ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS.
Variflex, Inc. (the "Company") is a leading marketer in the United States of in-line skates, skateboards, bicycle and recreational safety helmets and athletic protective equipment (such as wrist guards, elbow pads and knee pads used by skaters and skateboarders). The Company designs and develops these products which are then manufactured to the Company's detailed specifications by independent contractors. The Company also designs, manufactures and markets snowboards and related accessories and other products. The Company distributes its products throughout the United States and to foreign countries.
The Company was originally incorporated by Raymond H. Losi and Raymond H. Losi, II, in California in 1977, and reincorporated in Delaware in March 1994. Both Raymond H. Losi and Raymond H. Losi, II are executive officers of the Company. The Company has two wholly-owned subsidiaries, Oketa Ltd., a Hong Kong corporation incorporated in May 1987 to facilitate sales through international letters of credit, and Static Snowboards, Inc., a Delaware corporation incorporated in April 1995 for the purpose of manufacturing and marketing snowboards. Unless the context otherwise requires, references in this Form 10-K to the "Company" refer to Variflex, Inc. and its subsidiaries.
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS.
For each of its last three fiscal years, the Company has been engaged in only one industry segment, namely the manufacture and distribution of sporting and athletic goods. Financial information concerning the Company's business is included in Items 6, 7, 8 and 14.
(c) NARRATIVE DESCRIPTION OF BUSINESS.
(1) PRODUCTS.
The Company's principal products are in-line roller skates, which feature wheels mounted in a straight line on a composite plastic chassis, functioning much like the blade on an ice skate. The Company currently sells 27 models of in-line skates to the mass market under the Variflex(TM) brand. These models are sold under various names, including Assault(TM), Alien(TM), Comet XT(TM), Crystal(TM), Dasher(TM), Excell(TM), Firebird(TM), Fury(TM), GX-2(TM), Maverick(TM), Mystic(TM), Nighthawk(TM), Ranger(TM), Reactor(TM), Roadwolf(TM), Sabre XT(TM), Shadow(TM), Silhouette(TM), Ventura(TM), VFX(TM), Voltage(TM) and X-2(TM), or versions thereof. Overall, the Company has 10 adult and young adult models and 18 youth models.
The Company's in-line roller skates generally consist of a molded polymer boot with, depending upon the model, either an integrated wheel chassis or a wheel chassis riveted to the bottom of the boot, and high density polyurethane wheels mounted on ball bearings and bolted through the wheel chassis. The boot contains a removable breathable nylon liner which increases comfort. The wheel chassis is, depending on the model, made of either fiberglass-filled nylon or
various plastics. Each chassis holds four wheels mounted in line, and each pair of skates has either one or two brakes, consisting of a hard rubber pad mounted on the rear of the chassis.
The Company also markets and distributes skateboards, skoot skates and scooters. The Company presently offers six different models of skateboards under the Variflex(TM) brand and two models under the Static(TM) brand, four different models of the Variflex Skoot Skate, which is a skateboard with a removable handle for young children and beginners, and five models of scooters in two different sizes. Additionally, the Company offers a line of skating and skateboarding protective equipment, such as knee pads, elbow pads and wrist guards, as well as accessories and replacement parts such as bearings, wheels and straps.
The Company also markets and distributes a line of bicycle and recreational safety helmets. The helmets are marketed to cyclists, skateboarders and in-line skaters. The Company presently has five adult helmet models, five young adult models, five youth models, one child model and one toddler model. Each model features ventilated aerodynamic designs with adjustable harnesses, and each comes in a variety of colors and graphics. The Company's helmets are manufactured by independent contractors through a process of injecting a polyurethane foam to form a strong, lightweight protective inner shell bonded to a hard PVC outer shell. All of the Company's helmets meet or exceed the standards of the American Society for Testing and Materials (ASTM). The Company's helmets are sold under the Chaser(TM), Excell(TM), Lil' Pal(TM), Magnum XT(TM), Spitfire(TM), Street Heat XT(TM) and Vectra(TM) names or versions thereof.
During the fiscal year ended July 31, 1996, the Company, through its wholly-owned subsidiary, Static Snowboards, Inc., began manufacturing and marketing a line of snowboards. The snowboards carry the Static(TM) brand name, and are manufactured at the Company's factory in California. The Company presently offers three series, Freestyle, All Mountain and Kids, with each coming in a variety of graphics and sizes. These snowboards feature a vertically laminated wood core, an epoxy adhesive matrix, stainless steel inserts, Rockwell 48 edges, P-Tex 1000 base material, PVT Pennite top sheet and ABS sidewall material. Also, during the fiscal year ended July 31, 1997, the Company exercised a purchase option in an agreement first entered into during the previous fiscal year, wherein its subsidiary, Static Snowboards, Inc., acquired the exclusive right to manufacture, market and distribute all snowboards bearing the Barfoot(TM) brand name. Barfoot(TM) is an existing snowboard brand (founded in 1978) sold world-wide through the specialty market in skiing and snowboarding pro shops and resorts.
During the fiscal year ended July 31, 1997, the Company developed and began marketing and distributing its new Quik Shade(TM) instant canopy, designed to offer portable shade and shelter for a variety of uses with the convenience of easy set-up and take-down. The frames and tops for the Quik Shade(TM) are manufactured overseas by independent contractors. The Company presently offers a single model of the Quik Shade in four different colors, and has plans to develop new models and accessories during the coming year.
For the fiscal years ended July 31, 1997, 1996 and 1995, these products comprised the following percentages of the Company's total gross sales:
- ---------------------- (*) Less than one-half of one percent.
The Company's products are marketed in North America primarily through a network of independent sales representatives and marketing organizations and through attendance by representatives of the Company at industry trade shows. The Company's customers consist primarily of national mass merchandisers, such as Kmart, Kaybee, Sears, Target, Toys "R" Us and Wal-Mart; regional mass merchandisers, such as Fred Meyer, Meijers, Shopko and Venture; catalog houses, such as Service Merchandise and Spiegel; major sporting goods chains, such as Sportmart and The Sports Authority; and international exporters, such as Krypto International. The Company also sells to independent
sporting goods stores and specialty shops, particularly with respect to its Static(TM) and Barfoot(TM) products. The Company's wholly owned subsidiary, Oketa Ltd., is used to facilitate sales and the shipment of products to international customers and to customers in the United States who desire to purchase product through international letter of credit transactions.
(2) STATUS OF PRODUCTS IN DEVELOPMENT.
The Company frequently changes the cosmetic features of its products, such as graphics and colors, and attempts to develop new products or new designs for existing products in response to customer requests or changes in consumer preferences.
During the fiscal year ended July 31, 1997, the Company designed and developed a new line of snowboards called Outrage(TM), offering quality features at low price points to appeal to mass market customers. These snowboards contain vertically laminated wood cores, stainless steel inserts, P-Tex base, PVT Pennite top sheet and ABS sidewall materials and are manufactured at the Static Snowboards, Inc. factory in California. The Company presently offers the Outrage(TM) in five different graphics. The Company made its first shipments of the Outrage(TM) snowboards in September 1997.
During the fiscal year ended July 31, 1997, the Company also introduced a new line of bicycle and recreational safety helmets with unique "three- dimensional" graphics. The initial designs and the manufacturing process for these helmets were developed by a vendor with whom the Company has a long-term working relationship. The Company has entered into an exclusive license agreement with that individual for the right to manufacture and market the product. The helmets will be manufactured by the Company's existing helmet suppliers overseas. These new helmets, called 3-D(TM), are targeted to youths and young adults and have been priced to compete directly with other helmets currently offered in the mass market. The Company expects to make its initial shipments of these helmets in the fall of 1997.
The Company continues to distribute products under its Static(TM) brand, developed during fiscal 1996. The Static(TM) snowboard line offers various sizes and graphics and are manufactured at the Company's factory in California. Static(TM) skateboards, manufactured domestically by the Company, are offered in a variety of graphics and "pro-spec" componentry, designed and priced to compete with models sold in pro shops. During the fiscal year ended July 31, 1997, however, the Company decided to discontinue its Static(TM) line of in-line skates, due to heavy competition, significant pricing pressures and excess inventories of "high-end" skates at retail.
Despite these and other efforts by the Company to update the designs, features and componentry of existing products and develop potential new products or new designs, there can be no assurance that such efforts will be successful nor that such changes or new products will be readily acceptable to customers and consumers.
(3) SOURCE OF MATERIALS.
With the exception of snowboards, all of the Company's products are sourced from independent contractors located in the Republic of China (Taiwan), the People's Republic of China (mainland China) and South Korea. These suppliers manufacture, assemble and package the Company's products under the detailed specifications of the Company's management representatives who visit frequently to oversee quality control and work on cost containment. The independent contractors are responsible for shipment to the Company's warehouse in Moorpark, California, or directly to certain major customers' distribution centers and warehouses. The raw materials and subcomponents for these products are manufactured by independent contractors, most of which are also located in Taiwan, mainland China and South Korea, that have been procured by the Company's suppliers or, often, by the management of Variflex itself.
The Company submits purchase orders to its manufacturers for the production of specific amounts of its products and has not entered into any long-term contractual agreements. The Company negotiates the cost of its products directly with its foreign suppliers in U.S. Dollars.
As stated above, a significant portion of the Company's products, including various models of its in-line skates, are manufactured in mainland China, which trades with the United States under a Most Favored Nation ("MFN") trade status. While the Company believes that alternative manufacturing sources could be found, maintaining existing costs will depend upon these products continuing to be treated under MFN tariff rates. From time to time, the U.S. has threatened to rescind MFN tariff rates and impose trade sanctions on certain goods manufactured in China. To date, no such sanctions have been imposed that have affected the Company or its products, however there can be no assurance with regard to the possible imposition of sanctions in the future.
(4) PATENTS, TRADEMARKS, LICENSES, FRANCHISES AND CONCESSIONS.
The Company holds or has pending certain design patents, but no utility patents. In the course of its business the Company employs various trademarks and trade names, including its own logos, in the packaging and advertising of its products. Registration of various other trademarks for the Company's products are pending. The Company also has registered the Variflex(TM) and Static(TM) trademarks in the United States, and has secured a worldwide watch to alert the Company to any unauthorized use in any other parts of the world.
(5) MAJOR CUSTOMERS.
The Company has four customers which have each individually accounted for more than 10% of the Company's sales in one or more of the past three fiscal years: the Kmart Corporation, based in Detroit, Michigan; Sears, Roebuck and Co., based in Chicago, Illinois; Target Stores, based in Minneapolis, Minnesota; and Toys "R" Us, Inc., based in Paramus, New Jersey.
Collectively, sales to Kmart, Sears, Target and Toys "R" Us represented approximately 70%, 74%, and 78% of the Company's total gross sales for the fiscal years ended July 31, 1997, 1996, and 1995, respectively.
Individually, sales to the Company's four largest customers as a percentage of the Company's total gross sales were 26%, 21%, 15% and 8% for fiscal 1997; 20%, 26%, 16% and 12% for fiscal 1996; and 29%, 19%, 24% and 6% for fiscal 1995.
(6) BACKLOG.
The Company had approximately $4,523,000 in unfilled purchase orders as of September 30, 1997, compared to approximately $6,044,000 as of September 30, 1996. The Company believes that substantially all of these unfilled orders are firm and will be filled in the 1998 fiscal year. Of the backlog as of September 30, 1997, approximately $690,000 represented orders for products which had not yet been received from suppliers as of that date. Substantially all of the remaining $3,833,000 of the backlog at September 30, 1997 represents fall booking orders of products on hand to be shipped at future dates.
(7) GOVERNMENT CONTRACTS.
The Company has no United States or foreign government contracts.
(8) COMPETITION.
The principal competitive factors in each of the Company's product categories are price and performance. With respect to in-line skates in particular, the main areas of difference in product performance are in the weight and strength of the boot and frame, the hardness of the wheels, and the quality and lubrication of the wheel bearings. The Company offers a 60-day warranty on its products. Beyond such warranty, the Company does not offer service on its products, and does not believe that is an important competitive factor.
Management believes that the Company has a significant market share in the in-line skate category, particularly in the mass market segment, where Variflex enjoys name recognition and is considered a market leader. The Company's primary competitors in the mass market include First Team Sports, Inc. (Skate Attack), Roller Derby, Seneca and certain models from Rollerblade, Inc. (Blade Runner). Primary competitors in the specialty or premium priced market for in-line skates include Rollerblade, Inc. (Rollerblades), First Team Sports, Inc. (Ultra Wheels) and Nike, Inc. (Bauer). In the case of athletic protective equipment, Franklin Sports is the Company's primary competitor in the mass market. Franklin Sports is also a primary competitor, together with Rollerblade, Inc. and First Team Sports, Inc., in the specialty or premium priced market. Bell Sports Corp. (Bell and BSI) and Troxel (Pro Action) are the primary competitors in the bicycle safety helmet mass market, and also are primary competitors, together with Giro, which was recently acquired by Bell Sports Corp., in the specialty or premium priced market. In the snowboard industry, the largest competitors include Burton Snowboards (Burton), Ride, Inc. (Ride, Liquid and Mercury), K2, Inc. (K2), Skis Rossignol (Rossignol) and Morrow.
While management believes that the quality of its products and the service it provides to its customers are important factors in retaining accounts, the Company clearly operates in a highly competitive environment and there are no significant technological or manufacturing barriers to entry. Management believes that price is a major competitive factor, particularly in the mass market. At present, the Company believes that its products in each category, when
compared to competitors' products of comparable quality, are currently offered at comparable or lower prices than most or all of its competitors. However there can be no assurance that other companies, whether new enterprises or established members of the retail or sporting goods industries, will not be able to develop products of comparable or higher quality at lower prices, or that the Company's price structure will not be affected by future circumstances.
(9) RESEARCH AND DEVELOPMENT.
Estimated research and development expenses for Company-sponsored research activities relating to the development of new products, services or techniques or the improvement of existing products, services or techniques were not material in fiscal 1997, fiscal 1996 and fiscal 1995.
(10) EFFECT OF ENVIRONMENTAL REGULATION.
To the extent that the Company's management can determine, there are no federal, state or local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment, with which compliance by the Company has had or is expected to have a material effect upon the capital expenditures, earnings or competitive position of the Company.
(11) EMPLOYEES.
As of July 31, 1997, the Company employed 132 full-time employees. None of the Company's employees are represented by unions.
ITEM 2.
ITEM 2. PROPERTIES.
The Company's principal facility is a leased 104,000 square foot concrete tilt-up building comprising the Company's corporate headquarters and executive offices, as well as serving as the United States distribution center for the Company's products, located at 5152 North Commerce Avenue, Moorpark, California, approximately forty miles northwest of Los Angeles, California. The Company also subleases in an immediately adjacent building approximately 27,000 square feet consisting primarily of additional warehouse space. The leases for these facilities expire December 31, 2000 and June 30, 1998, respectively, after which management believes new leases can be negotiated, at those locations or for other equivalent space, on satisfactory terms. The Company also stores inventory in temporary facilities from time to time as required due to the timing of shipments.
In July 1995, the Company's subsidiary, Static Snowboards, Inc. entered into a lease agreement for a facility of approximately 30,000 square feet, located in Huntington Beach, California, in which it has constructed and now conducts its snowboard manufacturing operations. The lease expires September 30, 2000.
Management believes that the Company's present facilities will be adequate for the near future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company may at any particular time, due to the nature of its products, become a defendant in product liability claims, including active litigation, arising out of personal injuries allegedly relating to its products. The Company is presently a party to certain proceedings of this nature, none of which management would consider outside of the normal course of business or material to the Company. The Company believes it has adequate liability insurance for the risks arising in the normal course of business. Coverage is on a claims made basis, and is subject to certain deductibles.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of the Company's stockholders during the quarter ended July 31, 1997.
EXECUTIVE OFFICERS OF THE COMPANY.
The following sets forth the names and ages of current executive officers of the Company, in addition to information regarding their positions with the Company, their periods of service in such positions, and their business experience for the past five years. Executive officers generally serve in office for terms of approximately one year.
PART II
Item 5.
Item 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
(A) MARKET INFORMATION.
The range of trading prices for the Company's Common Stock during each of the quarters of the fiscal years ended July 31, 1996 and 1997 was as follows (per share):
The Company's Common Stock is traded on the Nasdaq National Market under the symbol "VFLX."
(b) HOLDERS.
The Company believes there were approximately 1,958 holders of the Company's Common Stock as of October 13, 1997. The number of stockholders was computed by including an estimate of the number of those stockholders whose stock is held for them by participants in a clearing agency as of that date. There were 126 holders of record of the Company's Common Stock on October 13, 1997.
(c) DIVIDENDS.
The Company has never paid cash dividends and has no present intention to pay cash dividends in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The Company's initial public stock offering, completed in June 1994, had a significant impact upon the balance sheet data above. The Company's net proceeds after fees and expenses were approximately $20,723,000.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
RESULTS OF OPERATIONS
YEAR ENDED JULY 31, 1997 COMPARED TO YEAR ENDED JULY 31, 1996
NET SALES. Net sales for the fiscal year ended July 31, 1997 totaled $51,661,000, a decrease of $20,718,000, or 29% from fiscal 1996 net sales of $72,379,000. Decreases in volume and average selling prices with respect to the Company's in-line skate, athletic protective equipment and bicycle and recreational safety helmet categories were the principal factors leading to the decline in total sales.
With respect to in-line skates, gross sales for fiscal 1997 totaled $36,932,000, a decrease of approximately $20,214,000, or 35%, compared to fiscal 1996, as unit volume in fiscal 1997 totaled 2,027,000 units, a decrease of approximately 600,000, or 23%. The average price per unit (gross revenues divided by units sold) of the Company's in-line skates was approximately $18.22 during fiscal 1997, compared to $21.75 for fiscal 1996. The decrease in in-line skate sales was primarily due to heavy inventory levels at retail throughout much of the year, as well as an industry-wide decline in consumer demand for in- line skates in general compared to prior year. These factors, as well as the influences of strong competition in the mass market, in turn led to continued significant pricing pressures within the category during the year.
Gross sales for athletic protective equipment during fiscal 1997 totaled $2,697,000, a decrease of approximately $2,971,000, or 52%, compared to fiscal 1996, while unit volume in fiscal 1997 was 516,000, a decrease of approximately 519,000, or 50%. The Company's sales of these products generally correlate with sales of in-line skates; thus the decrease in sales of protective equipment also is primarily attributable to the factors discussed above. Additionally, consumer preferences within the market have led to substantially all of the Company's sales of protective equipment now being made via multiple-unit packages, usually "triple packs" containing three pairs of pads one pair each of knee pads, elbow pads and wrist guards which yields less total revenue than sales of separate single-unit packages.
Gross sales of bicycle and recreational safety helmets during fiscal 1997 totaled $2,508,000, a decrease of approximately $1,554,000, or 38%, compared to fiscal 1996, while unit volume decreased approximately 173,000, or 33%, to a total of 347,000 units during fiscal 1997. These decreases in comparison with the prior year are primarily due to continued high inventory levels at the retail level, increased competition and pricing pressures within the category and less safety awareness programs and legislation designed to promote helmet use by bicyclists. The year-over-year decrease in gross sales is greater as a percentage than the decrease in unit volume due to discounting and other price reductions in response to competitive pressures in the marketplace. The average price per unit for the Company's helmets was approximately $7.22 during fiscal 1997, compared to $7.81 during fiscal 1996. Competition and high inventory levels continue to put downward pressure on retail and wholesale prices throughout the industry.
Gross sales of skateboards and scooters during fiscal 1997 totaled $9,273,000, an increase of approximately $1,972,000, or 27%, compared to fiscal 1996, on total volume of 669,000 units, an increase of approximately 143,000 units, or 27%. A resurgence in the demand for skateboards began during fiscal 1996 and carried through the first half of fiscal 1997, with momentum then slowing in the latter half of the year as more inventory became available at retail and a greater proportion of the Company's shipments represented customer re-orders. Fiscal 1996 sales had increased 300% from the prior year. During fiscal 1997, the Company introduced a new line of children's scooters, which accounted for approximately $549,000 in gross sales on 17,000 units.
Gross sales of snowboards and snowboarding accessories, such as bindings, leashes and miscellaneous apparel items, totaled $1,483,000 during fiscal 1997, which was the Company's first full year in the category. Gross sales for fiscal 1996 totaled $159,000. The Company sold a total of approximately 9,700 snowboards during fiscal 1997, compared to approximately 1,100 in the prior year.
Sales to the Company's four largest accounts, each of which is a major mass market merchandiser, represented 70% of the Company's gross sales in fiscal 1997, compared to 74% in fiscal 1996. This decrease is the result of several factors, including the growth of the Company's snowboard business during the year, increases in sales of the Company's Static(TM) brand skateboards and the introduction during fiscal 1997 of the Company's new Quik Shade(TM) canopies; a significant portion of these sales were made through the sporting goods and specialty markets rather than mass market channels.
By product category, in-line skates, athletic protective equipment and helmets accounted for 69%, 5% and 5%, respectively, of the Company's total gross sales during fiscal 1997, compared to 77%, 8% and 5%, respectively, during fiscal 1996. Skateboards and scooters accounted for 17% of the Company's total gross sales during fiscal 1997, compared to 10% during fiscal 1996. Snowboards and snowboarding accessories represented 3% of total gross sales during fiscal 1997, compared to less than one-half of one percent in the prior year.
GROSS PROFIT. Gross profit for the fiscal year ended July 31, 1997 decreased by $5,620,000 compared to the fiscal year ended July 31, 1996, representing a 46% decrease. The Company's gross profit margin as a percentage of net sales was 13.0% in fiscal 1997, compared with 17.0% in fiscal 1996. The decrease in gross margin is due primarily to the price reductions mentioned above, particularly within the in-line skate and helmet categories and the effects of higher than usual amounts of close-out sales during the year. Surplus inventory and increased competition in the mass market, again principally with respect to in-line skates and safety helmets, has had and continues to have an impact upon the Company's gross margin. There can be no assurance that the Company can continue to obtain its products from suppliers at sufficiently low costs to fully offset the downward pressure on sales prices in order to sustain or improve present gross profit margins.
OPERATING EXPENSES. The Company's operating expenses (consisting of selling and marketing expenses and general and administrative expenses) for fiscal 1997 totaled $10,599,000, or 20.5% of net sales. Operating expenses for fiscal 1996 were $12,267,000, or 16.9% of net sales.
Selling and marketing expenses decreased by $1,327,000, or 17%, to $6,344,000 for fiscal 1997 compared to fiscal 1996. Selling and marketing expenses for fiscal 1997 amounted to 12.3% of net sales, compared to 10.6% in the prior year. The increase as a percentage of net sales is due to several factors, including increased advertising expenses for co-op programs with certain of the Company's major customers and increases in other marketing related expenses such as for trade shows, catalogs and promotional materials, particularly with respect to the Company's snowboard operations, and the increased percentage that these types of expenses, as well as corporate sales and marketing salaries, represent upon a lower sales base. In dollars, these increases were more than offset by decreases in sales commissions because of the decline in sales during the year.
General and administrative expenses decreased by $341,000, or 7%, to $4,255,000 for fiscal 1997 compared to fiscal 1996. General and administrative expenses for fiscal 1997 amounted to 8.2% of net sales, compared to 6.3% in fiscal 1996. The dollar decrease is primarily due to decreases in legal and other professional fees, expenses associated with the Company's defined benefit pension plan, donations and other expenditures resulting from management's enhanced efforts to control administrative costs, offset in part by increases in expenses associated with the first full year of the Company's new snowboard operations.
OTHER INCOME (EXPENSE). Other income for the fiscal year ended July 31, 1997 was $799,000, an increase of $189,000, or 31%, compared to fiscal 1996. This increase is due to a decrease in interest expense of $77,000 resulting from a decrease in the level of short-term borrowings under the Company's line of credit, as well as an increase in interest income of $112,000 due to higher balances of marketable securities and other investments during fiscal 1997 compared to the prior year.
(BENEFIT FROM) PROVISION FOR INCOME TAXES. The Company's benefit from income taxes during fiscal 1997 was $(1,278,000), or (41.5%) of loss before income taxes, reflecting the federal tax benefit, net of applicable state taxes, associated with the results of operations for the year, compared to a provision for income taxes of $116,000, or 17.1% of income before income taxes, during fiscal 1996. The Company's effective tax rates differ from the federal statutory rate primarily due to interest income, most of which is exempt from federal income taxes due to the nature of the investments from which it is derived.
RECENT RESULTS
Net sales for the three months ended July 31, 1997, which represents the fourth quarter of the Company's fiscal year, were $10,973,000, a decrease of 15%, compared to $12,865,000 for the corresponding period of the prior year. For the quarter, sales of in-line skates, helmets and athletic protective equipment were down 30%, 21% and 33%, respectively, while skateboards and scooters increased 27% and snowboards and snowboarding accessories increased 635% in comparison to the fourth quarter of the prior year. These fluctuations were due to similar factors as discussed above in the year-over-year comparisons for each of these product categories.
The Company's net loss for the quarter ended July 31, 1997 was $895,000, or $0.15 per share, compared with a net loss of $1,189,000, or $0.20 per share for the corresponding period of the prior year. The decrease in the loss is
primarily due to a more significant impact during the fourth quarter of the prior year of inventory close-out sales and other price discounts.
YEAR ENDED JULY 31, 1996 COMPARED TO YEAR ENDED JULY 31, 1995
NET SALES. Net sales for the fiscal year ended July 31, 1996 totaled $72,379,000, a decrease of $27,938,000, or 28% from fiscal 1995 net sales of $100,317,000. This decrease was attributable to decreases in sales volume of the Company's in-line skate, athletic protective equipment, and bicycle and recreational safety helmet lines, resulting primarily from general weakness in retail sales, particularly in the mass merchandise market segment, compared to the prior fiscal year. The effect of the decreases in these three product categories was partially offset by a significant increase in sales of skateboards.
With respect to in-line skates, gross sales for fiscal 1996 totaled $57,145,000, a decrease of approximately $25,921,000, or 31%, compared to fiscal 1995, as unit volume in fiscal 1996 totaled 2,627,000 units, a decrease of approximately 1,235,000, or 32%. The average price per unit (gross revenues divided by units sold) of the Company's in-line skates was approximately $21.75 during fiscal 1996, compared to $21.51 for fiscal 1995. As discussed above, the decrease in in-line skate sales was primarily due to a soft retail market, as well as to a decline in consumer demand for in-line skates in general as compared to the significant annual growth in this market experienced over the past few years. These factors in turn led to high levels of inventory at retail, which further affected the amount of new skate orders placed by the Company's customers.
Gross sales for athletic protective equipment during fiscal 1996 totaled $5,668,000, a decrease of approximately $2,684,000, or 32%, compared to fiscal 1995, while unit volume in fiscal 1996 was 1,035,000, a decrease of approximately 846,000, or 45%. The Company's sales of these products generally correlate with sales of in-line skates; thus the decrease in sales of athletic protective equipment is attributable to the same factors discussed above. The decrease in gross sales is less as a percentage than the decrease in unit volume due to a greater proportion of sales of "triple packs" and other combination packages during fiscal 1996.
Gross sales of bicycle and recreational safety helmets during fiscal 1996 totaled $4,063,000, a decrease of approximately $4,238,000, or 51%, compared to fiscal 1995, while unit volume decreased approximately 307,000, or 37%, to a total of 520,000 units during fiscal 1996. These decreases in comparison with the prior year are primarily due to higher inventories of these products at certain of the Company's major customers, a weaker sell-through at retail during the holidays and significantly less legislation at the state and local levels aimed toward mandatory helmet use by bicyclists. The year-over-year decrease in gross sales is greater as a percentage than the decrease in unit volume due to discounting and other price reductions in response to competitive pressures in the marketplace. The average price per unit for the Company's helmets was approximately $7.81 during fiscal 1996, compared to $10.03 during fiscal 1995. Competitive influences and high inventory levels continue to put downward pressure on retail and wholesale prices throughout the industry.
Gross sales of skateboards during fiscal 1996 totaled $7,301,000, an increase of approximately $5,475,000, or 300%, compared to fiscal 1995, on total volume of 525,000 units, an increase of approximately 380,000 units, or 261%. These increases are due to a significant surge in the popularity of and demand for skateboards during fiscal 1996 and the ability of the Company to respond to that demand and fill the pipelines for its customers. The increase in gross sales is greater as a percentage than the increase in unit volume due to an increase in demand for higher quality componentry and also due to the Company's introduction during fiscal 1996 of its higher-priced Static(TM) brand skateboards for the pro and specialty market. The average price per unit for the Company's skateboards was approximately $13.90 during fiscal 1996, compared to $12.57 during fiscal 1995.
Sales to the Company's four largest accounts represented approximately 74% of the Company's total sales in fiscal 1996, compared to 78% in fiscal 1995. This decrease is the result of significantly less shipments during fiscal 1996, particularly of the Company's in-line skate, protective equipment and helmet products, to two major retail customers. The Company believes that the decreases in sales to these customers during fiscal 1996 are primarily due to excess inventory resulting from overforecasted consumer demand as opposed to declines in the Company's share of shelf space. The decrease in the percentage of total sales represented by the Company's four largest accounts, each of which is a national mass merchandiser, is also due in part to the Company's introduction of its Static(TM) lines of products for the sporting goods and specialty markets.
By product category, in-line skates, athletic protective equipment and helmets accounted for 77%, 8% and 5%, respectively, of the Company's total gross sales during fiscal 1996, compared to 81%, 8% and 8%, respectively, during
fiscal 1995. Skateboards accounted for 10% of the Company's total gross sales during fiscal 1996, compared to 2% during fiscal 1995, as a result of a significant increase in consumer demand for skateboards during the year.
GROSS PROFIT. Gross profit for the fiscal year ended July 31, 1996 decreased by $11,439,000 compared to the fiscal year ended July 31, 1995, representing a 48% decrease. The Company's gross profit margin as a percentage of net sales was 17.0% in fiscal 1996, compared with 23.7% in fiscal 1995. The decrease in gross margin is due to a combination of factors, including the impact, particularly during the third and fourth quarters of fiscal 1996, of price discounts offered in connection with the close-out of certain models of in-line skates and bicycle safety helmets, markdown credits and returns negotiated between the Company and certain of its customers in connection with excess retail inventory issues, and write-downs for increases in the Company's inventory reserves. Increased competition in the mass market, particularly with respect to in-line skates and safety helmets, also has had and continues to have an impact upon the Company's gross margin.
OPERATING EXPENSES. The Company's operating expenses (consisting of selling and marketing expenses and general and administrative expenses) for fiscal 1996 totaled $12,267,000, or 16.9% of net sales. Operating expenses for fiscal 1995 were $12,861,000, or 12.8% of net sales.
Selling and marketing expenses decreased by $113,000, or 1%, to $7,671,000 for fiscal 1996 compared to fiscal 1995. Selling and marketing expenses for fiscal 1996 amounted to 10.6% of net sales, compared to 7.8% in the prior year. The increase as a percentage of net sales is due to several factors, including wages and benefits associated with additional marketing personnel, increased advertising expenses for co-op programs with certain of the Company's major customers and for the promotion of the Company's new Static(TM) brand of products, and increases in other marketing related expenses such as for trade shows, catalogs and promotional materials. In dollars, these increases were more than offset by decreases in sales commissions because of the decline in sales during the year.
General and administrative expenses decreased by $481,000, or 9%, to $4,596,000 for fiscal 1996 compared to fiscal 1995. General and administrative expenses for fiscal 1996 amounted to 6.3% of net sales, compared to 5.1% in fiscal 1995. The dollar decrease is primarily due to a decrease in product development expenses, since in the prior year the Company was in the early and more costly stage of developing its new Static(TM) line of products, and reductions in expenses resulting from adjustments to certain accrual accounts, including accrued bonuses and accrued product liability claims, offset in part by increases in costs associated with the Company's new snowboard operations.
OTHER INCOME (EXPENSE). Other income for the fiscal year ended July 31, 1996 was $610,000, an increase of $332,000, or 119%, compared to fiscal 1995. This increase is due to a decrease in interest expense of $235,000 resulting from a decrease in the level of short-term borrowings under the Company's line of credit and lower interest rates on such borrowings compared to the prior year, as well as an increase in interest income of $97,000 due to higher balances of marketable securities and other investments during fiscal 1996 compared to the prior year.
PROVISION FOR INCOME TAXES. The Company's provision for income taxes during fiscal 1996 was $116,000, representing 17.1% of income before provision for income taxes, compared to $4,272,000, or 38.2% of income before provision for income taxes during fiscal 1995. The reduction in the Company's effective tax rate is primarily due to interest income representing a greater portion of income before provision for income taxes, and the fact that most of that interest income is exempt from federal income taxes due to the nature of the investments from which it is derived.
LIQUIDITY AND CAPITAL RESOURCES
From inception to completion of its initial public offering, the Company funded its activities principally from cash flow generated from operations, credit facilities with institutional lenders and, to a lesser degree, loans from its stockholders. In June 1994, the Company completed an initial public stock offering, issuing a total of 1,500,000 new common shares which raised approximately $20,723,000 in proceeds to the Company, net of fees and expenses. A portion of these proceeds was used by the Company to pay off borrowings on its line of credit and for other working capital purposes. The remainder was invested in marketable securities with maturities generally ranging from one to three years.
The Company has a credit agreement with a major bank providing a $12 million revolving line of credit, with separate sublimits of $12 million for the issuance of commercial letters of credit and $2 million for actual borrowings. The agreement, which expires February 1, 1998, is unsecured and carries an interest rate equal to prime minus 0.25%, and also offers certain LIBOR-based interest options. The agreement requires that the Company satisfy certain financial
covenants. Over the past several years, borrowings have varied, typically reaching highest levels in the pre-Christmas periods. However, more recently the Company has borrowed against its line of credit less frequently due to the ability to finance operations internally from cash and marketable securities available for sale. Balances on the line of credit are classified as current liabilities on the Company's balance sheet. There was no balance outstanding under the revolving line of credit as of July 31, 1997.
The Company had cash of $7,823,000 on hand as of July 31, 1997, compared to $3,351,000 as of July 31, 1996. Cash and marketable securities available for sale totaled $22,782,000 as of July 31, 1997, compared to $16,612,000 as of July 31, 1996. Net working capital as of July 31, 1997 was $25,251,000 compared to $28,346,000 as of July 31, 1996, and the Company's current ratio was 6.3:1 as of July 31, 1997, compared to 7.2:1 as of July 31, 1996. These fluctuations are primarily due to cash generated from operations, particularly via reductions in inventory and collections on accounts receivable, that was invested in long-term marketable securities.
The Company had no long-term debt as of July 31, 1997 and 1996. The Company had net stockholders' equity of $43,100,000 as of July 31, 1997, compared to $44,812,000 as of July 31, 1996, with such decrease due primarily to operating results for the fiscal year ended July 31, 1997, as well as fluctuations in unrealized gains and losses on marketable securities investments. Management believes that inflation has not had a significant impact upon the Company's costs and prices during the past three fiscal years.
Capital expenditures for fiscal 1997 totaled $888,000, compared to $2,317,000 during fiscal 1996. The decrease is primarily due to equipment purchases made in the prior year in connection with the construction of the Company's new snowboard manufacturing facility. Of the fiscal 1997 total, approximately $368,000 represented machinery and equipment expenditures for the snowboard plant and $470,000 represented production molds and other related equipment, compared to $938,000 and $1,157,000, respectively, for such expenditures during the prior year.
FUTURE LIQUIDITY AND FINANCIAL POSITION
The Company intends to continue to focus upon building and maintaining its existing product lines, including its new line of snowboards. The Company also plans to continue to devote resources toward the pursuit and development of new products, including its new line of Quik Shade(TM) instant canopies. In addition, management continues to explore the possibility of making selected acquisitions of other companies or products which would offer a strategic fit with the Company's existing products and its sourcing and distribution channels in the mass market. The Company also is considering expanding international distribution and developing additional distribution arrangements in order to take further advantage of growth opportunities which management believes exist for its products outside the United States.
Management believes that its current cash position, funds available under existing banking arrangements, and cash generated from operations will be sufficient to meet the Company's presently projected cash and working capital requirements for the next fiscal year assuming continued financial performance at present levels.
FOREIGN EXCHANGE
Management does not believe that the fluctuation in the value of the dollar in relation to the currency of its suppliers (the New Taiwan Dollar) has in the last three fiscal years had any significant adverse impact on the Company's ability to purchase products at agreed upon prices. Typically, the Company and its suppliers negotiate prices in New Taiwan Dollars. At the same time, they will agree upon a fixed exchange rate for a specified period, generally three to six months. The Company's payments to suppliers are then made in U.S. Dollars based upon the agreed upon exchange rate. Nonetheless, there can be no assurance that exchange rate fluctuations will not have an impact upon the Company in the future.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The financial statements and schedules included herein are listed in Item 14.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Item 11.
Item 11. EXECUTIVE COMPENSATION.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Except as noted in the following paragraph, the information required by Items 10, 11, 12 and 13 is incorporated herein by reference to the Company's definitive Proxy Statement to be filed pursuant to Regulation 14(A) not later than 120 days after the close of fiscal 1997 in connection with the Company's 1997 Annual Meeting of Stockholders, or shall be filed by amendment to this Form 10-K not later than the end of such 120 day period.
The information called for by Item 10 with respect to executive officers of the Registrant appears following Item 4 under Part I of this Report.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
FINANCIAL STATEMENTS
The following financial statements are included in Part II, Item 8 of this Annual Report on Form 10-K:
Independent Auditors' Report on Consolidated Financial Statements and Schedule Consolidated Balance Sheets as of July 31, 1997 and 1996 Consolidated Statements of Operations for the years ended July 31, 1997, 1996 and 1995 Consolidated Statements of Stockholders' Equity for the years ended July 31, 1997, 1996 and 1995 Consolidated Statements of Cash Flows for the years ended July 31, 1997, 1996 and 1995 Notes to Consolidated Financial Statements
FINANCIAL STATEMENT SCHEDULES
The following schedule is included in Part II, Item 8 of this Annual Report on Form 10-K:
Schedule II. Valuation and Qualifying Accounts
Schedules I and III through V are omitted for the reason that they are not applicable, not required or the information is presented in the consolidated financial statements or related notes.
REPORTS ON FORM 8-K
The Company filed no reports on Form 8-K during the quarter ended July 31, 1997.
EXHIBITS
(1) Previously filed together with the Company's Registration Statement on Form S-1, Reg. No. 33-77362. (2) Previously filed together with the Company's annual report on Form 10-K (file no.: 0-24338) on October 24, 1995. (3) Filed herewith the Company's annual report on Form 10-K (file no.: 0- 24338) on November 4, 1997.
* Management contract, compensatory plan or arrangement.
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.
VARIFLEX, INC.
October 27, 1997 By /s/ RAYMOND H. LOSI II --------------------------- Raymond H. Losi II President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
October 27, 1997 By /s/ RAYMOND H. LOSI --------------------------- Raymond H. Losi Chairman of the Board
October 27, 1997 By /s/ RAYMOND H. LOSI II --------------------------- Raymond H. Losi II President (Principal Executive Officer) Director
October 27, 1997 By /s/ WILLIAM B. OGDEN --------------------------- William B. Ogden Chief Financial Officer (Principal Financial and Accounting Officer)
October 27, 1997 By /s/ BARBARA LOSI ------------------------- Barbara Losi Director
October 27, 1997 By /s/ GERALD I. BOYCE --------------------------- Gerald I. Boyce Director
October 27, 1997 By /s/ LOREN HILDEBRAND --------------------------- Loren Hildebrand Director
October 27, 1997 By /s/ MARVIN G. MURPHY --------------------------- Marvin G. Murphy Director
Consolidated Financial Statements
Variflex, Inc.
Years ended July 31, 1997 and 1996 with Report of Independent Auditors
Variflex, Inc.
Consolidated Financial Statements and Supplemental Information
Years ended July 31, 1997 and 1996
CONTENTS
Report of Independent Auditors
The Board of Directors Variflex, Inc.
We have audited the accompanying consolidated balance sheets of Variflex, Inc. (the Company) as of July 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended July 31, 1997. Our audits also included the financial statement schedule listed in the Index at Item 14. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Variflex, Inc. at July 31, 1997 and 1996, and the consolidated results of its operations and its cash flows for each of the three years in the period ended July 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
Woodland Hills, California October 3, 1997
Variflex, Inc.
Consolidated Balance Sheets
(In thousands, except share and per share data)
See accompanying notes.
Variflex, Inc.
Consolidated Statements of Operations
(In thousands, except per share data)
See accompanying notes.
Variflex, Inc.
Consolidated Statements of Stockholders' Equity
(In thousands, except share data)
See accompanying notes.
Variflex, Inc.
Consolidated Statements of Cash Flows
(In thousands)
Supplemental disclosure of non-cash financing and investing activities: In May 1995, the Company issued 25,397 shares of common stock with a market value of $302,000 in connection with the acquisition further described in Note 10.
See accompanying notes.
Variflex, Inc.
Notes to Consolidated Financial Statements
July 31, 1997
1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Variflex, Inc. (Variflex), a Delaware corporation, and its two wholly owned subsidiaries, Oketa Limited (Oketa), a Hong Kong corporation, and Static Snowboards, Inc., a Delaware corporation (collectively the Company). The Company markets and distributes in-line roller skates, skateboards, bicycle and recreational safety helmets and athletic protective equipment, such as knee pads, elbow pads and wrist guards, and other products. The Company designs and develops these products which are then manufactured to the Company's specifications by independent contractors. The Company, through Static Snowboards, Inc., also designs, manufactures and markets snowboards and related accessories. The Company's products are sold primarily to retailers, with some sales to wholesalers and distributors. All significant intercompany accounts and transactions have been eliminated in consolidation.
USE OF ESTIMATES
Financial statements prepared in accordance with generally accepted accounting principles require management to make estimates and judgments that affect amounts and disclosures reported in the financial statements. Actual results could differ from those estimates.
REVENUE RECOGNITION AND WARRANTY
The Company recognizes revenue from product sales upon shipment. The Company has established programs with its customers which enable them to receive credit for defective merchandise covered under its warranty policy. The Company's products are generally under warranty against defects in material and workmanship for a period of usually 60 days from date of purchase. The amount of potential credits is estimated and provided for in the period of sale.
CONCENTRATION OF RISK
The Company performs periodic evaluation of the credit worthiness of its customers and generally does not require collateral. Credit losses relating to the Company's customers, mainly mass merchant retailers, have consistently been within management's expectations and are provided for in the financial statements.
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CONCENTRATION OF RISK (CONTINUED)
The Company operates predominantly within one industry segment where certain customers represent a significant portion of the Company's business. Sales to the Company's four largest customers as a percentage of consolidated gross sales, were 26%, 21%, 15% and 8% for fiscal 1997; 20%, 26%, 16% and 12% for fiscal 1996; 29%, 19%, 24% and 6% for fiscal 1995. Receivables from these customers as a percentage of the Company's total trade accounts receivable were 41%, 14%, 15% and 9% at July 31, 1997.
With the exception of snowboards, which are manufactured domestically at the Company's factory, all of the Company's products are manufactured by independent contractors located in the Republic of China (Taiwan), The People's Republic of China and South Korea. The Company presently knows of no circumstances that would materially affect its supply or costs of goods; however, there can be no assurances with respect to events which may arise in the future.
CASH EQUIVALENTS
Short-term investments and money market funds with original maturities of three months or less are classified as cash equivalents. The carrying value of cash equivalents approximates market value.
MARKETABLE SECURITIES
The Company accounts for investments in marketable securities in accordance with Statement of Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Management has determined all investments should be classified as available-for-sale.
Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as a component of retained earnings. The amortized cost of debts securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. Realized gains, losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in interest income. The cost of securities is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in interest income.
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INVENTORY
Inventory is stated at the lower of cost (first-in, first-out method) or market and consists of the following:
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the related assets or, for leasehold improvements, over the terms of the related leases, if shorter.
GOODWILL
Goodwill arising from the acquisitions described in Note 10 is amortized on a straight-line basis over a period of 15 years and is included net of amortization as a component of other assets. Accumulated amortization of goodwill as of July 31, 1997 and 1996 amounted to $69,000 and $39,000, respectively.
EARNINGS (LOSS) PER SHARE
Earnings (loss) per share is computed based on the weighted average number of shares of common stock and common stock equivalents, when dilutive, outstanding during the period. Common stock equivalents represent the dilutive effect of the assumed exercise of certain outstanding options. Such common stock equivalents are excluded from the computation for the year ended July 31, 1997 because their effect is antidilutive.
Statement of Financial Accounting Standard No. 128, "Earnings per Share" (SFAS 128) was issued in February 1997 and must be adopted by the Company starting with the quarter ended December 31, 1997. Early adoption is not permitted but all prior year earnings per share data must be restated upon adoption. SFAS 128 simplifies the calculation of earnings per share data by replacing primary earnings per share with basic earnings per share, which uses weighted average shares outstanding and does not include any dilutive securities in the denominator of the calculation. Fully diluted earnings per share is essentially unchanged. For fiscal 1997, 1996 and 1995 basic earnings per share would have been the same as primary earnings per share.
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ADVERTISING COSTS
Advertising costs are generally expensed as incurred. Advertising costs for the years ended July 31, 1997, 1996 and 1995 amounted to $3,845,000, $4,542,000 and $3,861,000, respectively.
STOCK-BASED COMPENSATION
Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation," was recently issued and encourages but does not require companies to record compensation expenses for stock options at fair value. The Company has chosen to continue to account for stock options using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, the Company has computed the pro forma disclosures of the earnings per share as determined under the provision of SFAS No. 123.
RECLASSIFICATIONS
Certain reclassifications have been made to the 1996 and 1995 financial statements to conform with the 1997 presentation.
2.INVESTMENTS
Available-for-sale securities consist of the following:
The Company experienced net realized losses of $63,000 and $8,000 on sales of available-for-sale securities during the fiscal years ended July 31, 1997 and 1995, respectively. There were no realized gains or losses during the fiscal year ended July 31, 1996. The net adjustments to unrealized holding gains and losses on available-for-sale securities as of July 31, 1997 and 1996 are reflected in retained earnings.
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
2. INVESTMENTS (CONTINUED)
The amortized cost and estimated fair value of debt securities by contractual maturity are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties.
The classification of marketable securities between current and noncurrent assets differs from the contractual maturity dates because it is management's expectation that, unless a need or use of the funds develops, the funds will be reinvested upon the respective maturity dates rather than used in current operations.
3. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
4. REVOLVING LINE OF CREDIT
The Company has a $12,000,000 revolving line of credit with a major bank, with separate sublimits of $12,000,000 for the issuance of commercial letters of credit and $2,000,000 for actual borrowings. Borrowings are unsecured and carry an interest rate equal to the bank's prime interest rate less 0.25%, with other Libor-based interest options available. Interest is payable monthly. The credit line matures on February 1, 1998. The agreement requires the Company to comply with certain financial ratios and covenants.
As of July 31, 1997, letters of credit in the amount of $1,328,000 were open for the receipt of future merchandise. Of this amount, $758,000 has not been reflected on these financial statements since title to the merchandise has not yet passed to the Company.
5. COMMITMENTS AND CONTINGENCIES
LEASE COMMITMENTS
The Company leases warehouse and office facilities under an operating lease that requires minimum monthly payments of $34,000, and also provides for the lessee to pay property taxes, insurance, repairs and maintenance and utilities. The lease expires on December 31, 2000. The Company also subleases additional warehouse and office space in an adjacent building under a separate operating lease requiring minimum monthly payments of $7,000, which amount includes property taxes and utilities, but which provides for the Company to pay insurance and repairs and maintenance costs. This agreement expires June 30, 1998. The Company's subsidiary, Static Snowboards, Inc., leases office and manufacturing facilities under an operating lease that requires monthly payments of $11,000 and expires in September 2000.
The Company has no capital leases as of July 31, 1997. Annual future minimum lease payments under existing operating leases are as follows:
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
5. COMMITMENTS AND CONTINGENCIES (CONTINUED)
LEASE COMMITMENTS (CONTINUED)
Total rent expense was $687,000, $725,000 and $530,000 for the fiscal years ended July 31, 1997, 1996 and 1995, respectively.
LITIGATION
The Company is involved in various claims arising primarily from sales of products in the normal course of business. Management has recorded a $111,000 allowance for product liability losses at July 31, 1997 ($175,000 at July 31, 1996). In addition, the Company carries product liability insurance on its products. In the opinion of management, any additional liability to the Company arising under any pending product liability litigation would not materially affect its financial position, cash flow or results of operations.
EMPLOYMENT AGREEMENTS
The Company has employment and consulting agreements in effect with certain of its employees. The agreements provide for varying terms of employment aggregating $816,000, $450,000 and $247,000 in base compensation during the fiscal years ended July 31, 1998, 1999 and 2000, respectively.
In connection with the acquisition of the assets of Plunkett Snowboards, Inc. described in Note 10, the Company entered into agreements which provide for bonus, royalties, establishment of a phantom earnings plan (the Plan) and a put option which allows the holder to sell the rights under the Plan to the Company after five years. The Company will record compensation expense pursuant to the terms of these agreements, the phantom earnings plan and the put option.
6. PENSION PLAN
The Company has a defined benefit pension plan (the Plan) covering substantially all of its employees. The benefits are based on years of service and the employee's compensation during the last five years of employment. The Company's funding policy is generally to contribute annually the minimum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. During 1997 the Company amended the Plan to provide for its termination effective July 31, 1997. Accordingly, included in net periodic pension expense for the year ended July 31, 1997 is a curtailment gain of $219,000 resulting from the reduction of the projected bene-
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
6. PENSION PLAN (CONTINUED)
fit obligation due to the termination of the Plan. The assets of the Plan will be used to settle the pension obligation in fiscal 1998. Effective August 1, 1997 the Company established a defined contribution pension plan covering substantially all of its employees. Company contributions are determined at the discretion of the Company.
The following table sets forth the plan's funded status and amounts recognized in the Company's consolidated balance sheet at July 31, 1997 and 1996:
Net pension cost for the fiscal years ended July 31, 1997, 1996 and 1995 included the following components:
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
6. PENSION PLAN (CONTINUED)
The weighted-average discount rate and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations was 8 percent and 5 percent, respectively, in 1996 and 1995, and 6% and zero percent in 1997, respectively. The expected long-term rate of return on assets and the increase in cost of living assumption used in computing the periodic pension cost was 8 percent and 3 percent, respectively, for 1996 and 1995, and was zero percent and zero percent, respectively, in the year ended July 31, 1997. The change in the assumptions during 1997 are due to the termination of the plan as previously discussed.
7. INCOME TAXES
The (benefit from) provision for income taxes for the fiscal years ended July 31, 1997, 1996 and 1995 is as follows:
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
7. INCOME TAXES (CONTINUED)
The deferred income tax asset consists of the tax effect of timing differences related to the following components:
A reconciliation of the statutory federal income tax rate to the effective tax rate, as a percentage of income before taxes based on income, follows:
Pretax income earned by Oketa amounted to $215,000, $1,393,000 and $1,736,000 in fiscal 1997, 1996 and 1995, respectively, and is not subject to Hong Kong tax as provided under that country's taxation requirements. The Company provides deferred taxes on Oketa's income until such income is repatriated to the United States.
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
8. STOCK OPTION PLANS
In April 1993, the Company established a non-qualified stock option plan (the Plan) to grant stock options to one of its officers. Under the Plan, stock options were granted each April through April 1997, and each grant shall vest cumulatively at 20% per year over five years. The options are exercisable over ten years at an exercise price of $0.0004 per share. The number of shares granted at each grant date will have an aggregate fair market value of $20,000 as of such grant date. In April 1995, 1996 and 1997, the Company granted options to purchase 1,379, 2,667 and 3,951 shares, respectively, and in sum the Company has granted options to purchase a total of 20,129 shares of the Company's common stock under the Plan. The Company has recorded compensation expense related to these options.
On April 1, 1994, the stockholders of the Company approved the 1994 Variflex Stock Plan (the 1994 Stock Plan) which became effective at the initial public offering date of June 17, 1994. Under the 1994 Stock Plan, options, stock appreciation rights (SARS) and bonus stock may be granted for the purpose of attracting and motivating deserving employees and directors of the Company. The exercise price of the options is to be not less than the market price of the common stock at the time of grant with respect to incentive stock options, and not less than 85% of the market price of the common stock at the time of grant with respect to non-qualified options. The maximum number of shares reserved for issuance under the 1994 Stock Plan is 200,000.
In June 1997, in connection with the termination of certain incentive stock option plans and stock options granted in April 1994 to purchase 280,000 shares of common stock at $15.50 per share, the Company granted to certain officers and employees of the Company incentive stock options, under the 1994 Stock Plan, for the purchase of an aggregated amount of 145,000 shares of the Company's common stock. The options vest over the next two to five years, carry exercise prices ranging from $5.00 to $5.50 per share and are exercisable over 10 years from the date of grant.
There were no options exercised in the years ended July 31, 1997, 1996 and 1995 and no options were canceled in the years ended July 31, 1996 and 1995.
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
8. STOCK OPTION PLANS (CONTINUED)
A summary of stock option activity and data is as follows:
Information regarding stock options outstanding as of July 31, 1997 is as follows:
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
8. STOCK OPTION PLANS (CONTINUED)
Fair Value Disclosures
The weighted average exercise prices and fair market value of stock options using the Black-Scholes option valuation model were as follows:
The weighted average fair values of 1997 and 1996 stock option grants were estimated at the date of grant using the Black-Scholes option valuation model and the following average actuarial assumptions:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options. The Company's employee stock options have characteristics significantly different from those of traded options such as vesting restrictions and extremely limited transferability. In addition, the assumptions used in option valuation models (see above) are highly subjective, particularly the expected stock price volatility of the underlying stock. Because changes in these subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not provide a reliable single measure of the fair value of its employee stock options.
For purposes of the pro forma disclosure of net income, the estimated fair value of the stock options granted in 1996 and 1997 is amortized as compensation expense over the options' vesting period. The pro forma effect on net income for 1997 and 1996 is not presented because it is not material. However, the pro forma effect on net income for 1997 and 1996 is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants prior to 1996. Pro forma information in future years will reflect the amortization of a larger number of stock options granted in several succeeding years.
Variflex, Inc.
Notes to Consolidated Financial Statements (continued)
9. QUARTERLY OPERATING DATA (UNAUDITED)
The following is a summary of unaudited quarterly results of operations:
10. ACQUISITIONS
In April 1995, the Company formed a new wholly owned subsidiary, Static Snowboards, Inc., for the purpose of acquiring the assets of Plunkett Snowboards, Inc., an existing snowboard manufacturer. The acquisition was completed in May 1995, in exchange for $100,000 in cash and 25,397 shares of Variflex, Inc. common stock which had a market value of $302,000.
In June 1996, Static Snowboards, Inc. entered into an agreement with another company for the joint manufacture, marketing and distribution of Barfoot(TM) snowboards. The joint agreement contained a purchase option, which the Company exercised in May 1997, thereby acquiring all rights to the Barfoot brand name in exchange for $85,000 in cash.
The Company recorded each of the acquisitions referred to above using the purchase method of accounting. In each case, substantially all of the purchase price was recorded by the Company as goodwill, to be amortized over 15 years.
Variflex, Inc.
Valuation and Qualifying Accounts
Three years ended July 31, 1997