, our reputation and the value of our brand could be damaged. The lack of market acceptance of new products we develop or our inability to generate satisfactory net sales from any new products to offset their cost could harm our business.
Substantially all of our assets are pledged to secure obligations under our outstanding indebtedness.
O21NA granted a security interest in substantially all of its assets to BFI as security for its obligations under the Loan Agreement. O21NA also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between O21NA and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to O21NA any amounts remaining after payment of all amounts due under the Loan Agreement. Additionally, Orange 21 Inc. guaranteed O21NA’s obligations under the Loan Agreement and granted BFI a blanket security interest in substantially all of its assets as security for its obligations under its guaranty.
If O21NA defaults on any of its obligations under the Loan Agreement, BFI will be entitled to exercise its remedies under the Loan Agreement and applicable law, which could harm our results of operations and reputation. Additionally, our Promissory Note with Costa Brava is subordinated to our Loan Agreement with BFI. Pursuant to the terms of a Debt Subordination Agreement, by and between Costa Brava and BFI, Costa Brava has the option to purchase the outstanding amount under the BFI Loan Agreement. Specifically, the remedies available to BFI include, without limitation, increasing the applicable interest rate on all amounts outstanding under the Loan Agreement, declaring all amounts under the Loan Agreement immediately due and payable, assuming control of the Collateral Account or any other assets pledged by O21NA or Orange 21 Inc. and directing our customers to make payments directly to BFI. Our results of operations and reputation may be harmed by BFI’s exercise of its remedies.
Our business could be harmed if we fail to maintain proper inventory levels.
We place orders with our manufacturers for some of our products prior to the time we receive orders for these products from our customers. We do this to minimize purchasing costs, the time necessary to fill customer orders and the risk of non-delivery. We also maintain an inventory of selected products that we anticipate will be in high demand. We may be unable to sell the products we have ordered in advance from manufacturers or that we have in our inventory. Inventory levels in excess of customer demand may result in inventory write-downs, and the sale of excess inventory at discounted prices could significantly impair our brands’ image and harm our operating results and financial condition. Conversely, if we underestimate consumer demand for our products or if our manufacturers fail to supply the quality products that we require at the time we need them, we may experience inventory shortages. Inventory shortages might delay shipments to customers, negatively impact retailer and distributor relationships and diminish brand loyalty, thereby harming our business.
Our manufacturers must be able to continue to procure raw materials and we must continue to receive timely deliveries from our manufacturers to sell our products profitably.
The capacity of our manufacturers, including our subsidiary LEM, to manufacture our products is dependent in substantial part, upon the availability of raw materials used in the fabrication of sunglasses and goggles. Any shortage of raw materials or inability of a manufacturer to manufacture or ship our products in a timely manner, or at all, could impair our ability to ship orders of our products in a timely manner and could cause us to miss the delivery requirements of our customers. As a result, we could experience cancellation of orders, refusal to accept deliveries or a reduction in purchase prices, any of which could harm our net sales, results of operations and reputation. Our manufacturers, including LEM, have experienced in the past, and may experience in the future, shortages of raw materials and other production delays, which have resulted in, and may in the future result in, delays in deliveries of our products of up to several months. In addition, LEM provides manufacturing services to other companies under supply agreements. The inability of LEM and our other suppliers to manufacture and ship products in a timely manner could result in breaches of the agreements with our customers, which could harm our results of operations, reputation and demand for our products.
If we are unable to recruit and retain key personnel necessary to operate our business, our ability to develop and market our products successfully may be harmed.
We are heavily dependent on our current executive officers and management. The loss of any key employee or the inability to attract or retain qualified personnel, including product design and sales and marketing personnel, could delay the development and introduction of, and harm our ability to sell our products and damage our brand. We believe that our future success is significantly dependent on the contributions of A. Stone Douglass, who became our Chief Executive Officer in October 2008 and our acting Chief Financial Officer in February 2010, as well as Stefano Lodigiani, our General Manager of LEM and Director of Operations, Italy and our Vice President of Sales, Erik Darby. The loss of the services of Mr. Douglass, Mr. Lodigiani or Mr. Darby would be difficult to replace. Our future success may also depend on our ability to attract and retain additional qualified management, design and sales and marketing personnel. We do not currently have key man insurance on Mr. Douglass or Mr. Darby. We do carry key man life insurance on Mr. Lodigiani for $1.0 million. If our management team is unable to execute on our business strategy, our business may be harmed, which could adversely impact our branding strategy, product development strategy and net sales.
If we are unable to maintain and expand our endorsements by professional athletes, our ability to market and sell our products may be harmed.
A key element of our marketing strategy has been to obtain endorsements from prominent action sports athletes to sell our products and preserve the authenticity of our brands. We generally enter into endorsement contracts with our athletes for terms of one to three years. There can be no assurance that we will be able to maintain our existing relationships with these individuals in the future or that we will be able to attract new athletes or public personalities to endorse our products in order to grow our brands or product categories. Further, we may not select athletes that are sufficiently popular with our target demographics or successful in their respective action sports. Even if we do select successful athletes, we may not be successful in negotiating commercially reasonable terms with those individuals. If we are unable in the future to secure athletes or arrange athlete endorsements of our products on terms we deem to be reasonable, we may be required to modify our marketing platform and to rely more heavily on other forms of marketing and promotion which may not prove to be as effective as endorsements. In addition, negative publicity concerning any of our sponsored athletes could harm our brand and adversely impact our business.
Any interruption or termination of our relationships with our manufacturers could harm our business.
We purchase a substantial amount of our sunglass products from LEM and substantially all of our goggle products are manufactured by OGK in China. We expect to continue to manufacture substantially all of our
goggles through OGK in 2010. We do not have long-term agreements with any of our manufacturers other than LEM. We cannot be certain that we will not experience difficulties with our manufacturers, such as reductions in the availability of production capacity, errors in complying with product specifications, insufficient quality control, failures to meet production deadlines or increases in manufacturing costs and failures to comply with our requirements for the proper utilization of our intellectual property. Many of our manufacturers have extended credit to us and there can be no assurances that they will continue to do so on commercially reasonable terms or at all. If our relationship with any of our manufacturers is interrupted or terminated for any reason, including the failure of any manufacturer to perform its obligations to us, we would need to locate alternative manufacturing sources. The establishment of new manufacturing relationships involves numerous uncertainties, and we may not be able to obtain alternative manufacturing sources in a manner that would enable us to meet our customer orders on a timely basis or on satisfactory commercial terms. If we are required to change any of our major manufacturers, we would likely experience increased costs, substantial disruptions and delays in the manufacture and shipment of our products and a loss of net sales.
Any failure to maintain ongoing sales through our independent sales representatives or maintain our international distributor relationships could harm our business.
We sell our products to retail locations in the United States and internationally through retail locations serviced by us through our direct sales team and a network of independent sales representatives in the United States, and through our international distributors. We rely on these independent sales representatives and distributors to provide customer contacts and market our products directly to our customer base. Our independent sales representatives are not obligated to continue selling our products, and they may terminate their arrangements with us at any time with limited notice. We do not have long-term agreements with all of our international distributors. Our ability to maintain or increase our net sales will depend in large part on our success in developing and maintaining relationships with our independent sales representatives and our international distributors. It is possible that we may not be able to maintain or expand these relationships successfully or secure agreements with additional sales representatives or distributors on commercially reasonable terms, or at all. Any failure to develop and maintain our relationships with our independent sales representatives or our international distributors, and any failure of our independent sales representatives or international distributors to effectively market our products, could harm our net sales.
We face business, political, operational, financial and economic risks because a significant portion of our operations and sales are to customers outside of the United States.
Our European sales and administration operations as well as some of our manufacturers are located in Italy. We are subject to risks inherent in international business, many of which are beyond our control, including:
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difficulties in obtaining domestic and foreign export, import and other governmental approvals, permits and licenses and compliance with foreign laws, including employment laws;
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difficulties in staffing and managing foreign operations, including cultural and regulatory differences in the conduct of business, labor and other workforce requirements;
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transportation delays and difficulties of managing international distribution channels;
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longer payment cycles for, and greater difficulty collecting, accounts receivable;
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ability to finance our foreign operations;
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fluctuations in currency exchange rates;
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ability to finance our foreign operations;
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trade restrictions, higher tariffs or the imposition of additional regulations relating to import or export of our products;
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unexpected changes in regulatory requirements, royalties and withholding taxes that restrict the repatriation of earnings and effect our effective income tax rate due to profits generated or lost in foreign countries;
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political and economic instability, including wars, terrorism, political unrest, boycotts, curtailment of trade and other business restrictions; and
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difficulties in obtaining the protections of the intellectual property laws of other countries.
Any of these factors could reduce our net sales, decrease our gross margins or increase our expenses.
If we fail to secure or protect our intellectual property rights, or upon expiration of our intellectual property rights, competitors may be able to use our technologies, which could weaken our competitive position, reduce our net sales or increase our costs.
We rely on patent, trademark, copyright, trade secret and trade dress laws to protect our proprietary rights with respect to product designs, product research and trademarks. Our efforts to protect our intellectual property may not be effective and may be challenged by third parties. Despite our efforts, third parties may have violated and may in the future violate our intellectual property rights. In addition, other parties may independently develop similar or competing technologies. If we fail to protect our proprietary rights adequately, our competitors could imitate our products using processes or technologies developed by us and thereby potentially harm our competitive position and our financial condition. We are also susceptible to injury from parallel trade (i.e., gray markets) and counterfeiting of our products, which could harm our reputation for producing high-quality products from premium materials. Infringement claims and lawsuits likely would be expensive to resolve and would require substantial management time and resources. Any adverse determination in litigation could subject us to the loss of our rights to a particular patent, trademark, copyright or trade secret, could require us to obtain licenses from third parties, could prevent us from manufacturing, selling or using certain aspects of our products or could subject us to substantial liability, any of which would harm our results of operations.
Since we sell our products internationally and are dependent on foreign manufacturing in Italy and China, we also are dependent on the laws of foreign countries to protect our intellectual property. These laws may not protect intellectual property rights to the same extent or in the same manner as the laws of the U.S. Although we will continue to devote substantial resources to the establishment and protection of our intellectual property on a worldwide basis, we cannot be certain that these efforts will be successful or that the costs associated with protecting our rights abroad will not be significant. We have been unable to register Spy as a trademark for our products in a few selected markets in which we do business. In addition, although we have filed applications for federal registration, we have no trademark registrations for Spy for our accessory products currently being sold. We may face significant expenses and liability in connection with the protection of our intellectual property rights both inside and outside of the United States and, if we are unable to successfully protect our intellectual property rights or resolve any conflicts, our results of operations may be harmed.
We may be subject to claims by third parties for alleged infringement of their proprietary rights, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.
From time to time, we may receive notices of claims of infringement, misappropriation or misuse of other parties’ proprietary rights. Some of these claims may lead to litigation. Any intellectual property lawsuit, whether or not determined in our favor or settled, could be costly, could harm our reputation and could divert our management from normal business operations. Adverse determinations in litigation could subject us to
significant liability and could result in the loss of our proprietary rights. A successful lawsuit against us could also force us to cease sales or to develop redesigned products or brands. In addition, we could be required to seek a license from the holder of the intellectual property to use the infringed technology, and it is possible that we may not be able to obtain a license on reasonable terms, or at all. If we are unable to redesign our products or obtain a license, we may have to discontinue a particular product offering. If we fail to develop a non-infringing technology on a timely basis or to license the infringed technology on acceptable terms, our business, financial condition and results of operations could be harmed.
If we fail to manage any growth that we might experience, our business could be harmed and we may have to incur significant expenditures to address this growth.
If we experience growth in our operations, our operational and financial systems, procedures and controls may need to be expanded and we may need to train and manage an increasing number of employees, any of which will distract our management team from our business plan and involve increased expenses. Our future success will depend substantially on the ability of our management team to manage any growth effectively. These challenges may include:
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maintaining our cost structure at an appropriate level based on the net sales we generate;
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implementing and improving our operational and financial systems, procedures and controls;
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managing operations in multiple locations and multiple time zones; and
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ensuring the distribution of our products in a timely manner.
Our eyewear products and business may subject us to product liability claims or other litigation, which are expensive to defend, distracting to our management and may require us to pay damages.
Due to the nature of our products and the activities in which our products may be used, we may be subject to product liability claims or other litigation, including claims for serious personal injury, breach of contract, shareholder litigation or other litigation. Successful assertion against us of one or a series of large claims could harm our business by causing us to incur legal fees, distracting our management or causing us to pay damage awards.
We could incur substantial costs to comply with foreign environmental laws, and violations of such laws may increase our costs or require us to change certain business practices.
We use numerous chemicals and generate other hazardous by-products in our manufacturing operations. As a result, we are subject to a broad range of foreign environmental laws and regulations. These environmental laws govern, among other things, air emissions, wastewater discharges and the acquisition, handling, use, storage and release of wastes and hazardous substances. Such laws and regulations can be complex and change often. Remediation of chemicals or other hazardous by-products could require substantial resources which could reduce our cash available for operations, consume valuable management time, reduce our profits or impair our financial condition.
For example, contaminants have been detected at some of our present facilities in Italy. Remediation efforts for such contaminants included the purchase and installation of new paint booths and related equipment, which are nearly complete. Costs related to the remediation efforts during the years ended December 31, 2009 and 2008 included approximately 499,000 Euros and 57,000 Euros, respectively, for machinery and equipment capitalized on the balance sheet under property, plant and equipment, of which 358,000 Euros was purchased through a capital lease during 2009. In addition, we incurred approximately 5,000 Euros for environmental analysis costs, maintenance, spare parts and installation during each of the years ended December 31, 2009 and 2008. We do not expect to incur any further material amounts related to such remediation efforts and expect to be completed by April 30, 2010. However, it is possible that we could incur additional costs in the future related to U.S. and foreign environmental laws.
In the event we are unable to remedy any deficiency we identify in our system of internal controls over financial reporting, or if our internal controls are not effective, our business and our stock price could suffer.
Under Section 404 of the Sarbanes-Oxley Act, or Section 404, management is required to assess the adequacy of our internal controls, remediate any deficiency that may be identified for which there are no compensating controls in place, validate that controls are functioning as documented and implement a continuous reporting and improvement process for internal controls. As part of this continuous process, we may discover deficiencies that require us to improve our procedures, processes and systems in order to ensure that our internal controls are adequate and effective and that we are in compliance with the requirements of Section 404. If any deficiency we may find from time to time is not adequately addressed, or if we are unable to complete all of our testing and any remediation in time for compliance with the requirements of Section 404 and the SEC rules thereunder, we would be unable to conclude that our internal controls over financial reporting are effective, which could adversely affect investor confidence in our internal controls over financial reporting.
We may not successfully integrate any future acquisitions, which could result in operating difficulties and other harmful consequences.
We expect to consider opportunities to acquire or make investments in other technologies, products and businesses from time to time that could enhance our capabilities, complement our current products or expand the breadth of our markets or customer base, although we have no specific agreements with respect to potential acquisitions or investments. We have limited experience in acquiring other businesses and technologies. Potential and completed acquisitions and strategic investments involve numerous risks, including:
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problems assimilating the purchased technologies, products or business operations or managing various different brands;
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problems maintaining uniform standards, procedures, controls and policies;
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unanticipated costs associated with the acquisition;
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diversion of management’s attention from our core business;
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inability to generate sufficient revenues to offset acquisition startup costs;
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harm to our existing business relationships with manufacturers and customers;
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risks associated with entering new markets in which we have no or limited prior experience; and
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potential loss of key employees of acquired businesses.
Acquisitions also frequently result in the recording of goodwill and other intangible assets which are subject to potential impairments that could harm our financial results. If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our stockholders would be diluted.
We will be unable to compete effectively if we fail to anticipate product opportunities based upon emerging technologies and standards and fail to develop products and solutions that incorporate these technologies and standards in a timely manner.
To date, we have introduced various sunglass and goggle products developed around various technologies and standards and we may spend significant time and money on research and development to design and develop
products around any new emerging technologies or industry standards. If an emerging technology or industry standard that we have identified fails to achieve broad market acceptance in our target markets, we may be unable to generate significant revenue from our research and development efforts. Moreover, even if we are able to develop products using adopted standards, our products may not be accepted in our target markets. As a result, our business would be materially harmed.
We have limited experience in designing and developing products that support new technologies or industry standards. If our competitors move away from the use technologies or industry standards that we support with our products and adopt alternative technologies and standards, we may be unable to design and develop new products that conform to these new technologies and standards. The expertise required is unique to each technology and industry standard, and we would have to either hire individuals with the required expertise or acquire such expertise through a licensing arrangement or by other means. The demand for individuals with the necessary expertise to develop a product relating to a particular technology or industry standard is generally high, and we may not be able to hire such individuals. The cost to acquire such expertise through licensing or other means may be high and such arrangements may not be possible in a timely manner, if at all.
Risks Related to the Market for Our Common Stock
Our common stock now trades on the over-the-counter market, which may impact the liquidity of our common stock and our ability to raise additional capital.
Until March 25, 2010, our common stock was quoted on the NASDAQ Capital Market. On September 16, 2009, we received a notice from NASDAQ indicating that, for the preceding 30 consecutive business days, the bid price of our common stock had closed below the $1.00 minimum bid price required for continued listing on the NASDAQ Capital Market under Marketplace Rule 5550(a)(2). Pursuant to Marketplace Rule 5810(c)(3)(A), we had 180 calendar days from the date of the notice, or until March 15, 2010, to regain compliance with the minimum bid price rule. On March 16, 2010, we received a letter from NASDAQ indicating that we had not regained compliance with the Rule and are not eligible for an additional 180 day compliance period. Accordingly, our securities were delisted from the NASDAQ Capital Market on March 25, 2010. We expect our common stock to be traded on the over-the-counter market.
The trading market for our common stock is limited and an active trading market may not develop. Selling our common stock may be difficult because the limited trading market for our shares on the over-the-counter market could result in lower prices and larger spreads in the bid and ask prices of our shares, as well as lower trading volume. In addition, our ability to raise additional capital may be significantly limited as a result of our delisting from the NASDAQ Capital Market. We could face other significant material adverse consequences, including the following:
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a limited availability of market quotations for our common stock;
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a reduced amount of news and analyst coverage of us;
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a decreased ability to issue additional securities or obtain additional financing in the future;
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reduced liquidity for our stockholders;
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increased volatility of our stock price;
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potential loss of confidence by collaboration partners and employees; and
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loss of institutional investor interest and fewer business development opportunities.
In addition, our stock may be defined as a “penny stock” under Rule 3a51-1 under the Exchange Act. “Penny stocks” are subject to Rule 15g-9, which imposes additional sales practice requirements on broker-dealers that sell low-priced securities to persons other than established customers and institutional accredited investors. For transactions covered by this rule, a broker-dealer must make a special suitability determination for the purchaser and have received the purchaser’s written consent to the transaction prior to sale. Consequently, the rule may affect the ability of broker-dealers to sell our common stock and affect the ability of holders to sell their shares of our common stock in the secondary market. To the extent our common stock is subject to the penny stock regulations, the market liquidity for the shares will be adversely affected.
Our stock price may be volatile, and you may not be able to resell our shares at a profit or at all.
The trading price of our common stock fluctuates due to the factors discussed in this section and elsewhere in this report. For example, between January 1, 2008 and February 25, 2010, our stock has traded as high as $5.00 and as low as $0.41. In addition, the trading market for our common stock may be influenced by the public float that exists in our stock from time to time. For example, although as of February 25, 2010 we have approximately 11.9 million shares outstanding, approximately 8.7 million, or approximately 73%, of those shares are held by 10 stockholders. If any of those investors were to decide to sell a substantial portion of their respective shares, it would place substantial downward pressure on our stock price. We also have 1,484,125 shares of our common stock reserved for the exercise of outstanding stock options, of which 553,416 were fully vested and exercisable as of December 31, 2009. Additionally, in connection with our initial public offering, we issued warrants to purchase up to 147,000 shares of common stock to Roth Capital Partners, LLC, and an affiliate, which are fully vested as of December 31, 2009. All 11,903,943 of our outstanding shares of common stock at February 25, 2010 may be sold in the open market, subject to certain limitations.
The trading market for our common stock also is influenced by the research and reports that industry or securities analysts publish about us or our industry. If one or more of the analysts who cover us were to publish an unfavorable research report or to downgrade our stock, our stock price likely would decline. If one or more of these analysts were to cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.
Fluctuations in our operating results on a quarterly and annual basis could cause the market price of our common stock to decline.
Our operating results fluctuate from quarter to quarter as a result of changes in demand for our products, our effectiveness in managing our suppliers and costs, the timing of the introduction of new products and weather patterns. Historically, we have experienced greater net sales in the second and third quarters of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products, and our first and fourth fiscal quarters have traditionally been our weakest operating quarters due to seasonality. We generally sell more of our sunglass products in the first half of the fiscal year and a majority of our goggle products in the last half of the fiscal year. We anticipate that this seasonal impact on our net sales will continue. As a result, our net sales and operating results have fluctuated significantly from period to period in the past and are likely to do so in the future. These fluctuations could cause the market price of our common stock to decline. You should not rely on period-to-period comparisons of our operating results as an indication of our future performance. In future periods, our net sales and results of operations may be below the expectations of analysts and investors, which could cause the market price of our common stock to decline.
Our expense levels in the future will be based, in large part, on our expectations regarding net sales and based on acquisitions we may complete. Many of our expenses are fixed in the short term or are incurred in advance of anticipated sales. We may not be able to decrease our expenses in a timely manner to offset any shortfall of sales.
Because of their significant stock ownership, some of our existing stockholders are able to exert control over us and our significant corporate decisions.
Four of our stockholders and affiliates control over 60% of our outstanding capital stock. Directors Seth Hamot and John Pound have direct or indirect control over approximately 48% of our capital stock, and our current executive officers, directors and their affiliates own or control, in the aggregate, approximately 52% of our outstanding common stock. These stockholders are able to exercise influence over matters requiring stockholder approval, such as the election of directors and the approval of significant corporate transactions, including transactions involving an actual or potential change of control of the company or other transactions that non-controlling stockholders may not deem to be in their best interests. This concentration of ownership may harm the market price of our common stock by, among other things:
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delaying, deferring, or preventing a change in control of our company;
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impeding a merger, consolidation, takeover, or other business combination involving our company;
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causing us to enter into transactions or agreements that are not in the best interests of all stockholders; or
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discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of our company.
Item 1B.
Item 1B. Unresolved Staff Comments
None
Item 2.
Item 2. Properties
Our corporate headquarters totals 30,556 square feet and is located in Carlsbad, California. Our current monthly rent for this facility is approximately $38,000 per month, which we lease on a month to month basis. We also lease one building in Varese, Italy totaling approximately 9,000 square feet with monthly lease payments of approximately $5,000. These facilities are used for international sales and distribution and the lease expires in June 2010; however, we have an option to terminate this lease upon six months’ notice. Additionally, our subsidiary LEM leases three buildings in Italy totaling approximately 29,000 square feet with monthly lease payments of approximately $26,000. These facilities are used for office space, warehousing and manufacturing and the leases expire between March 2010 and March 2011.
We believe our facilities are adequate for our current needs and that suitable additional or substitute space will be available to accommodate foreseeable expansion of our operations or to move our operations in the event one or more of our leases can no longer be renewed on commercially reasonable terms.
Item 3.
Item 3. Legal Proceedings
From time to time we may be party to lawsuits in the ordinary course of business. We are not currently a party to any material legal proceedings.
Item 4.
Item 4. Reserved
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Principal Market and Holders
Our common stock, par value $0.0001, was traded on the NASDAQ Capital Market under the symbol “ORNG” until March 25, 2010 when we were delisted as a result of noncompliance with NASDAQ Listing Rules. Our common stock is now traded in the over-the-counter market. At March 19, 2010, there were 73 stockholders of record of our common stock. Many of the holders are brokers and other institutions on behalf of stockholders; therefore, we are unable to estimate the total number of beneficial owners represented by these stockholders of record.
Dividends
We have never declared or paid any cash dividend on our common stock, nor do we currently intend to pay any cash dividend on our common stock in the foreseeable future. We expect to retain our earnings, if any, for the growth and development of our business. In addition, the terms of our credit facility limit our ability to pay cash dividends on our common stock. A description of our credit facility can be found in this Annual Report under Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Annual Report contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report. Additionally, statements concerning future matters such as the development of new products, our ability to increase manufacturing capacity and sales levels, manage expense levels and other statements regarding matters that are not historical are forward-looking statements.
Although forward-looking statements in this Annual Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to the following: matters generally affected by the domestic and global economy, such as changes in consumer discretionary spending, changes in the value of the U.S. dollar, Canadian dollar and the Euro, and changes in commodity prices; the ability to source raw materials and finished products at favorable prices; risks related to our history of losses; risks related to our ability to access capital market transactions; risks related to our ability to manage growth; risks related to the limited visibility of future orders; the ability to identify and work with qualified manufacturing partners and consultants; the ability to expand distribution channels and retail operations in a timely manner; unanticipated changes in general market conditions or other factors, which may result in cancellations of advance orders or a reduction in the rate of reorders placed by retailers; the ability to continue to develop, produce and introduce innovative new products in a timely manner; the ability to identify and execute successfully cost control initiatives; uncertainties associated with our ability to maintain a sufficient supply of products and to successfully manufacture our products; the performance of new products and continued acceptance of current products; the execution of strategic initiatives and alliances; uncertainties associated with intellectual property protection for our products; and other factors described in Item 1A of Part I of this Annual Report under the caption “Risk Factors,” as well as those discussed elsewhere in this Annual Report. Readers are urged not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Annual Report. Readers are urged to carefully review and consider the various disclosures made in this Annual Report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Annual Report.
Overview
We are a multi-branded designer, developer, manufacturer and distributor of premium sunglasses and goggles. We began as a grassroots brand in Southern California and entered the action sports and lifestyle markets with innovative and performance-driven products and an authentic connection to the action sports and lifestyle markets under the Spy Optic™ brand. We recently entered into a licensing agreement with O’Neill Trademark BV (“O’Neill”) to develop and sell O’Neill™ branded eyewear in addition to our existing brands, Spy™ and SpyOptic™. We have two wholly owned subsidiaries incorporated in Italy, Orange 21 Europe S.r.l. (formerly known as Spy Optic S.r.l., “O21 Europe”) and LEM S.r.l. (“LEM”) (sunglass and goggle manufacturer), and a wholly owned subsidiary incorporated in California, Orange 21 North America (formerly known as Spy Optic, Inc. (“O21NA”), all of which we consolidate in our financial statements. Spy Optic S.r.l. changed its name to Orange 21 Europe effective October 13, 2009. Spy Optic, Inc. changed its name to Orange 21 North America Inc. effective January 11, 2010.
Action Sports Lifestyle Brands
We design, develop and market premium products for the action sports, motorsports, snowsports and lifestyle markets. Our principal products, sunglasses and goggles, are marketed primarily under the brands, Spy™, SpyOptic™ and O’Neill™. These products target the action sport and power sports markets, including surfing, skateboarding, snowboarding, ski and motocross, and the lifestyle market within fashion, music and entertainment. We have built our brands by developing innovative, proprietary products that utilize high-quality materials and optical lens technology to convey performance, style, quality and value. We sell our products in approximately 3,000 retail locations in the United States and Canada and internationally through approximately 3,000 retail locations serviced by our international distributors and us. We have developed strong relationships with key multi-store action sport and lifestyle retailers as well as sunglass specialty retailers in the United States, such as Zumiez, Inc., Sunglass Hut, Tilly’s Clothing, Shoes & Accessories, No Fear, Solstice, Totes/Sunglass World, Sun Diego, Industrial Skateboards and a strategically selective collection of specialized individually owned and operated surf, skate, snow and motocross stores. We began marketing and selling the O’Neill™ brand following our entry into a license agreement with O’Neill Trademark BV in 2009.
For the Spy and O’Neill brands, we focus our marketing and sales efforts on the action sports, motorsports, snowsports and lifestyle markets, and specifically, persons ranging in age from 17 to 35. We separate our eyewear products into two groups: sunglasses, which includes fashion, performance sport and women-specific sunglasses, and goggles, which includes snowsport and motocross goggles. In addition, we sell branded sunglass and goggle accessories. In managing our business, we are particularly focused on ensuring that our product designs are keyed to current trends in the fashion industry, incorporate the most advanced technologies to enhance performance and provide value to our target market.
Other Lifestyle Brand
In February of 2010, we further diversified our brand portfolio by partnering with Jimmy Buffett and his Margaritaville™ brand for eyewear. Mr. Buffett has developed the Margaritaville brand into a commercially successful brand platform built around the island culture lifestyle and music. The Margaritaville brand has had a successful track record with its sales of attire, foods, spirits and party/tailgate essentials. The Margaritaville brand attracts a diverse customer base that enjoys bringing Margaritaville with them wherever they go.
Results of Operations
Years Ended December 31, 2009 and 2008
Net Sales
Consolidated net sales decreased 27.6% to $34.2 million for the year ended December 31, 2009 from $47.3 million for the year ended December 31, 2008. We believe that the overall decrease is largely due to a decline in the economy and consumer discretionary spending. Sales have decreased across all lines including snow and motocross goggles and sunglasses and amongst all customer classes. Sunglass sales represented approximately 71% and 67% of net sales during the years ended December 31, 2009 and 2008, respectively. Goggle sales represented approximately 28% and 31% of net sales during the years ended December 31, 2009 and 2008, respectively. Apparel and accessories represented approximately 1% and 2% of net sales during the years ended December 31, 2009 and 2008, respectively. We increased sunglass prices mid 2008 and decreased prices for certain goggles during 2009. We also limited the production of apparel and accessories during late 2008 and early 2009 and began to sell only select items primarily on a prebook basis. Domestic net sales represented 70% and 71% of total net sales for the years ended December 31, 2009 and 2008, respectively. Foreign net sales represented 30% and 29% of total net sales for the years ended December 31, 2009 and 2008, respectively.
Cost of Sales and Gross Profit
Our consolidated gross profit decreased 35% to $13.8 million for the year ended December 31, 2009 from $21.3 million for the year ended December 31, 2008. Gross profit as a percentage of net sales decreased to 40% for the year ended December 31, 2009 from 45% for the year ended December 31, 2008 largely due to: (1) a $0.1 million net decrease in inventory reserves for slow moving and obsolete inventory during the year ended December 31, 2009 compared to a $1.0 million net decrease in inventory reserves during the year ended December 31, 2008 as a result of the sale and disposal of previously reserved inventory. The net decreases for each year included additions of $0.9 million and $0.3 million during the years ended December 31, 2009 and 2008, respectively, (2) a $0.6 million decrease in capitalized inventory overhead costs during the year ended December 31, 2009 compared to a $0.1 million decrease during the year ended December 31, 2008 both as a result of the reduction of inventory levels and purchasing due to management’s efforts to decrease inventory levels at O21NA and O21 Europe, (3) $0.4 million for impairment charges on molds and tooling no longer in use and (4) unabsorbed fixed costs at LEM due to the decrease in sales as a result of the reduced discretionary spending and decreased plant hours during 2009 due to the reduction in employee-related costs discussed below. In addition, the gross profit margin was positively impacted by the decrease of $0.6 million in sales return reserve during the year ended December 31, 2009 compared to increase of $0.1 million during the year ended December 31, 2008. The decrease in 2009 was mainly due to the decrease in average returns percentage and the overall decrease in net sales.
Employee-related decreases were achieved in 2009 over 2008 as a result of temporary plant and office shutdowns both in the U.S. and in Italy, reduction in workforce through no replacement of certain terminated employees and as a result of a temporary 10% reduction in compensation for our U.S. employees and 20% to 30% reduction of salary expense in Italy resulting from a ten-week government-subsidized leave program at LEM, whereby certain employees’ work schedules were reduced. As part of this program at LEM, the Italian government subsidized a portion of employees’ salaries to minimize the effect on the employees and us. Both the reduction in the U.S. and the program at LEM began on March 13, 2009 and continued in the U.S. through the date of this report. These efforts in the U.S. and at LEM were and are currently aimed at reducing expenses during the current global economic downturn.
Sales and Marketing Expense
Sales and marketing expense decreased 38% to $7.3 million for the year ended December 31, 2009 from $11.8 million for the year ended December 31, 2008. The decrease is primarily due to reduced sales commissions of $1.5 million as a result of declining sales and the restructuring of sales compensation plans, as well as reductions of other sales and marketing expenditures, including point-of-purchase displays and materials of $0.8 million, employee-related expenses of $0.3 million, advertising of $0.4 million, athletes of $0.3 million, consulting of $0.2 million, depreciation of $0.1 million due to disposal of vehicles, travel, tradeshows and events and various other expenses. Marketing expense reductions are primarily due to an overall effort by management to improve efficiencies and cut costs to be more in line with the decline in sales due to the current economic conditions.
General and Administrative Expense
General and administrative expense decreased 23% to $7.6 million for the year ended December 31, 2009 from $9.9 million for the year ended December 31, 2008. The decrease was largely due to the $0.9 million decrease in bad debt reserve at O21NA due to the reversal of $0.4 million reserve during 2009, which was previously reserved for in 2008 for related parties, No Fear and MX No Fear, as a result of the Settlement Agreement with the No Fear Parties as discussed in Note 13 “Related Party Transactions” to the Notes to Consolidated Financial Statements in Item 8.
Item 8. Financial Statements and Supplementary Data
ORANGE 21 INC. AND SUBSIDIARIES
Index to Consolidated Financial Statements
Page
Report of Independent Registered Public Accounting Firm
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2009 and 2008
Consolidated Statements of Operations for the years ended December 31, 2009 and
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2009 and
Consolidated Statements of Cash Flows for the years ended December 31, 2009 and
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
Orange 21 Inc. and Subsidiaries
Carlsbad, California
We have audited the accompanying consolidated balance sheets of Orange 21 Inc. (a Delaware corporation) and its subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. We have also audited the financial statement schedule listed at Item 15(a). These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and the schedule 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 audit 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 audit 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. 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 consolidated financial position of Orange 21 Inc. and its subsidiaries as of December 31, 2009 and 2008, and the consolidated 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. Also, in our opinion, the schedule listed at item 15(a) presents fairly, in all material respects, the information set forth therein.
/s/ Mayer Hoffman McCann P.C.
San Diego, California
March 26, 2010
ORANGE 21 INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Thousands, except number of shares and per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
ORANGE 21 INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
ORANGE 21 INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(Thousands)
The accompanying notes are an integral part of these consolidated financial statements.
ORANGE 21 INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Thousands)
The accompanying notes are an integral part of these consolidated financial statements.
ORANGE 21 INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Significant Accounting Policies
Basis of Presentation
Description of Business
Orange 21 Inc. (the “Company”) was originally formed as a California corporation in 1992. On November 29, 2004, upon reincorporation in the State of Delaware, the Company changed its name from Spy Optic, Inc. to Orange 21 Inc. and the Board of Directors of the Company approved a 16 to 1 reverse stock split and authorized 5,000,000 shares of preferred stock. All financial data and share data in these consolidated financial statements give retroactive effect to this split.
The Company designs, develops, manufactures and distributes high quality and high performance products for the action sports, motor sports and lifestyle markets. The Company’s current products include sunglasses, snowsport and motocross goggles and branded accessories. Orange 21 Europe, S.r.l., formerly known as Spy Optic, S.r.l. (“O21 Europe”), a wholly owned subsidiary, was incorporated in Italy in July 2001. O21 Europe manages the distribution, sales, customer service and administration for the Company’s business outside of North America. Orange 21 North America Inc., formerly known as Spy Optic, Inc. (“O21NA”), a California corporation, was formed on December 20, 2004 as a wholly owned subsidiary. In January 2006, the Company completed the acquisition of its manufacturer LEM S.r.l. (“LEM”). See Note 18 “Acquisitions” of the Notes to the Consolidated Financial Statements.
Basis of Presentation
The accompanying consolidated financial statements of Orange 21 Inc. and its subsidiaries have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States. In the opinion of management, the consolidated financial statements contain all adjustments, consisting of normal recurring items, considered necessary for a fair presentation of the Company’s financial position, results of operations and cash flows.
Capital Resources
If the Company is able to achieve anticipated net sales, manage its inventory and manage operating expenses, the Company believes that its cash on hand and available loan facilities will be sufficient to enable the Company to meet their operating requirements for at least the next 12 months. Otherwise, changes in operating plans, lower than anticipated net sales, increased expenses or other events, including those described in Item 1A, “Risk Factors,” may require the Company to seek additional debt or equity financing in the future. Due to current economic conditions, on March 13, 2009, the Company temporarily reduced its employee-related expenses by approximately 10% in the U.S., which reductions are currently continuing into the first quarter 2010, and approximately 20%-30% in salary costs at its Italian-based subsidiary, LEM, which reductions lasted approximately ten weeks. The reductions were and are being achieved through a combination of temporarily-reduced salaries and work schedules as well as mandatory vacation leave. The reductions at LEM were partly offset by reimbursements through the Italian government to minimize the effects on the employees. In addition, the Company is in the process of streamlining its Italian manufacturing and sales operations, which the Company expects could provide additional savings.
The Company’s future capital requirements will depend on many factors, including its ability to maintain or grow net sales, its ability to manage expenses and expected capital expenditures among other issues. The Company may be required to seek additional equity or debt financing in the future, which may result in additional dilution of its stockholders. Additional debt financing would result in increased interest expense and
could result in covenants that would restrict its operations. The Company relies on its credit line with BFI Business Finance (“BFI”), San Paolo IMI and other credit arrangements to fund working capital needs. The recent unprecedented disruptions in the credit and financial markets and resulting decline in general economic and business conditions may adversely impact the Company’s access to capital through its credit line and other sources. Under the terms of the Company’s Loan Agreement with BFI (see Note 6 “Financing Arrangements” to the Consolidated Financial Statements), BFI may reduce the Company’s borrowing availability in certain circumstances, including, without limitation, if in its reasonable business judgment the Company’s creditworthiness, sales or the liquidation value of the Company’s inventory have declined materially. Further, the Loan Agreement provides that BFI may declare the Company in default if the Company experiences a material adverse change in its business or financial condition or if BFI determines that the Company’s ability to perform under the Loan Agreement is materially impaired. The current economic environment could also cause lenders and other counterparties who provide the Company credit to breach their obligations to the Company, which could include, without limitation, lenders or other financial services companies failing to fund required borrowings under the Company’s credit arrangements. Any of the foregoing could adversely impact the Company’s business, financial condition or results of operations.
Effective March 23, 2010, the Company entered into a $3.0 million Promissory Note with Costa Brava Partnership III, L.P. (“Costa Brava”) which matures on July 29, 2011. The Promissory Note is subordinated to the Company’s Loan Agreement, as amended, with BFI, pursuant to the terms of a Debt Subordination Agreement, dated March 23, 2010, by and between Costa Brava and BFI. The proceeds from the Note are expected to be used (i) to prepay the current balance on the Company’s revolving line of credit balance with BFI in its entirety and (ii) if any proceeds remain after such prepayment, for working capital purposes. However, the Company may continue to re-borrow from BFI under the Loan and Security Agreement after such prepayment is made. The terms of the Promissory Note include customary representations and warranties, as well as reporting and financial covenants, customary for financings of this type.
If the Company requires additional financing as a result of the foregoing or other factors, the capital markets turmoil could negatively impact the Company’s ability to obtain such financing. The Company’s access to additional financing will depend on a variety of factors (many of which the Company has little or no control over) such as market conditions, the general availability of credit, the overall availability of credit to its industry, its credit ratings and credit capacity, as well as the possibility that lenders could develop a negative perception of its long-term or short-term financial prospects. If future financing is not available or is not available on acceptable terms, the Company may not be able to fund its future needs which could also restrict its operations.
NASDAQ Deficiency
On September 16, 2009, the Company received a notice from NASDAQ indicating that, for the preceding 30 consecutive business days, the bid price of its common stock had closed below the $1.00 minimum bid price required for continued listing on the NASDAQ Capital Market under Marketplace Rule 5550(a)(2). Pursuant to Marketplace Rule 5810(c)(3)(A), the Company had 180 calendar days from the date of the notice, or until March 15, 2010, to regain compliance with the minimum bid price rule. To regain compliance, the closing bid price of the Company’s common stock had to be at or above $1.00 per share for a minimum of 10 consecutive business days, which was not achieved. On March 16, 2010, the Company received a letter from NASDAQ indicating that it had not regained compliance with the Rule and is not eligible for an additional 180 day compliance period given that the Company does not meet the NASDAQ Capital Market initial listing standard set forth in Listing Rule 5505. Accordingly, the Company’s securities were delisted from the NASDAQ Capital Market on March 25, 2010. The Company’s common stock was suspended from trading on the NASDAQ Capital Market was suspended on March 25, 2010 and is now traded in the over-the-counter market.
Use of Estimates
The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Significant estimates
used in preparing these consolidated financial statements include those assumed in computing allowance for doubtful accounts receivable, reserve for obsolete inventory, reserve for sales returns, the testing of goodwill and long-lived assets for impairment and the valuation allowance on deferred tax assets. Accordingly, actual results could differ from those estimates.
Accounts Receivable, Reserve for Refunds and Returns and Allowance for Doubtful Accounts
Throughout the year, the Company performs credit evaluations of its customers, and adjusts credit limits based on payment history and the customer’s current creditworthiness. The Company continuously monitors its collections and maintains a reserve for estimated credits. The Company reserves for estimated future refunds and returns at the time of shipment based upon historical data and adjusts reserves as considered necessary. The Company makes judgments as to its ability to collect outstanding receivables and provides allowances for anticipated bad debts and refunds. Provisions are made based upon a review of all significant outstanding invoices and overall quality and age of those invoices not specifically reviewed. In determining the provision for invoices not specifically reviewed, the Company analyzes collection experience, customer credit-worthiness and current economic trends. If the data used to calculate these allowances does not reflect future ability to collect outstanding receivables, an adjustment in the reserve for refunds may be required. Historically, the Company’s losses have been consistent with estimates, but there can be no assurance that it will continue to experience the same credit loss rates that it has experienced in the past. Unforeseen, material financial difficulties experienced by its customers could have an adverse impact on profits.
Inventories
Inventories consist primarily of raw materials and finished products, including sunglasses, goggles, apparel and accessories, product components such as replacement lenses and purchasing and quality control costs. Inventory items are carried on the books at the lower of cost or market using the weighted average cost method for LEM and first in first out method for our distribution business. Periodic physical counts of inventory items are conducted to help verify the balance of inventory. A reserve is maintained for obsolete or slow moving inventory. Products are reserved at certain percentages based on their probability of selling, which is estimated based on current and estimated future customer demands and market conditions.
Long-Lived Assets
Property and equipment are recorded at cost and are depreciated over the estimated useful lives of the assets (two to thirty three years) using the straight-line method. Amortization of leasehold improvements is computed on the straight-line method over the shorter of the remaining lease term or the estimated useful lives of the assets. Expenditures for repairs and maintenance are expensed as incurred. Gains and losses from the sale or retirement of property and equipment are charged to operations in the period realized or incurred.
Intangible assets consist of trademarks, patents and a customer related intangible that are being amortized on a straight-line basis over 5 to 8.3 years. Amortization expense was approximately $110,000 and $103,000 for the years ended December 31, 2009 and 2008, respectively. Amortization expense related to intangible assets at December 31, 2009 in each of the next five years and beyond is expected to be incurred as follows:
The Company evaluates the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that such carrying values may not be recoverable. The Company estimates the future undiscounted cash flows derived from an asset to assess whether or not a potential impairment exists when events or circumstances indicate the carrying value of a long-lived asset may differ. If the sum of the undiscounted cash flows is less than the carrying value, an impairment loss will be recognized, measured as the amount by which the carrying value exceeds the fair value of the asset. The Company uses its best judgment based on the most current facts and circumstances surrounding its business when applying these impairment rules to determine the timing of the impairment test, the undiscounted cash flows used to assess impairments and the fair value of a potentially impaired asset. Changes in assumptions used could have a significant impact on the Company’s assessment of recoverability. Numerous factors, including changes in the Company’s business, industry segment or the global economy could significantly impact management’s decision to retain, dispose of or idle certain of its long-lived assets. For the years ended December 31, 2009 and 2008, the Company recorded impairment charges of approximately $336,000 and $250,000, respectively. See Note 4, “Property and Equipment”, for information regarding asset impairment charges recognized by the Company. At December 31, 2009 and 2008, no impairment of the intangible assets had occurred and the amortization periods remain appropriate.
Goodwill
Goodwill is not amortized, but instead is measured for impairment at least annually on October 1 to allow for the necessary time to complete an external valuation of the reporting units based on the best estimate at that date. The Company also tests for impairment if events or circumstances indicate that it is more likely than not that the fair value of a reporting unit is below its carrying amount. The Company evaluates the recoverability of goodwill based on a two-step impairment test. The first step compares the fair value of each reporting unit, with its carrying amount, including goodwill. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. The fair value of each reporting unit is determined using a combination of the income approach and the market approach. Under the income approach, the fair value of a reporting unit is calculated based on the present value of estimated future cash flows. The present value of estimated future cash flows uses estimates of profit for the reporting units, driven by assumed market growth rates and assumed market segment share and estimated costs as well as appropriate discount rates. These estimates are consistent with the plans and estimates that the Company uses to manage the underlying business. Under the market approach, fair value is estimated based on market multiples of earnings for comparable companies and similar transactions.
The Company uses a discounted cash flow model to estimate the fair value of reporting units, which involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the extent of such charge. Estimates and assumptions critical to the Company’s fair value estimates under the discounted cash flow models include discount rates, royalty rates and cash flow projections and inherent in cash flow projections are estimates regarding projected revenue growth rates, projected cost reductions and efficiencies and projected long-term growth rates in the determination of terminal values.
The Company measures the amount of any goodwill impairment based upon the estimated fair value of the underlying assets and liabilities of the reporting unit, including any unrecognized intangible assets and estimates the implied fair value of goodwill. The Company identifies the unrecognized intangible assets, such as trade name and customer relationships, and uses discounted cash flow models to estimate the values of the reporting unit’s recognized and unrecognized intangible assets. The estimated values of the reporting unit’s intangible assets and net tangible assets are deducted from the reporting unit’s total value to determine the implied fair value of goodwill. An impairment charge is recognized to the extent the recorded goodwill exceeds the implied fair value of goodwill.
The Company performed an annual test of goodwill on October 1, 2008 and determined that the fair values of the reporting units exceeded their carrying values, with a “cushion” of approximately 4% on a combined fair value basis. Since there were no indications of impairment the second step was not performed.
With the significant deterioration in the retail business climate as well as a large decline in the market value of the Company’s common stock during the fourth quarter for the year ended December 31, 2008, the Company determined an interim evaluation of goodwill impairment was warranted. As a result of this interim testing, the Company determined that the goodwill associated with the January 2006 acquisition of its manufacturer, LEM, was fully impaired. The Company recorded a pre-tax non-cash goodwill impairment charge of $8.4 million in its December 31, 2008 financial statements. As of December 31, 2008, the Company had no further goodwill recorded on its balance sheet and therefore no annual test was performed during the year ended December 31, 2009. See also Note 18.
Point-of-Purchase Displays
In the U.S., the cost of point-of-purchase displays is currently being charged to sales and marketing expense as ownership is transferred to the customer upon shipment of the display. In Italy, the cost is capitalized and ownership remains with Orange 21 Europe.
Revenue Recognition
The Company’s revenue is primarily generated through sales of sunglasses, goggles and apparel, net of returns and discounts. Revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. These criteria are usually met upon delivery to the Company’s carrier, which is also when the risk of ownership and title passes to the Company’s customers.
Generally, the Company extends credit to its customers after performing credit evaluations and does not require collateral. The Company’s payment terms generally range from net-30 to net-90, depending on the country or whether it sells directly to retailers in the country or to a distributor. The Company’s distributors are typically set up as prepay accounts; however credit may be extended to certain distributors, usually upon receipt of a letter of credit. Generally, the Company’s sales agreements with its customers, including distributors, do not provide for any rights of return or price protection. However, the Company does approve returns on a case-by-case basis in its sole discretion. The Company records an allowance for estimated returns when revenues are recorded. The allowance is calculated using historical evidence of actual returns. Historically, actual returns have been within the Company’s expectations. If future returns are higher than the Company’s estimates, the Company’s earnings would be adversely affected.
Advertising
The Company expenses advertising costs as incurred. Total advertising expense was approximately $144,000 and $464,000 for the years ended December 31, 2009 and 2008, respectively.
Product Warranty
The Company warrants its products for one year. The standard warranty requires the Company to replace any product or portion thereof that is deemed a manufacturer’s defect. The Company records warranty expense as incurred and records the expense in cost of sales. Based on historical evidence and future estimates warranty expense is not considered to be material for additional accrual.
Research and Development
The Company expenses research and development costs as incurred.
Shipping and Handling
The Company records shipping and handling costs charged to customers as revenue and other shipping and handling costs to cost of sales as incurred.
Financial Instruments
Certain financial instruments are carried at cost on the consolidated balance sheets, which approximates fair value due to their short-term, highly liquid nature. These instruments include cash, accounts receivable, accounts payable, accrued expense, other short-term liabilities, capital leases and notes payable. The carrying fair value of the Company’s long-term debt, including the current portion approximates fair value as of December 31, 2009. The estimated fair value has been determined based on rates for the same or similar instruments.
Fair value is defined as the exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. There is an established hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use in valuing the asset or liability and are developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the factors market participants would use in valuing the asset or liability. There are three levels of inputs that may be used to measure fair value:
Level 1 uses unadjusted quoted prices that are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the assets or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.
Level 2 uses inputs other than level 1 that are either directly or indirectly observable as of the reporting date through correlation with market data, including quoted prices for similar assets and liabilities in active markets and quoted prices in markets that are not active. Level 2 also includes assets and liabilities that are valued using models or other pricing methodologies that do not require significant judgment since the input assumptions used in the models, such as interest rates volatility factors, are corroborated by readily observable data.
Level 3 uses inputs that are unobservable and are supported by little or no market activity and reflect the use of significant management judgment. These values are generally determined using pricing models for which the assumptions utilize management’s estimates of market participant’s assumptions.
As of December 31, 2009, the financial liabilities measured at fair value consisted of an interest rate swap agreement. The value is based on model-driven valuation whose inputs are observable. The following table summarizes the financial liabilities measured at fair value on a recurring basis as of December 31, 2009 and the level it falls within the fair value hierarchy:
Foreign Currency
The functional currencies of the Company’s wholly owned subsidiaries, O21NA, O21 Europe and LEM are their respective local currency. Accordingly, the Company is exposed to transaction gains and losses that could result from changes in foreign currencies. Assets and liabilities denominated in foreign currencies are translated at the rate of exchange on the balance sheet date. Revenues and expenses are translated using the average exchange rate for the period. Gains and losses from translation of foreign subsidiary financial statements are included in accumulated other comprehensive income (loss).
Derivatives and Hedging
The Company is exposed to gains and losses resulting from fluctuations in foreign currency exchange rates relating to forecasted product purchases denominated in foreign currencies and transactions of its foreign subsidiaries. As part of its overall strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, the Company has used foreign exchange contracts in the form of forward contracts.
Net gains on cash flow hedges included in OCI are as follows:
During the years ended December 31, 2009 and 2008, the Company did not discontinue any cash flow hedges for which it was probable that a forecasted transaction would not occur.
For foreign currency contracts designated as cash flow hedges, hedge effectiveness is measured using the spot rate. Changes in the spot-forward differential are excluded from the test of hedge effectiveness and are recorded currently in earnings in the foreign currency transaction gain. The Company measures effectiveness by comparing the cumulative change in the hedge contract with the cumulative change in the hedged item.
Foreign currency derivatives are used only to meet the Company’s objectives of minimizing variability in the Company’s operating results arising from foreign exchange rate movements which may include derivatives that do not meet the criteria for hedge accounting. The Company does not enter into foreign exchange contracts for speculative purposes.
In 2009, the Company acquired an interest rate option with a notional principal amount of 200,000 Euros to reduce its exposure to changing European interest rates. This option has not been designated as a hedging instrument. It is carried on the balance sheet at fair value. Changes in the fair value are recorded in current earnings and are considered to be immaterial.
Earnings (Loss) Per Share
Basic earnings (loss) per share is computed by dividing net income or loss by the weighted-average number of common shares outstanding during the period. Diluted earnings per share is calculated by including the additional shares of common stock issuable upon exercise of outstanding options and warrants and upon vesting of restricted stock, using the treasury stock method. The following table lists the potentially dilutive equity instruments, each convertible into one share of common stock, used in the calculation of diluted earnings per share for the periods presented:
The following potentially dilutive instruments were not included in the diluted per share calculation for periods presented as their inclusion would have been antidilutive:
Income Taxes
In assessing the realization of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The Company considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based on the level of historical operating results and the uncertainty of the economic conditions, the Company has recorded a full valuation allowance against its deferred tax assets at December 31, 2009 and 2008 in each jurisdiction where it cannot conclude that it is more likely than not that those assets will be realized.
Royalties
The Company has several royalty agreements with third parties, which represent agreements that the Company has with several athletes to use them in endorsing or advertising several of its products. Royalty expense during the years ended December 31, 2009 and 2008 was approximately $121,000 and $170,000, respectively.
Comprehensive Income (Loss)
Comprehensive income (loss) represents the results of operations adjusted to reflect all items recognized under accounting standards as components of comprehensive income (loss). Total comprehensive loss for the years ended December 31, 2009 and 2008 was approximately $3.4 million and $16.8 million, respectively.
The components of accumulated other comprehensive income, net of tax, are as follows:
Share-Based Compensation
The Company measures the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the consolidated statement of operations over the period during which the employee is required to provide service in exchange for the award-the requisite service period. No compensation cost is recognized for equity instruments for which
employees do not render the requisite service. The grant-date fair value of employee share options and similar instruments is estimated using the Black-Scholes option-pricing valuation model adjusted for the unique characteristics of those instruments.
Recently Issued Accounting Pronouncements
In June 2009, the FASB issued authoritative guidance, which establishes the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP. The guidance is effective for interim and annual periods ending after September 15, 2009 and did not have a material impact on the Company’s consolidated financial statements.
In August 2009, the FASB issued changes to fair value accounting for liabilities. These changes clarify existing guidance that in circumstances in which a quoted price in an active market for the identical liability is not available, an entity is required to measure fair value using either a valuation technique that uses a quoted price of either a similar liability or a quoted price of an identical or similar liability when traded as an asset, or another valuation technique that is consistent with the principles of fair value measurements, such as an income approach (e.g., present value technique). This guidance also states that both a quoted price in an active market for the identical liability and a quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. These changes became effective for the Company on October 1, 2009. The Company determined that the adoption of these changes did not have an impact on the consolidated financial statements.
2. Accounts Receivable
Accounts receivable consisted of the following:
3. Inventories
Inventories consisted of the following:
The Company’s balances are net of an allowance for obsolescence of approximately $1,187,000 and $1,284,000 at December 31, 2009 and 2008, respectively.
4. Property and Equipment
Property and equipment consisted of the following:
Impairment charges of $336,000 were recorded during the year ended December 31, 2009. Approximately $387,000 relates to molds and tooling no longer in service and is recorded under the caption “Cost of Sales” in the accompanying Consolidated Statement of Operations and $24,000 relates to property and equipment no longer in service and is recorded under the caption “General and administrative”. These charges are partially offset by a $75,000 recovery of a deposit on production assets that was previously impaired and are recorded in “Cost of Sales”. Impairment charges of $250,000 were recorded during the year ended December 31, 2008. Approximately $92,000 relates to molds and tooling no longer in service and is recorded under the caption “Cost of Sales” in the accompanying Consolidated Statement of Operations. The remaining $158,000 relates to property and equipment no longer in service, of which $100,000, $48,000 and $10,000 are recorded under the captions “Cost of sales,” Sales and marketing” and “General and administrative,” respectively, in the accompanying Consolidated Statements of Operations.
Depreciation expense was approximately $1,669,000 and $1,880,000 for the years ended December 31, 2009 and 2008, respectively.
5. Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities consisted of the following:
6. Financing Arrangements
Credit Facilities
On February 26, 2007, O21NA, the Company’s wholly owned subsidiary, entered into a Loan and Security Agreement (“Loan Agreement”) with BFI with a maximum borrowing capacity of $5.0 million, which was subsequently modified on December 7, 2007 and February 12, 2008 to extend the maximum borrowing capacity to $8.0 million and affect certain other changes. Actual borrowing availability under the Loan Agreement is based on eligible trade receivable and inventory levels of O21NA. Loans extended pursuant to the Loan Agreement will bear interest at a rate per annum equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5% with a minimum monthly interest charge of $2,000. The Company granted BFI a security interest in substantially all of O21NA’s assets as security for its obligations under the Loan Agreement. Additionally, the obligations under the Loan Agreement are guaranteed by Orange 21 Inc. The Loan Agreement renews annually in February for one additional year unless otherwise terminated by either the Company or by BFI. The Loan Agreement renewed in February 2010 until February 2011.
The Loan Agreement imposes certain covenants on O21NA, including, but not limited to, covenants requiring the Company to provide certain periodic reports to BFI, inform BFI of certain changes in the business, refrain from incurring additional debt in excess of $100,000 and refrain from paying dividends. O21NA also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between O21NA and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to O21NA any amounts remaining after payment of all amounts due under the Loan Agreement. To secure its obligations under the guaranty, Orange 21 Inc. granted BFI a blanket security interest in substantially all of its assets. The Company was in compliance with the covenants under the Loan Agreement at December 31, 2009. At December 31, 2009 and December 31, 2008, there were outstanding borrowings of $3.0 million and $3.8 million, respectively, under the Loan Agreement. The interest rate at December 31, 2009 was 5.8%, and availability under this line was $0.9 million.
The Company has a 1.3 million Euros line of credit in Italy with San Paolo IMI for LEM S.r.l., the Company’s wholly owned subsidiary and manufacturer (“LEM”), which was reduced at December 31, 2009 to 0.6 million Euros. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At December 31, 2009, there was approximately 0.1 million Euros available under this line of credit. At December 31, 2009 and 2008, outstanding amounts under this line of credit amounted to $0.8 million and $1.9 million, respectively. The interest rate at December 31, 2009 was 2.5%.
As a result of the reductions in the Italian line of credit with San Paolo IMI, LEM entered into an unsecured note with San Paolo IMI during June 2009 for 0.4 million Euros. The note is guaranteed by Eurofidi, a government sponsored third party that guarantees debt, and bears interest at EURIBOR 3 months interest rate plus a 1.27% spread, payable in quarterly installments due from June 2009 through September 2014. LEM was not in compliance with certain debt covenants required by San Paolo IMI related to this note and therefore the entire balance of the note is classified as current. If San Paola IMI were to call this unsecured note as a result of noncompliance with the debt covenants, LEM’s operations and cash flow would be adversely impacted.
Effective March 23, 2010, O21NA entered into a $3.0 million Promissory Note with Costa Brava. The Promissory Note is subordinated to O21NA’s Loan Agreement with BFI. The proceeds from the Note are expected to be used (i) to prepay the current balance on O21NA’s revolving line of credit balance with BFI in its entirety and (ii) if any proceeds remain after such prepayment, for working capital purposes. However, O21NA may continue to re-borrow from BFI under the Loan Agreement after such prepayment is made.
Interest under the Promissory Note accrues daily at the following rates: (i) from the date of receipt of funds under the Promissory Note through April 30, 2010, at (A) 6% per annum on the last day of each calendar
month and (B) 6% per annum payable on April 30, 2010, and (ii) from May 1, 2010 through the maturity date, at (A) 9% per annum on the last day of each calendar month and (B) 3% per annum payable on the maturity date. In addition, the Promissory Note requires that O21NA pays a facility fee of 1% of the original principal amount on December 31, 2010 and the maturity date. The Promissory Note matures on July 29, 2011. The terms of the Promissory Note include customary representations and warranties, as well as reporting and financial covenants, customary for financings of this type.
7. Notes Payable
Notes payable at December 31, 2009 consist of the following:
(1) LEM was not in compliance with certain debt covenants required by San Paolo IMI related to this note and therefore the entire balance of the note is classified as current.
Future minimum payments under long-term debt agreements are as follows:
8. Stockholder’s Equity
Common Stock
During 2009 and 2008 an aggregate of 135,275 and 15,000 shares of common stock, respectively, were issued to individuals upon vesting of restricted stock awards.
Shares Reserved
The Company had 100,000,000 authorized shares of common stock at December 31, 2009. The table below outlines common shares reserved for future issuance:
9. Fair Value of Financial Instruments
In April 2009, the Company adopted the FASB’s authoritative guidance on interim disclosures about fair value of financial instruments, which requires disclosures about fair value of financial instruments in interim as well as in annual financial statements. The Company’s financial instruments include cash, accounts receivable and payable, short-term borrowings and accrued liabilities. The carrying amount of these instruments approximates fair value because of their short-term nature. The carrying fair value of the Company’s long-term debt, including the current portion approximates fair value as of December 31, 2009. The estimated fair value has been determined based on rates for the same or similar instruments.
10. Share-Based Compensation
In December 2004, the Board of Directors of the Company adopted, and the stockholders of the Company approved, the 2004 Stock Incentive Plan (the “Plan”). The Plan provides for the grant of incentive stock options to employees only, and restricted stock, stock units, nonqualified options or SARS to employees, consultants and outside directors. The Plan is administered by the Compensation Committee who determines the vesting period, exercise price and other details for each award. In April 2007, in connection with a determination by the Board of Directors to reduce the annual cash compensation paid to the non-employee directors of the Company, the Board of Directors approved an amendment and restatement of the Plan that: (1) increases the number of shares of the Company’s Common Stock underlying the non-qualified stock options that are automatically granted to the Company’s non-employee directors upon their appointment to the Board of Directors and on an annual basis thereafter and (2) modifies the vesting schedule for the automatic option grants made to non-employee directors upon their initial appointment to the Board of Directors. The amendment and restatement of the Plan was approved by the Company’s stockholders at the annual meeting held on June 12, 2007.
Stock Option Activity
Intrinsic value is defined as the difference between the relevant current market value of the common stock and the grant price for options with exercise prices less than the market values on such dates. During the years ended December 31, 2009 and 2008, the Company received $0 in cash proceeds from the exercise of stock options.
On May 26, 2009, the Compensation Committee of the Company’s Board of Directors (the “Committee”) determined, in accordance with the terms of the Company’s 2004 Stock Incentive Plan, as amended, to reprice certain outstanding options held by A. Stone Douglass, the Company’s Chief Executive Officer and Chief Financial Officer, and Jerry Collazo, the Company’s former Chief Financial Officer. Specifically, the exercise price for Mr. Douglass’ option to purchase 250,000 shares of the Company’s common stock granted on September 29, 2008 was reduced from $3.28 to $1.50 and the exercise prices of Mr. Collazo’s options to purchase 20,000 and 150,000 shares of the Company’s common stock granted on October 12, 2006 and August 29, 2007, respectively, were reduced from $4.89 and $5.38, respectively, to $1.50 (the foregoing options held by Messrs. Douglass and Collazo are referred to herein as, the “Options”). The reduced price of $1.50 represents a 103% premium over the closing price of the Company’s common stock on May 22, 2009, the last trading day before the Committee’s decision to reprice the Options. Other than the change to the exercise price, the terms of the Options remain in effect and unchanged.
In determining to reprice the Options, the Committee considered the fact that the Options had exercise prices well above the recent trading prices of the Company’s common stock and, therefore, no longer provided sufficient incentives for Messrs. Douglass and Collazo, and determined that repricing the Options was in the best interest of the Company and its stockholders. The incremental expense incurred as a result of the repricing of the Options was approximately $51,000.
Information regarding stock options outstanding as of December 31, 2009 is as follows:
Restricted Stock Award Activity
The Company periodically issues restricted stock awards to certain directors and key employees subject to certain vesting requirements based on future service. Fair value is calculated using the Black-Scholes option-pricing valuation model (single option approach).
The Company recognized the following share-based compensation expense during the years ended December 31, 2009 and 2008:
The following table summarizes the approximate unrecognized compensation cost for the share-based compensation awards and the weighted average remaining years over which the cost will be recognized:
Determining Fair Value of Stock Option Grants
Valuation and Amortization Method. The Company uses the Black-Scholes option-pricing valuation model (single option approach) to calculate the fair value of stock option grants. For options with graded vesting, the option grant is treated as a single award and compensation cost is recognized on a straight-line basis over the vesting period of the entire award.
Expected Term. The expected term of options granted represents the period of time that the option is expected to be outstanding. The Company estimates the expected term of the option grants based on historical exercise patterns that it believes to be representative of future behavior as well as other various factors.
Expected Volatility. The Company estimates its volatility using our historical share price performance over the expected life of the options, which management believes is materially indicative of expectations about expected future volatility.
Risk-Free Interest Rate. The Company uses risk-free interest rates in the Black-Scholes option valuation model that are based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life of the options.
Dividend Rate. The Company has not paid dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future. Therefore, the Company uses an expected dividend yield of zero.
Forfeitures. The FASB requires companies to estimate forfeitures at the time of grant and revise those estimates in subsequent reporting periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest.
The following weighted average assumptions were used to estimate the fair value of options granted during the years ended December 31, 2009 and 2008:
11. Income Taxes
Income tax expense attributed to income from operations consists of:
The components that comprise deferred tax assets and liabilities are as follows:
The reconciliation of computed “expected” income taxes to effective income tax expense by applying the federal statutory rate of 34% is as follows:
The change in the valuation allowance for the years ended December 31, 2009 and 2008 was an increase of $188,000 and $3,477,000, respectively. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based on the level of historical operating results and the uncertainty of the economic conditions, the Company has recorded a full valuation allowance of $9,991,000 for its worldwide operations at December 31, 2009. The Company has recorded a $7,584,000 and $6,746,000 valuation allowance for its U.S. Operations at December 31, 2009 and 2008, respectively. The Company has recorded a $1,267,000 and $1,491,000 valuation
allowance for its wholly owned subsidiary, Orange 21 Europe at December 31, 2009 and 2008, respectively. The Company has recorded a $1,140,000 and $1,565,000 valuation allowance for its wholly owned subsidiary, LEM at December 31, 2009 and 2008, respectively.
12. Employee Benefit Plans
In 1998, the Company adopted the Spy Optic 401(k) Plan, or the “Plan.” The Plan covers all employees who meet the eligibility requirements of a minimum of 270 hours of service and 18 years of age. The Plan is subject to the provisions of the Employee Retirement Income Security Act of 1974. Under the provisions of the Plan, eligible participants may contribute up to 15% of their annual compensation, not to exceed the maximum legal deferral. The Company is not required to contribute to the Plan and made no contributions to the Plan during the years ended December 31, 2009 and 2008.
13. Related Party Transactions
Customer Sales
At December 31, 2009, Simo Holdings, Inc. (fka No Fear, Inc., “No Fear”) and its affiliates beneficially owned approximately 11% of the Company’s outstanding common stock. In addition, No Fear and its subsidiaries, No Fear Retail Stores, Inc. (“No Fear Retail”) and MX No Fear Europe SAS (“MX No Fear”), own retail stores in the U.S. and Europe that purchase products from the Company. Aggregated sales to these stores during the years ended December 31, 2009 and 2008 were approximately $0.8 million and $1.2 million, respectively. The year ended December 31, 2009 included approximately $398,000 in sales achieved through product credit given to Mark Simo, the Company’s former Chief Executive Officer and director, in conjunction with the Settlement Agreement and Mutual General Release (the “Settlement Agreement”) discussed below. Accounts receivable due from these stores amounted to $187,000 and $429,000 at December 31, 2009 and 2008, respectively.
Aggregated sales to the MX No Fear stores during the years ended December 31, 2009 and 2008 were approximately $0.5 million and $1.0 million, respectively. Accounts receivable due from the MX No Fear stores amounted to $344,000 and $429,000 at December 31, 2009 and 2008, respectively.
No Fear Parties Settlement Agreement
On April 28, 2009, the Company entered into a Settlement Agreement, effective as of April 30, 2009, by and among the Company’s three wholly owned subsidiaries, O21NA, O21 Europe and LEM (collectively, the “Orange 21 Parties”), and Mark Simo, No Fear, No Fear Retail and MX No Fear, (collectively, the “No Fear Parties”). The Settlement Agreement relates to various disputes among the parties regarding outstanding accounts receivable owed to the Company by No Fear Retail and MX No Fear and certain claims by Mr. Simo regarding his compensation for services he rendered as former Chief Executive Officer of the Company.
Pursuant to the Settlement Agreement, No Fear and its subsidiaries agreed to pay all outstanding accounts receivable due to the Company as follows: (1) an aggregate of approximately 307,000 Euros to Orange 21 Europe on the execution of the Settlement Agreement, approximately 46,000 Euros of which was satisfied by the return of certain goggle products and (2) an aggregate of approximately $429,000 to O21NA, approximately $71,000 of which was paid on the execution of the Settlement Agreement with the remainder paid in monthly installments of approximately $71,000 over five months (the “Installment Payments”) with the final payment delivered on October 1, 2009. In exchange, the Company agreed to provide Mr. Simo, or such other No Fear parties as Mr. Simo may designate, with product credits in the aggregate amount of $600,000 for compensation for services rendered as the former Chief Executive Officer of the Company, less applicable payroll tax withholdings, to purchase products from the Company. The product credits accrue as follows: (1) $350,000 on the execution of the Agreement and (2) $50,000 per month for five months thereafter subject to payment of the
applicable Installment Payment in full. The Company recorded an additional $300,000 expense in the first quarter of 2009 for Mr. Simo’s compensation as discussed above. The remaining $300,000 was expensed in prior periods.
Additionally, pursuant to the Settlement Agreement, No Fear issued to the Company a promissory note in the amount of approximately $357,000 (the “No Fear Note”) to memorialize the Installment Payments. Interest of 10%, compounded annually, would have accrued if No Fear failed to make timely payment of any of the Installment Payments. The No Fear Note was secured by a pledge of 446,808 shares of the Company’s common stock held by No Fear, pursuant to a stock pledge agreement.
Pursuant to the Settlement Agreement, the Orange 21 Parties on the one hand and the No Fear Parties on the other hand each released the other with respect to any and all claims arising from or related to past dealings of any kind between the parties. The Settlement Agreement was signed on April 28, 2009, but its effectiveness was conditioned upon receipt of all funds required to be delivered on execution, which did not occur until April 30, 2009. As of December 31, 2009, the Company received payments of approximately $429,000 from No Fear and approximately 261,000 Euros (approximately $344,000 in U.S. Dollars) from No Fear MX Europe with no further amounts due in accordance with the Settlement Agreement.
Promissory Note with Shareholder, Costa Brava Partnership III, L.P.
Effective March 23, 2010, O21NA entered into a $3.0 million Promissory Note with Costa Brava, which matures on July 29, 2011. The Chairman of the Company’s Board of Directors, Seth Hamot, is the President and sole member of Roark, Rearden & Hamot, LLC, which is the sole general partner of Costa Brava. See also Notes 6 “Financing Arrangements” and 20 “Subsequent Events” to the Consolidated Financial Statements.
14. Commitments and Contingencies
Operating Leases
The Company leases its principal administrative and distribution facilities in Carlsbad, California, under a month to month operating lease with monthly payments of approximately $38,000, and a warehouse facility in Varese, Italy, which is used primarily for international sales and distribution. LEM leases three buildings in Italy that are used for office space, warehousing and manufacturing. The Company also leases certain computer equipment, vehicles and temporary housing in Italy. Rent expense was approximately $679,000 and $771,000 for the years ended December 31, 2009 and 2008, respectively.
Future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year are as follows:
Capital Leases
Future minimum lease payments under capital leases at December 31, 2009 are as follows:
The cost of buildings and improvements, molds and machinery and equipment under capital leases at December 31, 2009 was approximately $1,405,000, $65,000 and $1,319,000, respectively. The amount of accumulated depreciation at December 31, 2009 was approximately $361,000, $11,000 and $169,000, respectively. Amortization of assets held under capital leases is included in depreciation expense.
Athlete Contracts
The Company has entered into endorsement contracts with athletes to actively wear and endorse the Company’s products. These contracts are based on minimum annual payments totaling $106,000 in 2010 and may include additional performance-based incentives and/or product-specific sales incentives. At December 31, 2009 we also had approximately $438,000 due to athletes under contract in 2009.
Product Development and Design Services
In January 2009, the Company entered into a non-exclusive agreement with Bartolomasi, Inc. for the design and development of sunglasses, goggles and prescription sunglass frames. Bartolomasi, Inc. has agreed to provide services to the Company as an independent consultant through January 4, 2011 and to be bound by confidentiality obligations. Under the agreement, Bartolomasi, Inc. assigns all ideas, inventions and other intellectual property rights created or developed on the Company’s behalf during the term of the agreement to the Company. The agreement may be terminated by either party with or without cause upon 60 days prior written notice. The agreement has minimum monthly payments totaling $180,000 per annum in both 2009 and 2010.
Litigation
From time to time the Company may be party to lawsuits in the ordinary course of business. The Company is not currently a party to any material legal proceedings.
15. Concentrations
Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and accounts receivable. The Company grants unsecured credit to substantially all of its customers. Management does not believe that it is exposed to any extraordinary credit risk as a result of this policy.
The Company maintains cash balances at various financial institutions primarily located in San Diego and in Italy. Accounts at the U.S. institutions are secured by the Federal Deposit Insurance Corporation. The Company has not experienced any losses in such accounts. Management believes that the Company is not exposed to any significant credit risk with respect to its cash.
Customer
For the years ended December 31, 2009 and 2008, the Company had no sales to third party customers that accounted for 10% or more of total net sales.
Supplier
The Company purchases substantially all of its goggles from one manufacturer in China, OGK, and expects to continue to do so during 2010. LEM produces a substantial amount of sunglasses for the Company and currently purchases substantially all of its plastic frames from one supplier in Italy. The Company does not have long-term agreements with any of its manufacturers other than LEM. The Company believes that other suppliers could provide plastic frames on comparable terms, however, a change in suppliers could result in a delay in manufacturing and a possible loss of sales, which would adversely affect operating results.
16. Operating Segments and Geographic Information
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company’s management in deciding how to allocate resources and in assessing performance. The Company designs, produces and distributes sunglasses, snow and motocross goggles, and branded apparel and accessories for the action sports, snowsports and lifestyle markets. The Company owns a manufacturer LEM located in Italy. LEM manufactures products for non-competing brands in addition to a substantial amount of the Company’s sunglass products. Results for LEM reflect operations of this manufacturer after elimination of intercompany transactions. The Company operates in two business segments: distribution and manufacturing.
Information related to the Company’s operating segments is as follows:
The Company markets its products domestically and internationally, with its principal international market being Europe. Revenue is attributed to the location from which the product was shipped. Identifiable assets are based on location of domicile.
17. Quarterly Financial Data (unaudited)
18. Acquisitions
On January 16, 2006, the Company completed the acquisition of a manufacturer LEM. The total purchase price for LEM was 3.5 million Euros or $4.2 million in cash, plus a two year earn-out based on LEM’s future sales. Under the terms of the earn-out, the Company was obligated to make quarterly payments based on unit sales, up to a maximum of 1.4 million Euros, through December 31, 2007. The maximum amount of additional consideration was earned and paid out as of December 31, 2007. Accordingly, the entire amount has been included in the purchase price allocation. The acquisition of LEM has allowed the Company to control its primary manufacturer and ensure a continued source of supply for the Company’s products.
The acquisition was accounted for under the purchase method of accounting; and, accordingly, the purchased assets and liabilities assumed were recorded at their estimated fair values at the date of the acquisition based on internal valuations and third party appraisals. The purchase price allocation for this acquisition resulted in an excess of the purchase price over net tangible assets acquired of approximately $8.2 million, of which $0.2 million was allocated to customer relationships, which is being amortized on a straight-line basis over the estimated useful life of 7 years. The remaining $8.0 million was allocated to goodwill. An estimate of the fair value of the intangible asset acquired was made using the income approach and the residual earnings method. Significant assumptions used in the residual earnings method included an income tax rate of 37.25%, a target EBIT margin of 13% and a long-term growth rate of 3.0%.
Goodwill at December 31, 2008 and 2007 was $0 and $9.7 million, respectively. The change in goodwill from date of acquisition to December 31, 2007 represents a difference in foreign exchange spot rates used in translation of LEM’s books during consolidation. With the significant deterioration in the retail business climate as well as a large decline in the market value of the Company’s common stock during the fourth quarter for the year ended December 31, 2008, the Company performed an interim evaluation of goodwill impairment. As a result of this interim evaluation, the Company determined that the goodwill associated with the January 2006 acquisition of LEM was fully impaired and recorded a pre-tax non-cash goodwill impairment charge of $8.4 million in its December 31, 2008 financial statements. See Note 1 for further information.
19. Rights Offering
On January 22, 2009, the Company launched a rights offering to raise a maximum of $7.6 million pursuant to which holders of the Company’s common stock, options and warrants, were entitled to purchase additional shares of the Company’s common stock at a price of $0.80 per share (the “Rights Offering”). The proceeds from the Rights Offering are being used for general corporate purposes, which may include research and development, capital expenditures, payment of trade payables, working capital and general and administrative expenses. The Company may also use a portion of the net proceeds to acquire or invest in complementary businesses, products and technologies, although the Company has no current plans, commitments or agreements with respect to any such transactions.
In the Rights Offering, stockholders, option holders and warrant holders as of 5:00 p.m., New York City time January 21, 2009, were issued, at no charge, one subscription right for each share of common stock then outstanding or subject to outstanding options or warrants (whether or not currently exercisable). Each right entitled the holder to purchase one share of the Company’s common stock for $0.80 per share.
The Rights Offering was conducted via an existing effective shelf registration statement on Form S-3. An aggregate of 9,544,814 subscription rights were distributed in the Rights Offering entitling the Company’s stockholders, option holders and warrant holders to purchase up to 9,544,814 shares of the Company’s common stock at a price of $0.80 per share. The subscription rights were not transferable and were evidenced by subscription rights certificates. Fractional shares were not issued in the Rights Offering. The subscription rights issued pursuant to the Rights Offering expired at 5:00 p.m., New York City time, on March 6, 2009. The Company also reserved the right to allocate unsubscribed shares to other investors at $0.80 per share.
Approximately 3.6 million shares of the Company’s common stock were purchased in the Rights Offering for an aggregate of approximately $2.9 million, including approximately $0.5 million in proceeds from the purchase of unsubscribed shares. Costs related to the Rights Offerings during the year ended December 31, 2009 were approximately $0.4 million.
20. Subsequent event
Spy Optic, Inc. Name Change
On January 11, 2010 the Company’s subsidiary Spy Optic, Inc. changed its name to Orange 21 North America Inc.
On February 11, 2010, Jerry Collazo resigned as the Company’s Chief Financial Officer to pursue other opportunities. On February 12, 2010, the Company’s board of directors (the “Board”) appointed A. Stone Douglass, the Company’s Chairman and Chief Executive Officer, as the Company’s acting Chief Financial Officer. The Board does not have any immediate plans to replace Mr. Collazo.
Additionally, effective February 12, 2010, the Board elected Seth Hamot, an existing director of the Company, as Chairman of the Board to replace Mr. Douglass who will continue to serve as a director, Chief Executive Officer and acting Chief Financial Officer.
Promissory Note with Shareholder, Costa Brava Partnership III, L.P.
Effective March 23, 2010, O21NA entered into a $3.0 million Promissory Note with Costa Brava. The Promissory Note is subordinated to O21NA’s Loan Agreement, as amended, with BFI, pursuant to the terms of a Debt Subordination Agreement, dated March 23, 2010, by and between Costa Brava and BFI. The proceeds from the Note are expected to be used (i) to prepay the current balance on O21NA’s revolving line of credit balance with BFI in its entirety and (ii) if any proceeds remain after such prepayment, for working capital purposes. However, O21NA may continue to re-borrow from BFI under the Loan Agreement after such prepayment is made.
Interest under the Promissory Note accrues daily at the following rates: (i) from the date of receipt of funds under the Promissory Note through April 30, 2010, at (A) 6% per annum on the last day of each calendar month and (B) 6% per annum payable on April 30, 2010, and (ii) from May 1, 2010 through the maturity date, at (A) 9% per annum on the last day of each calendar month and (B) 3% per annum payable on the maturity date. In addition, the Promissory Note requires that O21NA pays a facility fee of 1% of the original principal amount on December 31, 2010 and the maturity date. The Promissory Note matures on July 29, 2011. The terms of the Promissory Note include customary representations and warranties, as well as reporting and financial covenants, customary for financings of this type.
The Chairman of the Company’s Board of Directors, Seth Hamot, is the President and sole member of Roark, Rearden & Hamot, LLC, which is the sole general partner of Costa Brava. Costa Brava and Seth Hamot together own approximately 28% of the Company’s common stock as of March 26, 2010.
Orange 21 Inc. and Subsidiaries
Schedule II-Valuation and Qualifying Accounts
For the Years Ended December 31, 2009 and 2008
Note: Additions to the allowance for doubtful accounts are charged to bad debt expense. Additions to the allowance for sales returns are charged against revenues. Additions to the allowance for inventory reserve are charged against cost of goods sold.
All other schedules have been omitted because they are either inapplicable or the required information has been provided in the Consolidated Financial Statements or the Notes thereto.
Item 9.
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A(T).
Item 9A(T). Controls and Procedures
Disclosure Control and Procedures
Management, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (Exchange Act)) as of December 31, 2009, the end of the period covered by this report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed is recorded, processed, summarized and reported within the time frames specified by the SEC’s rules and forms. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of December 31, 2009.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f) under the Exchange Act). Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes those policies and procedures that: (i) in reasonable detail accurately and fairly reflect our transactions; (ii) provide reasonable assurance that transactions are recorded as necessary for preparation of our financial statements in accordance with generally accepted accounting principles, and that provide reasonable assurance that our receipts and expenditures are made in accordance with management authorization; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting, however well designed and operated, can provide only reasonable, and not absolute, assurance that the controls will prevent or detect misstatements. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there is only the reasonable assurance that our controls will succeed in achieving their goals under all potential future conditions.
Management, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, conducted an evaluation of our internal control over financial reporting as of December 31, 2009, based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (or the “COSO” criteria). Based on our evaluation under the COSO framework, management concluded that our internal control over financial reporting was effective as of December 31, 2009.
This Annual Report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the SEC that permit us to provide only management’s report in this Annual Report.
Changes in Internal Control over Financial Reporting
During the fiscal quarter ended December 31, 2009, there were no changes in our internal control over financial reporting identified in connection with the evaluation described above that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
Promissory Note with Shareholder, Costa Brava Partnership III, L.P.
Effective March 23, 2010, we entered into a $3.0 million Promissory Note with Costa Brava Partnership III, L.P. (“Costa Brava”). The Promissory Note is subordinated to our Loan and Security Agreement with BFI Business Finance (“BFI”), pursuant to the terms of a Debt Subordination Agreement, dated March 23, 2010, by and between Costa Brava and BFI. The proceeds from the Note are expected to be used (i) to prepay the current balance on our revolving line of credit balance with BFI in its entirety and (ii) if any proceeds remain after such prepayment, for working capital purposes. However, we may continue to re-borrow from BFI under the Loan and Security Agreement after such prepayment is made.
Interest under the Promissory Note accrues daily at the following rates: (i) from the date of receipt of funds under the Promissory Note through April 30, 2010, at (A) 6% per annum on the last day of each calendar month and (B) 6% per annum payable on April 30, 2010, and (ii) from May 1, 2010 through the maturity date, at (A) 9% per annum on the last day of each calendar month and (B) 3% per annum payable on the maturity date. In addition, the Promissory Note requires that we pay a facility fee of 1% of the original principal amount on December 31, 2010 and the maturity date. The Promissory Note matures on July 29, 2011. The terms of the Promissory Note include customary representations and warranties, as well as reporting and financial covenants, customary for financings of this type.
The Chairman of our Board of Directors, Seth Hamot, is the President and sole member of Roark, Rearden & Hamot, LLC, which is the sole general partner of Costa Brava. Costa Brava and Seth Hamot together own approximately 28% of our common stock as of March 26, 2010.
PART III
Documents Incorporated by Reference
In response to Part III, Items 10, 11, 12, 13 and 14, parts of the Company’s definitive proxy statement (to be filed pursuant to Regulation 14A within 120 days after Registrant’s fiscal year-end of December 31, 2009) for its annual stockholders’ meeting are incorporated by reference in this Form 10-K.
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by Item 10 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2010 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2009.
Item 11.
Item 11. Executive Compensation
The information required by Item 11 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2010 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2009.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters
The information required by Item 12 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2010 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2009.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2010Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2009.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by Item 14 will be contained in, and is hereby incorporated by reference to, our Proxy Statement relating to our 2010 Annual Meeting of Stockholders.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Documents filed as part of this report:
(1) Financial Statements
Reference is made to the Index to Consolidated Financial Statements of Orange 21 Inc., under Item 8 of Part II hereof.
(2) Financial Statement Schedules
The following financial statement schedule of Orange 21 Inc. is filed as part of this Form 10-K (under Item 8 of Part II hereof):
Schedule II - Valuation and Qualifying Accounts
All other financial statement schedules have been omitted because they are not applicable or not required or because the information is included elsewhere in the Consolidated Financial Statements or the Notes thereto.
Exhibits
+ Management contract or compensatory plan or arrangement.
* Portions of the exhibit have been omitted pursuant to a request for confidential treatment.
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.
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints A. Stone Douglass, and each of them, his true and lawful attorneys-in-fact, each with full power of substitution, for him in any and all capacities, to sign any amendments to this report on Form 10-K and each amendment hereto and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact or their substitute or substitutes may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.