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Spy Inc. 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5.  
Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2006

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number: 000-51071

ORANGE 21 INC.

(Exact name of Registrant as specified in its charter)

 

Delaware   33-0580186

(State or other jurisdiction

of incorporation or organization)

  (IRS Employer Identification No.)
2070 Las Palmas Drive, Carlsbad, CA 92011   (760) 804-8420
(Address of principal executive offices)  

(Registrant’s telephone

number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  ¨    No  x

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨                Accelerated filer  ¨                Non-accelerated filer  x

Indicate by check mark whether the Registrant is a shell company, as defined in Rule 12b-2 of the Exchange Act.  Yes  ¨    No  x

As of November 6, 2006, there were 8,184,314 shares of Common Stock, par value $0.0001 per share, issued and outstanding.

 



Table of Contents

ORANGE 21 INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

 

PART I

   FINANCIAL INFORMATION   
  

Item 1. Financial Statements

   3
  

Consolidated Balance Sheets as of December 31, 2005 and September 30, 2006 (Unaudited)

   3
  

Consolidated Statements of Operations (Unaudited) for the three and nine month periods ended September 30, 2005 and 2006

   4
  

Consolidated Statements of Comprehensive (Loss) Income (Unaudited) for the three and nine month periods ended September 30, 2005 and 2006

   4
  

Consolidated Statements of Cash Flows (Unaudited) for the nine month periods ended September 30, 2005 and 2006

   5
  

Notes to Unaudited Consolidated Financial Statements

   6
  

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

   15
  

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   25
  

Item 4. Controls and Procedures

   26

PART II

   OTHER INFORMATION    28
  

Item 1. Legal Proceedings

   28
  

Item 1A. Risk Factors

   28
  

Item 5. Other Information

   36
  

Item 6. Exhibits

   36

Signatures

      37

 

2


Table of Contents

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

     December 31,
2005
    September 30,
2006
 
           (unaudited)  
Assets     

Current assets

    

Cash and cash equivalents

   $ 2,668,636     $ 4,019,838  

Short-term investments

     5,477,728       —    

Restricted cash

     —         857,440  

Accounts receivable—net

     9,142,264       8,081,563  

Inventories

     11,206,232       12,055,075  

Prepaid expenses and other current assets

     1,374,350       1,476,221  

Income taxes receivable

     239,046       439,755  

Deferred income taxes

     1,512,584       1,134,185  
                

Total current assets

     31,620,840       28,064,077  

Property, plant and equipment—net

     4,636,305       9,161,828  

Goodwill

     —         9,440,783  

Intangible assets, net of accumulated amortization of $395,760 (2005) and $432,449 (2006), respectively

     483,854       445,690  

Deferred income taxes

     126,000       1,123,000  

Other long-term assets

     1,389,682       64,152  
                

Total assets

   $ 38,256,681     $ 48,299,530  
                
Liabilities and Stockholders’ Equity     

Current liabilities

    

Lines of credit

   $ —       $ 1,476,296  

Current portion of notes payable

     —         1,161,427  

Current portion of capitalized leases

     19,575       429,481  

Accounts payable

     1,643,427       5,249,873  

Accrued expenses and other liabilities

     2,349,946       4,213,933  

Deferred purchase price obligation

     —         1,292,749  
                

Total current liabilities

     4,012,948       13,823,759  

Notes payable, less current portion

     —         667,179  

Capitalized leases, less current portion

     12,588       687,835  

Other liabilities

     —         851,743  
                

Total liabilities

     4,025,536       16,030,516  

Commitments and contingencies

    

Stockholders’ equity

    

Preferred stock; par value $0.0001; 5,000,000 authorized

     —         —    

Common stock; par value $0.0001; 100,000,000 shares authorized; 8,084,314 and 8,184,314 shares issued and outstanding December 31, 2005 and September 30, 2006, respectively

     806       807  

Additional paid-in capital

     36,099,820       36,250,066  

Accumulated other comprehensive income

     32,497       1,190,096  

Accumulated deficit

     (1,901,978 )     (5,171,955 )
                

Total stockholders’ equity

     34,231,145       32,269,014  
                

Total liabilities and stockholders’ equity

   $ 38,256,681     $ 48,299,530  
                

The accompanying notes are an integral part of these consolidated financial statements

 

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Table of Contents

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2005    2006     2005     2006  

Net sales

   $ 10,819,773    $ 11,379,236     $ 29,707,956     $ 31,032,248  

Cost of sales

     5,310,534      5,858,562       14,494,701       15,486,635  
                               

Gross profit

     5,509,239      5,520,674       15,213,255       15,545,613  
                               

Operating expenses

         

Sales and marketing

     3,462,546      3,492,318       9,381,103       10,494,076  

General and administrative

     1,368,080      2,287,354       4,223,149       6,887,046  

Shipping and warehousing

     334,917      343,140       924,508       1,293,219  

Research and development

     160,562      267,034       475,018       785,916  
                               

Total operating expenses

     5,326,105      6,389,846       15,003,778       19,460,257  
                               

Income (loss) from operations

     183,134      (869,172 )     209,477       (3,914,644 )

Other income (expense)

         

Interest income (expense)—net

     85,632      (43,715 )     236,045       (167,691 )

Foreign currency transaction gain (loss)

     165,933      (93,847 )     66,345       (47,309 )

Other (expense) income—net

     4,704      (19,741 )     (7,917 )     (14,520 )
                               

Total other income (expense)

     256,269      (157,303 )     294,473       (229,520 )
                               

Income (loss) before income taxes

     439,403      (1,026,475 )     503,950       (4,144,164 )

Income tax provision (benefit)

     247,293      (248,579 )     444,451       (874,187 )
                               

Net income (loss)

   $ 192,110    $ (777,896 )   $ 59,499     $ (3,269,977 )
                               

Net income (loss) per common share

         

Basic

   $ 0.02    $ (0.10 )   $ 0.01     $ (0.40 )
                               

Diluted

   $ 0.02    $ (0.10 )   $ 0.01     $ (0.40 )
                               

Weighted average common shares outstanding

         

Basic

     8,026,502      8,090,981       8,014,352       8,086,536  
                               

Diluted

     8,339,792      8,090,981       8,407,376       8,086,536  
                               

CONSOLIDATED STATEMENTS OF

COMPREHENSIVE (LOSS) INCOME (UNAUDITED)

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2005     2006     2005     2006  

Net income (loss)

   $ 192,110     $ (777,896 )   $ 59,499     $ (3,269,977 )

Other comprehensive (loss) income:

        

Unrealized (loss) income on cash flow hedges, net of tax

     (9,220 )     (48,317 )     (244,192 )     534,570  

Unrealized (loss) income on available-for-sale investments, net of tax

     1,322       —         (2,679 )     1,681  

Equity adjustment from foreign currency translation

     196,940       (27,303 )     187,565       369,690  

Unrealized (loss) gain on foreign currency exposure of net investment in foreign operations

     (20,100 )     (29,517 )     (264,900 )     251,658  
                                

Other comprehensive loss (income), net of tax

     168,942       (105,137 )     (324,206 )     1,157,599  
                                

Comprehensive (loss) income

   $ 361,052     $ (883,032 )   $ (264,707 )   $ (2,112,377 )
                                

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

     Nine months ended
September 30,
 
     2005     2006  

Cash flows from operating activities

    

Net loss

   $ 59,499     $ (3,269,977 )

Adjustments to reconcile net income to net cash (used in) provided by operating activities:

    

Depreciation and amortization

     1,636,503       2,383,009  

Deferred income taxes

     (100,937 )     (619,510 )

Provision for bad debts

     111,384       416,831  

Stock-based compensation

     —         150,247  

Loss on sale of fixed assets

     —         159,248  

Change in operating assets and liabilities:

    

Accounts receivable

     (311,861 )     1,428,194  

Inventories

     (1,200,366 )     1,223,672  

Prepaid expenses and other current assets

     (831,956 )     408,414  

Other assets

     —         9,645  

Accounts payable

     (331,310 )     853,672  

Accrued expenses and other liabilities

     150,793       (236,431 )

Income tax payable/receivable

     (385,106 )     (271,138 )
                

Net cash (used in) provided by operating activities

     (1,203,357 )     2,635,876  
                

Cash flows from investing activities

    

Purchases of fixed assets

     (1,587,120 )     (3,767,947 )

Purchases of fixed assets from related parties

     (1,095,501 )     —    

Purchases of short-term investments

     (14,371,966 )     (1,500,000 )

Maturities and sales of short-term investments

     5,292,000       6,980,000  

Cash paid for acquisition

     —         (2,982,127 )

Investment in restricted cash

     —         (857,439 )

Proceeds from the sale of fixed assets

     —         118,545  

Purchases of intangibles

     (403,951 )     (11,774 )
                

Net cash used in investing activities

     (12,166,538 )     (2,020,742 )
                

Cash flows from financing activities

    

Line of credit borrowings

     —         776,911  

Line of credit repayments

     —         (847,429 )

Principal payments on notes payable

     (291,667 )     (888,912 )

Proceeds from issuance of notes payable

     —         1,552,895  

Principal payments on capital leases

     (28,421 )     (349,018 )

Proceeds from sale of common stock

     4,177,035       —    

Proceeds from exercise of stock options

     48,910       —    
                

Net cash provided by (used in) financing activities

     3,905,857       244,447  
                

Effect of exchange rate changes on cash and cash equivalents

     (319,748 )     491,621  
                

Net (decrease) increase in cash and cash equivalents

     (9,783,786 )     1,351,202  

Cash and cash equivalents at beginning of period

     11,476,828       2,668,636  
                

Cash and cash equivalents at end of period

   $ 1,693,042     $ 4,019,838  
                

Supplemental disclosures of cash flow information:

    

Cash paid during the period for:

    

Interest

   $ 15,738     $ 261,496  
                

Income taxes

   $ 795,000     $ 282,858  
                

The accompanying notes are an integral part of these consolidated financial statements

 

5


Table of Contents

ORANGE 21 INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

1. Basis of Presentation

The accompanying unaudited consolidated financial statements of Orange 21 Inc. and its subsidiaries (the “Company”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles (“GAAP”) for complete financial statements.

In the opinion of management, the unaudited consolidated financial statements contain all adjustments, consisting only of normal recurring items, considered necessary for a fair presentation of the consolidated balance sheet as of September 30, 2006, the consolidated statements of operations and comprehensive income (loss) for the three and nine months ended September 30, 2005 and 2006, and the consolidated statements of cash flows for the nine month periods ended September 30, 2005 and 2006. The results of operations for the three and nine month periods ended September 30, 2006 are not necessarily indicative of the results of operations for the entire year ending December 31, 2006 or for any other period. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Company’s financial statements and notes thereto included in the Orange 21 Inc. Annual Report Form 10-K for the year ended December 31, 2005.

 

2. Recently Issued Accounting Pronouncements

In March 2005, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation Number (FIN) 47 to clarify the timing of the recording of certain asset retirement obligations required by SFAS 143. FIN 47 is effective December 31, 2005. The adoption of FIN 47 has not had a material impact on the Company’s consolidated results of operations or financial condition.

In May 2005, the FASB issued SFAS 154, which replaces APB Opinion No. 20, Accounting Changes, and SFAS 3, Reporting Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion No. 28. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will apply SFAS 154 in future periods when it becomes applicable.

In July 2006, the FASB issued Financial Interpretation Number (FIN) 48 “Accounting for Uncertainty in Income Taxes” which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for the Company beginning January 1, 2007. The Company is in the process of determining the effect the adoption of FIN 48 will have on its financial statements.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Current Year Misstatements.” SAB No. 108 requires analysis of misstatements using both an income statement (rollover) approach and a balance sheet (iron curtain) approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB No. 108 is effective for the Company’s fiscal year 2006 annual financial statements. The Company is currently assessing the potential impact that the adoption of SAB No. 108 will have on our financial statements; the impact is not expected to be material.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for the Company beginning January 1, 2008. The Company is currently assessing the potential impact that the adoption of SFAS No. 157 will have on our financial statements.

 

3. Cash, Cash Equivalents and Short-term Investments

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. The Company’s investments, which generally have maturities between three and twelve months at time of acquisition, are considered short-term and classified as available for sale. Cash, cash equivalents and short-term investments consist primarily of corporate obligations such as commercial paper and corporate bonds, but may also include government agency notes, certificates of deposit, bank time deposits and institutional money market funds.

At September 30, 2006, the Company had no short-term investments.

The following table summarizes short-term investments by security type at December 31, 2005:

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated
Fair Value

Auction rate securities

   $ 4,500,000    $ —      $ —      $ 4,500,000

Certificates of deposit

     480,000      —        2,457      477,543

State and municipal securities

     500,530      —        345      500,185
                           
   $ 5,480,530    $ —      $ 2,802    $ 5,477,728
                           

 

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Table of Contents

The following table summarizes the contractual maturities of the Company’s short-term investments:

 

     December 31,
2005
   September 30,
2006

Less than one year

   $ 977,728    $ —  

Due in one to five years

     —        —  

Due after five years

     4,500,000      —  
             
   $ 5,477,728    $ —  
             

Auction rate securities, for which the interest rate resets approximately every 7 to 28 days, have been allocated within the contractual maturities table based upon the set maturity date of the security. For the nine months ended September 30, 2005 and 2006, the Company did not record any realized gains or losses on its short-term investments.

As of December 31, 2005 and September 30, 2006, the Company had no investments that have been in a continuous unrealized loss position for a period of 12 months.

 

4. 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 subsidiary. As part of its overall strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, the Company uses foreign exchange contracts in the form of forward contracts. Prior to April 2005, the Company’s forward contracts did not qualify for hedge accounting, and changes in the fair value of the Company’s forward contracts were recorded in the consolidated statements of operations.

Beginning in April 2005, a majority of the Company’s derivatives were designated and qualified as cash flow hedges. The Company uses forward contracts designated as cash flow hedges primarily to protect against the foreign exchange risks inherent in its forecasted purchase of products at prices denominated in currencies other than the U.S. dollar. For derivative instruments that are designated and qualify as cash flow hedges, the Company records the effective portion of the gain or loss on the derivative in accumulated other comprehensive income as a separate component of stockholders’ equity and subsequently reclassifies these amounts into earnings in the period during which the hedged transaction is recognized in earnings. The Company reports the effective portion of cash flow hedges in the same financial statement line as the changes in the value of the hedged item. As of September 30, 2006, the notional amounts of the Company’s foreign exchange contracts designated as cash flow hedges were $7,451,000. As of September 30, 2006, a net gain of $247,000 related to derivative instruments designated as cash flow hedges was recorded in accumulated other comprehensive income.

In the nine months ended September 30, 2005 and 2006, the Company did not discontinue any material 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.

Other derivatives not designated as hedging instruments under SFAS No. 133 “ Accounting for Derivative Instruments and Hedges” consist of forward contracts the Company uses to hedge foreign currency balance sheet exposures and interest rate swaps. For derivative instruments not designated as hedging instruments under SFAS No. 133, the Company recognizes changes in fair value in earnings in the period of change. The Company recognizes the gains or losses on foreign currency forward contracts used to hedge balance sheet exposures in the foreign currency transaction gain.

As of December 31, 2005 and September 30, 2006, the notional amounts of the Company’s foreign exchange contracts not designated as hedging instruments were $1,775,000 and $1,144,000 respectively.

As of September 30, 2006, notional amounts of the interest rate swap were 1 million Euro. This swap was acquired with the purchase of LEM S.r.l. It is not an effective hedge of the Company’s interest rate exposures. In June 2006, one interest rate swap was closed at a loss of approximately 16,000 Euro or $20,000.

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.

 

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Table of Contents
5. Earnings (Loss) Per Share

Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is calculated by including the additional shares of common stock issuable upon exercise of outstanding options and warrants in the weighted average share calculation. Basic and diluted loss per share are the same for the three and nine months ended September 30, 2006 as all potentially dilutive securities are antidilutive. The following table lists the potentially dilutive equity instruments, each convertible into one share of common stock:

 

     Three Months Ended
September 30,
   Nine months ended
September 30,
     2005    2006    2005    2006

Weighted average common shares outstanding — basic

   8,026,502    8,090,981    8,014,352    8,086,536

Effect of dilutive securities:

           

Stock options

   313,290    —      393,024    —  

Warrants

   —      —      —      —  
                   

Dilutive potential shares

   313,290    —      393,024    —  
                   

Weighted average common shares outstanding — dilutive

   8,339,792    8,090,981    8,407,376    8,086,536
                   

The following potentially dilutive instruments were not included in the diluted per share calculation for the three and nine months ended September 30, 2005 and 2006 as their effect was antidilutive:

 

     Three Months Ended
September 30,
   Nine months ended
September 30,
     2005    2006    2005    2006

Stock options

   495,000    885,938    475,000    885,938

Restricted stock

   —      90,000    —      90,000

Warrants

   147,000    147,000    147,000    147,000
                   

Total

   642,000    1,122,938    622,000    1,122,938
                   

 

6. Comprehensive Income

Comprehensive income represents the results of operations adjusted to reflect all items recognized under accounting standards as components of comprehensive income.

The components of accumulated other comprehensive income, net of tax, are as follows:

 

     December 31,
2005
    September 30,
2006
 

Unrealized (loss) income on cash flow hedges, net of tax

   $ (287,668 )   $ 246,902  

Unrealized loss on available-for-sale investments, net of tax

     (1,681 )     —    

Equity adjustment from foreign currency translation

     642,021       1,011,711  

Unrealized loss on foreign currency exposure of net investment in foreign operations

     (320,175 )     (68,517 )
                

Accumulated other comprehensive income

   $ 32,497     $ 1,190,096  
                

 

7. Stock Based Compensation

On January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R) “Share-Based Payments.” Prior to January 1, 2006, the Company had accounted for stock-based payments under the recognition and measurement provisions of Accounting Principles Board (“APB”) Opinion 25 and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation.” In accordance with APB 25, no compensation expense was required to be recognized for options granted that had an exercise price equal to the market value of the underlying common stock on the date of grant.

 

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Table of Contents

Stock Options

Under the modified prospective method of SFAS No. 123(R), compensation expense was recognized during the three and nine months ended September 30, 2006 and includes compensation expense for all stock-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and compensation expense for all stock based payments granted after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). The Company’s financial results for the prior periods have not been restated.

As a result of adopting SFAS No. 123(R), during the three and nine months ended September 30, 2006, the Company’s net loss is approximately $17,000 and $46,000 net of tax higher, respectively, than if it had continued to account for stock based compensation under APB 25 as it did for the three and nine months ended September 30, 2005. Basic and diluted earnings per share for the three and nine months ended September 30, 2006 would not have been affected if the Company had not adopted SFAS No. 123(R). Compensation expense was included primarily in general and administrative expense for the period. The adoption of SFAS No. 123(R) had no impact on the Company’s cash flows.

Consistent with the valuation method used for the disclosure only provisions of SFAS No. 123, the Company is using the Black-Scholes option-pricing model to value compensation expense. The Black-Scholes option-pricing model uses the assumptions noted in the following table. No options were granted during the three months ended September 30, 2006. Forfeitures are estimated at the date of grant based on historical rates and reduce the compensation expense recognized. The expected term of options granted is derived from historical data on employee exercises. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the date of grant. Expected volatility is based on the historical volatility of the Company’s stock.

 

     Three months ended
September 30,
   Nine months ended
September 30,
 
     2005     2006    2005     2006  

Expected volatility

   64.0 %   —      64.0 %   61.0  %

Risk-free interest rate

   3.8 %   —      3.8 %   5.1  %

Dividend yield

   —       —      —       —    

Expected term (in years)

   5.0     —      5.0     5.0  

The stock option activity is summarized below:

 

     Shares     Weighted-
Average
Exercise Price
   Weighted-
Average
Remaining
Contractual
Term (years)
   Aggregate
Intrinsic Value

Options outstanding at December 31, 2005

   1,020,624     $ 6.69      

Granted (weighted-average fair value of $2.90)

   30,000       5.11      

Exercised

   —         —        

Canceled/forfeited

   (164,686 )     6.86      
              

Options outstanding at September 30, 2006

   885,938       6.60    6.9    $ 235,282
              

Exercisable outstanding at September 30, 2006

   813,123       6.75    7.0    $ 235,282
                        

The Company records stock compensation expense using the straight line vested method over the vesting period, which is generally one to five years. As of September 30, 2006, the Company had $92,000 of unrecognized compensation expense expected to be recognized over a weighted average period of approximately 1.1 years.

 

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The reported net income (loss) and net income (loss) per share for the three and nine months ended September 30, 2005 have been presented below to reflect the impact of the adoption of SFAS No. 123(R) had the Company been required to adopt this standard for the three and nine months ended September 30, 2005.

 

     Three months ended
September 30, 2005
    Nine months ended
September 30, 2005
 

Actual net income (loss)

   $ 192,110     $ 59,499  

Less stock-based employee compensation expense determined under the fair value based method

     (86,679 )     (103,542 )
                

Pro forma net income (loss)

   $ 105,431     $ (44,043 )
                

Basic earnings per share - actual

   $ 0.02     $ 0.01  
                

Diluted earnings per share - actual

   $ 0.01     $ (0.01 )
                

Basic earnings per share - pro forma

   $ 0.02     $ 0.01  
                

Diluted earnings per share - pro forma

   $ 0.01     $ (0.01 )
                

Restricted stock awards

On June 13, 2006, the Company issued an aggregate of 97,500 restricted shares of common stock to existing employees, 24,375 shares of which vest after a period of one year and 73,125 which vest monthly over the following three years in equal increments, in each case subject to continuing service by the recipient of the restricted stock. The fair value of the restricted stock is $5.01 per share (the market value of the stock on the date of issuance) or $488,475. Compensation expense recorded during both the three and nine months ended September 30, 2006, totaled approximately $24,000 and $29,000, respectively. At September 30, 2006, no shares were vested and 90,000 shares were subject to repurchase.

The following table summarizes information about non-vested restricted stock awards as of September 30, 2006 and changes during the nine months then ended:

 

     Shares     Weighted-
Average Grant-
Date Fair value
   Weighted-
Average
Remaining
Service Period
   Aggregate
Unrecognized
Compensation
Expense

Non-vested at December 31, 2005

   —       $ —        

Granted

   97,500       5.01      

Vested

   —         —        

Canceled

   (7,500 )     5.01      
              

Non-vested at September 30, 2006

   90,000     $ 5.01    3.75    $ 450,900
                        

 

8. Accounts Receivable

Accounts receivable consisted of the following:

 

     December 31,
2005
    September 30,
2006
 

Trade receivables

   $ 11,633,107     $ 10,464,218  

Less allowance for doubtful accounts

     (505,235 )     (872,943 )

Less allowance for returns

     (1,985,608 )     (1,509,712 )
                
   $ 9,142,264     $ 8,081,563  
                

 

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9. Inventories

Inventories consisted of the following:

 

     December 31,
2005
   September 30,
2006

Raw materials

   $ 95,110    $ 1,961,101

Work in process

     —        1,026,072

Finished goods

     11,111,122      9,067,902
             
   $ 11,206,232    $ 12,055,075
             

The Company’s inventory balances are net of an allowance for obsolescence of approximately $2,182,000 and $2,257,000 at December 31, 2005 and September 30, 2006, respectively.

 

10. Financing Arrangements

The Company has financing arrangements with Comerica Bank consisting of a line of credit facility and a foreign exchange facility. At September 30, 2006, the Company had $3.3 million available under the financing arrangements.

The Company’s line of credit facility allows for borrowings of up to $8 million and matures on December 5, 2006. The Company also has available letter of credit accommodations, with any payments made by the financial institution to any issuer thereof and/or related parties in connection with the letter of credit accommodations to constitute additional revolving loans to the Company and the amount of all outstanding letter of credit accommodations not to exceed $4.0 million. The available line of credit is reduced by the amount of outstanding letters of credit and 10% of outstanding foreign exchange forward contracts. At December 31, 2005, amounts outstanding under the line of credit were zero. On April 3, 2006, Comerica Bank issued a letter of credit on behalf of the Company and LEM S.r.l. to San Paolo IMI in the amount of 3.0 million Euro or $3.8 million. The letter of credit served to allow LEM to consolidate the debt outstanding of LEM with San Paolo IMI. The letter of credit reduces the amounts available to the Company under the line of credit by $3.8 million at September 30, 2006.

The Company’s foreign exchange facility allows the Company to purchase up to $20.0 million in currency contracts used primarily to hedge the Company’s foreign currency exposure. This foreign exchange facility is due to mature in December 2006. As of September 30, 2006, the Company’s total outstanding currency contracts under this facility was $9.2 million. Effective May 2006, 10% of any outstanding foreign exchange forward contracts reduces the amount available to the Company under the line of credit up to a maximum of $2 million. At September 30, 2006, amounts under available lines of credit would have been reduced by $920,000.

As a result, at September 30, 2006, the Company had unused lines of credit of $3.3 million.

The Company also had a term loan with Comerica which was paid in full in June 2005.

All of the Company’s loan facilities and term loans with Comerica described above are secured by all of the Company’s assets, excluding the Company’s intellectual property. The Company also has agreed to the following material covenants:

 

    The Company must maintain a ratio of current assets to current liabilities of at least 1.25 to 1;

 

    The Company must maintain a ratio of total liabilities to tangible net worth of not more than 2 to 1;

 

    The Company must maintain a ratio of total liabilities to tangible net worth of not more than 1.60 to 1 in order to avoid a borrowing base calculation;

 

    The Company must maintain a ratio of quick assets to current liabilities of at least 0.50 to 1;

 

    The Company must maintain a tangible net worth of not less than $34.4 million, to be increased on a quarterly basis by 50% of the aggregate net income of each fiscal quarter and 100% of capital infusions, including any subordinated debt;

 

    The Company must maintain an annual minimum profit of $500,000 and cannot have more than two consecutive quarterly losses;

 

    The Company must provide Comerica with periodic financial reports;

 

    The Company must maintain minimum insurance coverage; and

 

    The Company cannot pay dividends or make any other distributions or payments without Comerica’s prior written consent.

At December 31, 2005, the Company was not in compliance with the minimum annual profit and tangible net worth requirements and obtained a waiver of these covenants from the lender. At September 30, 2006, the Company was not in compliance with the two financial covenants related to maintaining a minimum tangible net worth and not incurring two consecutive quarterly net losses. There were no outstanding letters of credit at December 31, 2005.

On November 3, 2006, the Company received a letter from Comerica notifying the Company that it is in default under its credit facility as a result of the failure to be in compliance with the foregoing covenants. In the letter, Comerica notified the Company that it must make an immediate deposit equal to the amount of the undrawn letter of credit (3 million Euros). As of November 16, 2006, the Company obtained a waiver of these conditions and an extension of the borrowing and letter of credit facilities to February 14, 2007. The extension reduces the credit facility to maximum borrowings of $5.0 million. The credit facility can only be used to cover any outstanding letters of credit issued to San Paolo IMI. In addition, the line is reduced by 10% of any outstanding foreign exchange forward contracts. The extension also requires the Company to transfer $1.0 million in cash to Comerica to be used as collateral to secure the credit facility. The credit facility now requires the Company to maintain a minimum monthly profitability level as well as a minimum balance of eligible accounts receivable. The bank has notified the Company that they do not intend to further extend the line of credit. As such, the Company is currently seeking new sources of financing.

 

11. Lines of credit

Lines of credit represent short term borrowings and bank overdrafts for LEM S.r.l. This debt is normally negotiated on a yearly basis. Lines of credit amounted to $1,476,000 at September 30, 2006 and bear an interest rate ranging from 3.80% to 4.65%.

 

12. Notes Payable

The Company had a term loan with Comerica which was paid in full in June 2005.

Notes payables related to debt assumed by the Company as a result of its acquisition of LEM S.r.l. on January 16, 2006 consist of the following at September 30, 2006:

 

Unsecured San Paolo IMI debt (“bridge loan”) , EURIBOR interest plus spread at 4.65% , due on December 22, 2006

   $ 926,224  

Unsecured long-term debt, EURIBOR interest plus spread at 3.58% payable in half year installments due from December 2005

     201,574  

Unsecured long-term debt, fixed interest rate at 0.5% payable in half year installments due from December 2005

     85,751  
        
     1,213,549  

Less current portion

     (986,738 )
        

Notes payable, less current portion

   $ 226,811  
        

 

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In May 2006, the Company entered into a note to finance a software purchase. Interest on the note is at 4.55% and is secured by the software. Monthly payments of approximately $15,000 including interest for 36 months are due through August 2009. In September 2006, the Company entered in to a second note to finance an additional software purchase. Interest on the note is at 7.45% and is secured by the software. Monthly payments of approximately $4,200 including interest for 42 months are due through March 2010.

 

Notes Payable

   $ 615,057  

Less current portion

     (174,689 )
        

Notes payable, less current portion

   $ 440,368  
        

Future minimum payments under long-term debt agreements are as follows:

 

Twelve months ending September 30

   Amount

2007

   $ 1,161,427

2008

     272,011

2009

     270,209

2010

     91,049

2011

     33,910
      

Total

   $ 1,828,606
      

 

13. Related Party Transactions

Customer Sales

No Fear, Inc., a stockholder, owns retail stores that purchase products from the Company. Aggregated sales to these stores during the three months ended September 30, 2005 and 2006 were $281,000 and $267,000, respectively. Aggregated sales to these stores for the nine months ended September 30, 2005 and 2006 were $724,000 and $806,000, respectively. Accounts receivable due from these stores amounted to $502,000 and $444,000 at December 31, 2005 and September 30, 2006, respectively.

Stockholders of the Company, other than No Fear, own retail stores and distribution companies that purchase products from the Company. Aggregated sales to these stores during the three months ended September 30, 2005 and 2006 were $106,000 and $91,000, respectively. Aggregated sales to these stores during the nine months ended September 30, 2005 and 2006 were $695,000 and $531,000, respectively. Accounts receivable due from these entities amounted to $522,000 and $199,000 at December 31, 2005 and September 30, 2006, respectively.

Polinelli S.r.l., Inc., a stockholder of which is a member of the Board of Directors and a former shareholder of the Company’s wholly owned subsidiary LEM S.r.l., purchases products from the Company. Aggregated sales to Polinelli S.r.l. during the three months ended September 30, 2005 and 2006 were $0 and $68,000, respectively. Aggregated sales to Polinelli S.r.l. for the nine months ended September 30, 2005 and 2006 were $0 and $646,000, respectively. Accounts receivable due from Polinelli S.r.l. amounted to $0 and $160,000, at December 31, 2005 and September 30, 2006, respectively.

Contract Services

In August 2004, the Company began operating No Fear’s web site on its behalf. In December 2004, the Company signed an agreement with No Fear to develop and maintain their web site. In May 2005, the Company and No Fear mutually agreed to terminate this agreement effective September 30, 2005. Products sold on the site included No Fear and Spy Optic branded products. Under the agreement, the Company was responsible for products purchased from No Fear to fulfill orders including shipping and insurance costs, and all web site development, hosting, and maintenance costs. The Company also paid No Fear a royalty of 5% on net sales. For the three and nine months ended September 30, 2005, the Company purchased $0 and $31,000 of products from No Fear to fulfill web site orders, respectively. For the three and nine months ended September 30, 2005, the Company recorded operating income of $4,000 and an operating loss of $41,000, respectively, excluding other accounting and administrative costs incurred by the Company in managing the website.

 

14. Commitments and Contingencies

Operating Leases

The Company leases its principal administrative and distribution facilities under an operating lease that expires in March 2007. The lease provides for periodic rent adjustments. The Company also leases an administrative and distribution facility in Italy under an agreement that expires in September 2009, but may be terminated by the Company prior to such time with six-months notice. Rent expense was $98,000 and $141,000 for the three months ended September 30, 2005 and 2006, respectively. Rent expense was $276,000 and $496,000 for the nine months ended September 30, 2005 and 2006, respectively.

Litigation

From time to time, the Company may be party to lawsuits and or legal proceedings in the ordinary course of business.

On March 7, 2005, Oakley, Inc., a major competitor of the Company, filed a lawsuit alleging patent, trade dress and trademark infringement, unfair competition, and false designation of origin. The lawsuit specifically identifies three of the Company’s product styles which accounted for 5% and 7% of the Company’s total sales, excluding sales related to Lem S.r.l., for the nine months ended September 30, 2005 and 2006, respectively. While management believes that the lawsuit is without merit, litigation is subject to inherent uncertainties. The Company has sought coverage under its insurance policies with respect to these claims, but it appears coverage may be unavailable. The Company presently has no estimate of any potential loss or range of loss with respect to the lawsuit or any estimate as to the potential costs of defending the lawsuit.

The Company, its directors and certain of its officers have been named as defendants in two stockholder lawsuits filed in the United States District Court for the Southern District of California. A consolidated complaint, filed October 11, 2005, purported to seek unspecified damages on behalf of an alleged class of persons who purchased the Company’s common stock pursuant to the registration statement filed in connection with the Company’s public offering of stock on December 14, 2004. The complaint alleged that the Company and its officers and directors violated federal securities laws by failing to disclose in the registration statement material information about plans to make a distribution change in its European operations, the Company’s dealings with one of its customers and whether certain of the Company’s products infringe on the intellectual property rights of Oakley, Inc. The Company filed a motion to dismiss the complaint which the court granted on March 29, 2006. The court allowed plaintiffs to file an amended complaint only with respect to their claim about a European distribution change. Plaintiffs filed an amended complaint on April 7, 2006. On May 7, 2006, the Company filed a motion to dismiss that amended complaint. No discovery has been conducted. However, based on the facts presently known, management believes it has meritorious defenses to this action and intends to vigorously defend the action.

In December 2005, two stockholders filed derivative lawsuits in state court in San Diego, purportedly on the Company’s behalf, against eight of the Company’s current or former directors and officers and against one of the Company’s stockholders, No Fear. A consolidated amended complaint was filed in March 2006 alleging that the defendants breached their fiduciary duties and injured Orange 21 by allowing the Company to issue a misleading registration statement and prospectus in connection with the Company’s December 2004 public offering and alleging that No Fear sold Orange 21 stock while having knowledge of material, non-public information. The derivative plaintiffs seek compensatory damages, disgorgement of profits, treble damages and other relief. On May 4, 2006 the Court granted the defendants’ demurrer and dismissed the consolidated complaint, with leave to file an amended complaint. An amended complaint was filed on May 25, 2006, and on June 29, 2006 defendants filed their demurrer to that amended complaint.

 

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15. Information about Operating Segments and Geographic Areas

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 and lifestyle markets. In January 2006, the Company completed the acquisition of its primary manufacturer LEM S.r.l. located in Italy. LEM continues to manufacture products for non-competing brands in addition to most of the Company’s sunglass products and some of its goggle products. Results for LEM reflect operations of this manufacturer after elimination of intercompany transactions.

Information related to the Company’s operating segments for the three and nine months ended September 30, 2005 and 2006 is as follows (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2005    2006     2005    2006  

Net sales:

          

Distribution

   $ 10,820    $ 10,236     $ 29,708    $ 28,237  

Manufacturing

     —        1,143       —        2,795  

Intersegment

     —        2,713       —        6,251  

Other

     —        (2,713 )     —        (6,251 )
                              
   $ 10,820    $ 11,379     $ 29,708    $ 31,032  
                              

Operating income (loss):

          

Distribution

   $ 183    $ (876 )   $ 209    $ (3,566 )

Manufacturing

     —        7       —        (349 )
                              
   $ 183    $ (869 )   $ 209    $ (3,915 )
                              

Net income (loss):

          

Distribution

   $ 192    $ (658 )   $ 59    $ (2,584 )

Manufacturing

     —        (120 )     —        (686 )
                              
   $ 192    $ (778 )   $ 59    $ (3,270 )
                              

Identifiable assets:

          

Distribution

   $ 40,497    $ 30,268     $ 40,497    $ 30,268  

Manufacturing

     —        18,032       —        18,032  
                              
   $ 40,497    $ 48,300     $ 40,497    $ 48,300  
                              

The Company markets its products domestically and internationally, with its principal international market being Europe. The tables below contain information about the geographic areas in which the Company operates. Revenue is attributed to the location to which the product was shipped. Long-lived assets are based on location of domicile.

 

     Three months ended
September 30,
   Nine months ended
September 30,
     2005    2006    2005    2006

Net sales:

           

U.S.

   $ 8,352    $ 7,856    $ 22,516    $ 22,303

Canada

     1,242      1,064      3,136      2,915

Europe and Asia Pacific

     1,226      2,459      4,056      5,814
                           
   $ 10,820    $ 11,379    $ 29,708    $ 31,032
                           

Identifiable assets:

           

U.S.

   $ 31,095    $ 24,893    $ 31,095    $ 24,893

Canada

     3,933      5,375      3,933      5,375

Europe and Asia Pacific

     5,469      18,032      5,469      18,032
                           
   $ 40,497    $ 48,300    $ 40,497    $ 48,300
                           

 

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Table of Contents
16. Business Acquisitions

In January 2006, the Company completed the acquisition of its primary manufacturer LEM S.r.l. The total purchase price of LEM was 3.3 million Euro or $4.0 million in cash, plus a two year earn-out based on LEM’s future sales. Under the terms of the earn-out, the Company is obligated to make quarterly payments based on unit sales, up to a maximum of 1.4 million Euro, through December 31, 2007. It is considered probable that the maximum amount of additional consideration will be earned. Accordingly, the entire amount has been included in the preliminary purchase price allocation below. The acquisition of LEM has allowed the Company to control its primary manufacturer.

Fair value adjustments made herein and the allocation of the excess purchase price is preliminary. The final allocation will be based on estimates and appraisals that will be finalized within one year of the closing of the LEM acquisition and based on the Company’s final evaluation of LEM’s assets and liabilities, including both tangible and intangible assets, and the final purchase price as it relates to a two year earn-out based on LEM’s future sales. The final allocation of purchase price and the resulting effect on net income (loss) may differ significantly from the amounts included herein. The Company will also consider the fair value of the intangible asset purchased from LEM during 2005 and the purchase price of that asset in conjunction with the purchase price allocation. If the Company’s final purchase price allocation differs from the preliminary allocation, the Company’s tangible and intangible assets could be significantly higher or lower. Goodwill represents the excess purchase price after all other intangible assets have been identified. Components of the estimated purchase price and the preliminary allocations thereof are as follows:

 

Cash

   $ 3,972,950

Deferred purchase price

     1,696,240

Patent purchased

     186,375

Acquisition costs

     239,560
      

Total purchase price

   $ 6,095,125
      

Cash acquired

   $ —  

Accounts receivable

     610,668

Inventories

     1,757,876

Prepaid expense and other current assets

     341,407

Fixed assets

     3,145,981

Intangible assets

     180,723

Other assets

     70,582

Goodwill

     8,964,744
      

Total assets acquired

     15,071,981

Line of credit

     1,142,732

Notes payable

     1,406,136

Capital leases

     1,367,543

Accounts payable

     2,592,549

Other liabilities

     2,467,896
      

Net assets acquired

   $ 6,095,125
      

 

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In connection with the acquisition of LEM S.r.l., the Company has begun to formulate the LEM Integration Plan (the “Plan”). The Plan covers the operations of newly acquired LEM and the Company’s existing businesses, and it includes the evaluation of facility relocations, non-strategic business activities, duplicate functions and other related items. The Company has not finalized the Plan, but as of September 30, 2006 has recognized 501,000 Euro or $636,000 of liabilities related to the Plan, including employee severance costs, moving costs, and other costs related primarily to the consolidation of the Company’s manufacturing facilities. These liabilities were included in the allocation of the purchase price for LEM in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”. Costs that are not associated with the acquired company but relate to activities or employees of the Company’s existing operations are charged to earnings as incurred. The Company’s estimates of expected costs may change. Accordingly, as uncertainties related to the Plan are resolved, additional liabilities related to facility relocations, the elimination of nonstrategic business activities and duplicate functions, and other related costs could be recognized. These uncertainties are expected to be resolved within one year of the consummation date of the acquisition, and when determined, additional liabilities could be significant and would be recorded as adjustments to goodwill. If the Company has overestimated these costs, the excess will reduce goodwill in future periods. Conversely, if the Company has underestimated these costs, additional liabilities recognized more than one year after the consummation date of the acquisition will be recorded in earnings.

Assuming the LEM S.r.l. acquisition had occurred as of January 1, 2005, consolidated net sales would have been $11.4 for each of the three month periods ended September 30, 2005 and 2006. The net loss would have been $1.2 million and $951,000, respectively, for those same periods, and the diluted net loss per share would have been $0.15 and $0.12, respectively. Consolidated net sales would have been $32.4 million and $31.1 million for the nine months ended September 30, 2005 and 2006, respectively. The net loss would have been $1.3 million and $3.2 million, respectively, for those same periods, and the diluted loss per share would have been $0.16 and $0.40, respectively.

 

Item  2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Important Cautionary Notice to Investors

This report contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we, nor any other person, assume responsibility for the accuracy and completeness of the forward-looking statements. We are under no obligation to update any of the forward-looking statements after the filing of this Quarterly Report to conform such statements to actual results or to changes in our expectations.

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 Quarterly Report. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in Item 1A of Part II of this Quarterly Report under the caption “Risk Factors,” and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2005, previously filed with the Securities and Exchange Commission.

Risk factors that could cause actual results to differ from those contained in the forward-looking statements include but are not limited to: risks related 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 source raw materials and finished products at favorable prices; the ability to identify and execute successfully cost control initiatives; uncertainties associated with our ability to maintain a sufficient supply of products and to manufacture successfully our products; the integration of the LEM acquisition; the performance of new products and continued acceptance of current products; the execution of strategic initiatives and alliances; the impact of ongoing litigation; uncertainties associated with intellectual property protection for our products; matters generally affecting the domestic and global economy, such as changes in interest and currency rates; and other factors described in Item 1A of Part II of this Quarterly Report under the caption “Risk Factors.”

Overview

The following discussion includes the operations of Orange 21 Inc. and its subsidiaries for each of the periods discussed.

 

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We design, develop, manufacture and market premium products for the action sports, motorsports, and youth lifestyle markets. Our principal products, sunglasses and goggles, are marketed primarily under the brand Spy Optic. These products target the action sports market, including surfing, skateboarding and snowboarding, motocross, and the youth lifestyle market within fashion, music and entertainment. We have built our Spy ® brand by developing innovative, proprietary products that utilize high-quality materials, handcrafted manufacturing processes and engineered optical lens technology to convey performance, style, quality and value. We sell our products in approximately 5,200 retail locations in the United States and internationally through approximately 3,100 retail locations serviced by us and our international distributors. We have developed strong relationships with key multi-store action sport and youth lifestyle retailers in the United States, such as Cycle Gear, Inc., No Fear, Inc., Pacific Sunwear of California, Inc., Tilly’s Clothing, Shoes & Accessories and Zumiez, Inc., and a strategically selective collection of specialized surf, skate, snow, BMX, mountain bike and motocross stores.

We focus our marketing and sales efforts on the action sports, motorsports, and youth lifestyle markets, and specifically, individuals born between approximately 1965 and 1994, or Generation X and Y. We separate our eyewear products into two groups: sunglasses, which include fashion, performance sport and women-specific sunglasses, and goggles, which include snow and motocross goggles. In addition, we sell branded apparel and accessories. In managing our business, our management is 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.

We began as a grassroots brand in Southern California and entered the action sports and youth lifestyle markets with innovative and performance-driven products and an authentic connection to the action sports and youth lifestyle markets under the Spy Optic™ brand. We have a wholly owned subsidiary incorporated in Italy, Spy Optic, S.r.l., and a wholly owned subsidiary incorporated in California, Spy Optic, Inc., which we consolidate in our financial statements. We rely exclusively on an independent third-party consultant for the design of our products. In addition, we have maintained a semi-exclusive relationship with our primary manufacturer LEM S.r.l., which we acquired in January 2006. We were incorporated as Sports Colors, Inc. in California in August 1992. From August 1992 to April 1994, we had no operations. In April 1994, we changed our name to Spy Optic, Inc. In November 2004, we reincorporated in Delaware and changed our name to Orange 21 Inc.

In January 2006, we completed the acquisition of our primary manufacturer LEM S.r.l. The total purchase price of LEM was 3.3 million Euro or approximately $4.0 million in cash, plus a two year earn-out based on LEM’s future sales. Under the terms of the earn-out, we are obligated to make quarterly payments based on unit sales, up to a maximum of 1.4 million Euro, through December 31, 2007. It is considered probable that the maximum amount of additional consideration will be earned. Accordingly, the entire amount has been included in the preliminary purchase price allocation. The acquisition of LEM has allowed us to control our primary manufacturer.

In the nine months ended September 30, 2006 we have experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2006 and into 2007, and that these delays will continue to have a material effect on our results of operations. In particular, we currently are experiencing delays in our goggle shipments from our manufacturer in China. The delays are significant and may have a material adverse effect on our net sales in the fourth quarter of 2006, and potentially the first quarter of 2007.

Net Sales

Our net sales are derived primarily from the sale of sunglasses, snow and motocross goggles, and apparel and accessories. Net sales are also derived from sale of eyewear products manufactured by our Italian manufacturer to non-Company owned entities. All intercompany sales transactions are eliminated in the consolidated financial statements.

In 2006, we have experienced delays in manufacturing and shipping our sunglass and goggle products. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2006, and that these delays may have a material effect on our net sales.

In June 2006, we began offering a special promotion to retailers in the territories of France, Italy, Germany and Austria, whereby qualified new dealers and existing dealers in good standing could purchase packages of 50 units of sunglasses or packages of 90 units of sunglasses and have a right to return a maximum of 50% of this purchase before November 30, 2006. The total amount of sales shipped under this program at September 30, 2006 was 10,700 Euros or $13,600. These sales are being treated as consignment sales and the related revenue is being deferred until the period when the sales program is completed.

Cost of Sales and Gross Profit

Our cost of sales consists primarily of finished product, retail packaging and shipping costs. Other costs include costs associated with the purchasing function of our products, quality control and realized gains and losses on currency contracts, primarily in Euros, used to hedge our purchase risk on inventories. In addition, it includes both raw materials and indirect production and overhead costs related to our Italian based manufacturer. All intercompany purchases are eliminated in the consolidated financial statements. In addition, gross profit related to intercompany purchases still in inventory products at the end of the accounting period reported is eliminated in the consolidated financial statements.

 

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Sales and Marketing Expense

Our sales and marketing expense consists primarily of wages and related payroll and employee benefit costs, point-of-purchase expenses (depreciation) and store display and promotional items, athlete contracts and royalty expenses, advertising costs and trade show expenses. Advertising costs are expensed as incurred.

General and Administrative Expense

Our general and administrative expense consists primarily of wages and related payroll and employee benefit costs, facility costs, business insurance, bad debt expense, utilities, legal and accounting professional fees, other facility-related costs including depreciation, and other general corporate expenses.

Shipping and Warehousing Expense

Shipping and warehousing expense consists primarily of wages and related payroll and employee benefit costs, packaging supplies, third-party warehousing and third party fulfillment costs, facility costs and utilities.

Research and Development Expense

Research and development expense consists primarily of wages and related payroll and employee benefit costs, consulting fees to Mage Design, LLC, travel expenses and prototype and sample expenses.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of consolidated financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosures. On an ongoing basis, we evaluate our estimates, including those related to inventories, sales returns, income taxes, accounts receivable allowances and warranty. We base our estimates on historical experience, performance metrics and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results will differ from these estimates under different assumptions or conditions.

We apply the following critical accounting policies in the preparation of our consolidated financial statements:

Revenue Recognition

Revenues are recognized when the risk of ownership and title passes to our customers. Generally, we extend credit to our customers and do not require collateral. Our payment terms generally range from net-30 to net-90, depending on the country or whether we sell directly to retailers or to a distributor. None of our sales agreements with any of our customers provide for any rights of return. However, we do approve returns on a case-by-case basis at our sole discretion to protect our brands and our image. We provide allowances for estimated returns when revenues are recorded, and related losses have historically been within our expectations. If returns are higher than our estimates, our earnings would be adversely affected.

In June 2006, we began offering a special promotion to retailers in the territories of France, Italy, Germany and Austria, whereby qualified new dealers and existing dealers in good standing could purchase packages of 50 units of sunglasses or packages of 90 units of sunglasses and have a right to return a maximum of 50% of this purchase before November 30, 2006. The total amount of sales shipped under this program at September 30, 2006 was 10,700 Euros or $13,600. These sales are being treated as consignment sales and the related revenue is being deferred until the period when the sales program is completed.

Reserve for Refunds and Returns and Allowance for Doubtful Accounts

We reserve for estimated future refunds and returns at the time of shipment based upon historical data. We adjust reserves as we consider necessary. We make judgments as to our ability to collect outstanding receivables and provide 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, we analyze collection experience, customer credit-worthiness and current economic trends. If the data used to calculate these allowances does not reflect our future ability to collect outstanding receivables, an adjustment in the reserve for refunds may be required.

 

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Stock-Based Compensation Expense

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R) “Share-Based Payment,” using the modified prospective transition method, and therefore have not restated prior periods’ results. Under this method we recognize compensation expense for all stock-based payments granted after January 1, 2006 and prior to but not yet vested as of January 1, 2006, in accordance with SFAS 123(R). Under the fair value recognition provisions of SFAS 123(R), we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest using the straight line vested method over the requisite service period of the award. Prior to SFAS 123(R) adoption, we accounted for stock-based payments under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and accordingly, we were not required to recognize compensation expense for options granted that had an exercise price equal to the market value of the underlying common stock on the date of grant.

Restricted Cash

As of September 30, 2006, we had $857,000 of restricted cash which was held in an escrow account. The cash represents a requirement in accordance with the purchase agreement of LEM S.r.l. The escrow account relates to the earn-out provision of the purchase agreement. The escrow account must be maintained at a minimum level of 300,000 Euro through June 30, 2007.

Accounts Receivable

Throughout the year, we perform credit evaluations of our customers, and we adjust credit limits based on payment history and the customer’s current creditworthiness. We continuously monitor our collections and maintain a reserve for estimated credit losses based on our historical experience and any specific customer collection issues that have been identified. Historically, our losses have been consistent with our estimates, but there can be no assurance that we will continue to experience the same credit loss rates that we have experienced in the past. Unforeseen, material financial difficulties of our customers could have an adverse impact on our profits.

Inventories

Inventories consist primarily of raw materials and finished products, including sunglasses, goggles, apparel and accessories, product components such as replacement lens, purchasing and quality control costs, and packaging and shipping materials. Inventory items are carried on the books at the lower of cost or market using the first in first out method of inventory. 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.

Goodwill

We evaluate the recoverability of goodwill at least annually 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. Fair value is computed based on estimated future cash flows discounted at a rate that approximates our cost of capital. Such estimates are subject to change, and we may be required to recognize impairment losses in the future. Goodwill related to the LEM S.r.l acquisition will be evaluated in the fourth quarter of 2006.

Research and Development

We expense research and development costs as incurred. We capitalize product molds and tooling and depreciate these costs over the useful life of the asset.

Income Taxes

We account for income taxes pursuant to the asset and liability method, whereby deferred tax assets and liabilities are computed at each balance sheet date for temporary differences between the consolidated financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the temporary differences are expected to affect taxable income. We consider future taxable income and ongoing, prudent and feasible tax planning strategies in assessing the value of our deferred tax assets. If we determine that it is more likely than not that these assets will not be realized, we will reduce the value of these assets to their expected realizable value, thereby decreasing net income. Evaluating the value of these assets is necessarily based on our management’s judgment. If we subsequently determined that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.

Foreign Currency and Derivative Instruments

The functional currency of our wholly owned subsidiaries, Spy Optic, S.r.l., LEM S.r.l., and our Canadian division is the local currency. Accordingly, we are exposed to transaction gains and losses that could result from changes in foreign currency. 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).

 

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We designate our derivatives based upon the criteria established by SFAS 133 “Accounting for Derivative Instruments and Hedges,” which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS 133, as amended by Statement of Financial Accounting Standards No. 138, Accounting for Certain Derivative Instruments and Certain hedging Activities – an amendment of SFAS 133, (SFAS 138) and Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, (SFAS 149), requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for the changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation. For a derivative designated as a cash flow hedge, the effective portion of the derivative’s fair value gain or loss is initially reported as a component of accumulated other comprehensive income (loss). Any realized gain or loss on such derivative is reported in cost of goods sold in the accounting period in which the hedged transaction affects earnings. The fair value gain or loss from the ineffective portion of the derivative is reported in other income (expense) immediately. For a derivative that does not qualify as a cash flow hedge, the change in fair value is recognized at the end of each accounting period in other income (expense).

Commitments and Contingencies

We have entered into operating leases, primarily for facilities, and have commitments under endorsement contracts with selected athletes and others who endorse our products.

Results of Operations

Three Months Ended September 30, 2006 and 2005

Net Sales

Our consolidated net sales increased 5% to $11.4 million for the three months ended September 30, 2006 from $10.8 million for the three months ended September 30, 2005. LEM S.r.l., which we acquired on January 16, 2006, accounted for $1.1 million of our consolidated net sales for the three months ended September 30, 2006.

Excluding LEM S.r.l. net sales, net sales decreased 5% to $10.2 million for the three months ended September 30, 2006 from $10.8 million for the three months ended September 30, 2005. The decrease in net sales was due to manufacturing and product delivery delays. Net sales from our U.S. and Canada operations decreased 7% to $8.9 million for the three months ended September 30, 2006 from $9.6 million in the comparable period of the prior year and net sales from our foreign operations increased 7% to $1.3 million from $1.2 million for this same period. The decrease in net sales from the U.S. and Canada operations was due to manufacturing and product delivery delays. Foreign sales were positively impacted by 6% due primarily to a stronger Euro and a stronger Canadian dollar. Net sales from the U.S. and Canada operations represented 87% and 89% of total net sales for the three months ended September 30, 2006 and 2005, respectively. Net sales from the foreign operations represented 13% and 11% of total net sales for the three months ended September 30, 2006 and 2005, respectively. Sunglass unit shipments increased 8% with a 4% increase in the average sales price. Goggle unit shipments decreased 1% with an 8% decrease in the average sales price. The decrease in units was due to manufacturing and product delivery delays. The sales mix on a dollar basis for the three months ended September 30, 2006 was 55% for sunglasses, 39% for goggles and 6% for apparel and accessories. The sales mix on a dollar basis for the three months ended September 30, 2005 was 48% for sunglasses, 41% for goggles and 11% for apparel and accessories.

At September 30, 2006, excluding LEM S.r.l., we had received orders equal to $2.7 million and we expect to fulfill such orders during the next three months.

We recently have experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2006 and into 2007, and that these delays will continue to have a material effect on our results of operations. In particular, we currently are experiencing delays in our goggle shipments from our manufacturer in China. The delays are significant and may have a material adverse effect on our net sales in the fourth quarter of 2006, and potentially the first quarter of 2007.

Cost of Sales and Gross Profit

Our consolidated gross profit margin on an absolute dollar basis was essentially flat at $5.5 million for the three months ended September 30, 2006 and September 30, 2005. As a percentage of net sales, gross profit was 49% for the three month period ended September 30, 2006, compared to 51% for the three month period ended September 30, 2005. During the three months ended September 30, 2006, LEM S.r.l. contributed $515,000 to the gross margin of the consolidated results. The decrease in gross profit as a percentage of sales was due primarily to the comparatively lower gross margins on revenue from LEM’s non-Spy customers and an increase in inventory reserves. Partially offsetting this decrease was the favorable effect of LEM S.r.l.’s gross margin earned on Spy products.

We expect that our gross profit will fluctuate in the future based on our product mix, product costs, shipping costs, product return and refund rates and handling and packaging costs for the various products. We also expect gross profit margins will be affected in the future by our acquisition of LEM S.r.l. which has substantially lower margins than our other business segments and the impact of the Euro on product purchases.

 

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Sales and Marketing Expense

Sales and marketing expense was essentially flat at $3.5 million for the three months ended September 30, 2005 and 2006. During the three months ended September 30,2006 point-of-purchase and sales display expenses increased $209,000 and the acquisition of LEM S.r.l. added $73,000 of the consolidated sales and marketing expenses for the three months ended September 30, 2006. This was partially offset by a decrease in compensation and related payroll costs of $126,000 related primarily to the period over period decrease in Spy branded sales. As a percentage of net sales, sales and marketing expense was 31% for the three months ended September 30, 2006, down from 32% for the three months ended September 30, 2005.

We expect sales and marketing expense to continue to increase in absolute dollars as a result of continued expansion of our sales and marketing efforts outside of California but to decrease as a percentage of net sales if our net sales continue to increase in future periods.

General and Administrative Expense

General and administrative expense increased 67% to $2.3 million for the three months ended September 30, 2006 from $1.4 million in the comparable period in the prior year. The increase in general and administrative expense primarily was due to increases in wages and related payroll taxes of $142,000, stock based compensation charges of $92,000, an increase in accounting and software consulting costs of $101,000 due to our new software installation and other accounting requirements, an increase in accounting fees of $45,000, increases in insurance of $53,000, an increase in bad debt expense of $182,000 and an increase in legal expenses of $56,000. Legal costs related to our outstanding shareholder litigation in excess of our insurance deductible of $250,000 have been paid directly by our insurance company. LEM S.r.l. accounted for $260,000 of the consolidated general and administrative expenses for the three months ended September 30, 2006. As a percentage of net sales, general and administrative expense was 20% for the three months ended September 30, 2006, up from 13% for the three months ended September 30, 2005.

We expect general and administrative expense to remain at or below current levels in absolute dollars as a result of planned cost savings initiatives of our administrative function that we expect will be achieved over the next 12 months.

Shipping and Warehousing Expense

Shipping and warehousing expense increased 2% to $343,000 for the three months ended September 30, 2006 from $335,000 for the comparable period in the prior year. The increase was due primarily to third-party warehousing expenses of $81,000 due to the transfer of our fulfillment requirements for our international business to an outside agency, which transfer was completed in the fourth quarter of 2005. This was partially offset by a decrease in compensation and related payroll costs of $55,000 and a decrease in temporary labor of $61,000. LEM S.r.l. accounted for $75,000 of the consolidated shipping and warehousing expenses for the three months ended September 30, 2006. As a percentage of net sales, shipping and warehousing expense was 3% for both of the three month periods ended September 30, 2006 and 2005.

If our net sales increase, we expect shipping and warehousing expense to increase in absolute dollars but to decrease as a percentage of net sales as a result of leveraging the fixed expense over greater net sales. If our net sales decrease, we expect shipping and warehousing expense to decrease.

Research and Development Expense

Research and development expense increased 66% to $267,000 for the three months ended September 30, 2006 from $161,000 in the comparable period in the prior year. The increase was due primarily to the acquisition of LEM S.r.l., which accounted for $99,000 of the consolidated research and development expenses for the three months ended September 30, 2006. As a percentage of net sales, research and development expense was 2% for the three months ended September 30, 2006, up from 1% for the three months ended September 30, 2005.

We expect research and development expense to remain at or below current levels in absolute dollars in the future as a result of planned cost savings initiatives of our development function.

Other (Expense) Income

Other net expense was $157,000 for the three months ended September 30, 2006 compared to other net income of $256,000 in the comparable period in the prior year. The change was due to a net increase in foreign exchange transaction losses of $260,000, an increase in net interest expense of 129,000 and an increase in other expenses of $24,000. The increase in interest expense includes expense of $81,000 related to the outstanding debt of LEM S.r.l.

 

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Income Tax Provision (Benefit)

The income tax provision for the three months ended September 30, 2006 was a tax benefit of $249,000 compared to a tax provision of $247,000 in the comparable period in the prior year. The net change is due to a pretax loss incurred by the U.S. and Canada operations compared to a pretax profit in the comparable period in the prior year. In addition, the effective tax rate was adversely affected in both periods due to losses by our Italian subsidiaries for which a full valuation allowance was provided.

Net Loss

A net loss of $778,000 was incurred for the three months ended September 30, 2006 compared to net income of $192,000 in the comparable period in the prior year. LEM S.r.l. accounted for $120,000 of the net loss for the three months ended September 30, 2006. A net loss was incurred for our distribution business operations of approximately $658,000 for the three months ended September 30, 2006 compared to net income of $192,000 for the three months ended September 30, 2005. The higher net loss within our distribution business was due primarily to a decrease in sales caused by manufacturing and product delivery delays and distributor transitions primarily in Australia and Asia, and higher operating expenses particularly general and administrative expenses.

Nine months ended September 30, 2006 and 2005

Net Sales

Our consolidated net sales increased 5% to $31.0 million for the nine months ended September 30, 2006 from $29.7 million for the nine months ended September 30, 2005. LEM S.r.l., which we acquired on January 16, 2006, accounted for $2.8 million of our consolidated net sales for the nine months ended September 30, 2006.

Excluding LEM S.r.l. net sales, our net sales from our U.S. and Canada operations decreased 2% to $25.2 million for the nine months ended September 30, 2006 from $25.7 million in the comparable period of the prior year and net sales from our foreign operations decreased 26% to $3.0 million from $4.1 million for this same period. The decrease in net sales was due to manufacturing and product delivery delays. In addition, net sales decreases from foreign operations were also affected by a decrease in sales in Australia and Asia as a result of distributor changes. Net sales from the U.S. and Canada operations represented 89% and 86% of total net sales for the nine months ended September 30, 2006 and 2005, respectively. Net sales from the foreign operations represented 11% and 14% of total net sales for the nine months ended September 30, 2006 and 2005, respectively. Sunglass unit shipments decreased 5% with a 5% increase in the average sales price. The decrease in sunglass unit shipments was due to manufacturing and product delivery delays. Goggle unit shipments decreased 1% with no change in the average sales price. The decrease in goggle units shipments was due to manufacturing and product delivery delays. The sales mix on a dollar basis for the nine months ended September 30, 2006 was 66% for sunglasses, 27% for goggles and 7% for apparel and accessories. The sales mix on a dollar basis for the nine months ended September 30, 2005 was 65% for sunglasses, 27% for goggles and 8% for apparel and accessories.

At September 30, 2006, excluding LEM S.r.l., we had received orders equal to $2.7 million and we expect to fulfill such orders during the next three months.

We recently have experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2006 and into 2007, and that these delays will continue to have a material effect on our results of operations. In particular, we currently are experiencing delays in our goggle shipments from our manufacturer in China. The delays are significant and may have a material adverse effect on our net sales in the fourth quarter of 2006, and potentially the first quarter of 2007.

Cost of Sales and Gross Profit

Our consolidated gross profit margin on an absolute dollar basis increased 2% to $15.5 million for the nine months ended September 30, 2006 from $15.2 million in the comparable period of the prior year. As a percentage of net sales, gross profit was 50% for the nine month period ended September 30, 2006, down 1% from 51% for the nine month period ended September 30, 2005. During the nine months ended September 30, 2006, LEM S.r.l. contributed $1.3 million to the gross margin of the consolidated results. The decrease in gross profit as a percentage of sales was due primarily to the comparatively lower gross margins on revenue from LEM’s non-Spy customers and an increase in tooling depreciation. Partially offsetting this decrease was the favorable effect of LEM S.r.l.’s gross margin earned on Spy products.

We expect that our gross profit will fluctuate in the future based on our product mix, product costs, shipping costs, product return and refund rates and handling and packaging costs for the various products. We also expect gross profit margins will be affected in the future by our acquisition of LEM S.r.l. which has substantially lower margins than our other business segments and the impact of the Euro on product purchases.

Sales and Marketing Expense

Sales and marketing expense increased 12% to $10.5 million for the nine months ended September 30, 2006 from $9.4 million in comparable period in the prior year. The increase in sales and marketing expense primarily was due to increased point-of-purchase and sales display expenses of $606,000, an increase in sales meeting and trade show conference expenses of $122,000, an increase in marketing consulting costs of $80,000, and an increase in athlete endorsement expenses of $117,000. LEM S.r.l. accounted for $303,000 of the consolidated sales and marketing expenses for the nine months ended September 30, 2006. As a percentage of net sales, sales and marketing expense was 34% for the nine months ended September 30, 2006, up from 32% for the nine months ended September 30, 2005.

 

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We expect sales and marketing expense to continue to increase in absolute dollars as a result of continued expansion of our sales and marketing efforts outside of California but to decrease as a percentage of net sales if our net sales continue to increase in future periods.

General and Administrative Expense

General and administrative expense increased 63% to $6.9 million for the nine months ended September 30, 2006 from $4.2 million in the comparable period in the prior year. The increase in general and administrative expense primarily was due to increases in wages and related payroll taxes of $321,000, stock based compensation of $139,000, an increase in bad debt expense of $291,000, increases in accounting fees of $265,000, increases in insurance of $127,000, increases in accounting and software consulting costs of $284,000 due to our new software installation and other accounting requirements, increases in travel expenses of $96,000, and an increase in employee hiring and relocation costs of $101,000. Increases in accounting expenses were primarily due to our additional annual audit requirements as a result of the acquisition of LEM. Legal costs related to our outstanding shareholder litigation in excess of our insurance deductible of $250,000 are paid directly by our insurance company. LEM S.r.l. accounted for $856,000 of the consolidated general and administrative expenses for the nine months ended September 30, 2006. As a percentage of net sales, general and administrative expense was 22% for the nine months ended September 30, 2006, up from 14% for the nine months ended September 30, 2005.

We expect general and administrative expense to remain at or below current levels in absolute dollars as a result of planned cost savings initiatives of our administrative function that we expect will be achieved over the next 12 months.

Shipping and Warehousing Expense

Shipping and warehousing expense increased 40% to $1.3 million for the nine months ended September 30, 2006 from $925,000 for the comparable period in the prior year. The increase was due primarily to an increase in rent due to additional warehouse requirements for storing inventory of $90,000 and third-party warehousing expenses of $222,000 due to the transfer of our fulfillment requirements for our international business to an outside agency, which transfer was completed in the fourth quarter of 2005. This was offset by a reduction in compensation and payroll related costs of $164,000. LEM S.r.l. accounted for $253,000 of the consolidated shipping and warehousing expenses for the nine months ended September 30, 2006. As a percentage of net sales, shipping and warehousing expense was 4% for the nine months ended September 30, 2006, up from 3% for the nine months ended September 30, 2005.

If our net sales increase, we expect shipping and warehousing expense to increase in absolute dollars but to decrease as a percentage of net sales as a result of leveraging the fixed expense over greater net sales. If our net sales decrease, we expect shipping and warehousing expense to decrease.

Research and Development Expense

Research and development expense increased 65% to $786,000 for the nine months ended September 30, 2006 from $475,000 in the comparable period in the prior year. The increase was due primarily to increased compensation and related payroll taxes of $49,000 and increased consulting fees of $50,000. LEM S.r.l. accounted for approximately $188,000 of the consolidated research and development expenses for the nine months ended September 30, 2006. As a percentage of net sales, research and development expense was 2% for the nine months ended September 30, 2006 and, 2005.

We expect research and development expense to remain at or below current levels in absolute dollars in the future as a result of planned cost savings initiatives of our development function.

Other (Expense) Income

Other net expense was $230,000 for the nine months ended September 30, 2006 compared to other net income of $294,000 in the comparable period in the prior year. The change in other net expense is primarily due to an increase in net interest expense of $404,000, a net increase in foreign exchange transaction losses of $114,000 and an increase in other expenses of $6,000. The increase in interest expense includes expense of $291,000 related to the outstanding debt of LEM S.r.l.

Income Tax Provision (Benefit)

The income tax provision for the nine months ended September 30, 2006 was a tax benefit of $874,000 compared to a tax provision of $444,000 in the comparable period in the prior year. The net change is due to a pretax loss incurred by the U.S. and Canada operations compared to a pretax profit in the comparable period in the prior year. In addition, the effective tax rate was adversely affected in both periods due to losses by our Italian sibsidiaries for which a full valuation allowance was provided.

 

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Net Loss

A net loss of $3.3 million was incurred for the nine months ended September 30, 2006 compared to net income of $59,000 in the comparable period in the prior year. LEM S.r.l. accounted for $686,000 of the consolidated net loss for the nine months ended September 30, 2006. A net loss was incurred for our distribution business operations of approximately $2.6 million for the nine months ended September 30, 2006 compared to net income of $59,000 for the nine months ended September 30, 2005. The higher net loss within the distribution business was due primarily to a decrease in sales caused by manufacturing and product delivery delays, distributor transitions primarily in Australia and Asia, lower gross margins for the reasons previously mentioned, and higher operating expenses particularly sales and marketing expenses and general and administrative expenses.

Liquidity and Capital Resources

Historically we have financed our operations primarily through sales of our common stock and borrowings under our credit facilities and from private lenders.

Our principal sources of liquidity are our cash and lines of credit. At December 31, 2005, we had unused lines of credit of $8.0 million. However, in April 2006, we established a letter of credit on behalf of LEM in the amount of 3.0 million Euro or $3.8 million, which reduced the amount available under this facility. In addition, effective May 2006, availability under our lines of credit was reduced by 10% of any foreign exchange forward contracts outstanding up to a maximum of $2.0 million. At September 30, 2006, net foreign exchange forward contracts outstanding amounted to $9.2 million. This reduces the amount available to the company under its line of credit with Comerica by $920,000. As a result, at September 30, 2006, we had unused lines of credit of $3.3 million.

On November 3, 2006, we received a letter from Comerica notifying us that we are in default under the facility as a result of the failure to be in compliance with the foregoing covenants. In the letter, Comerica notified us that we must make an immediate deposit equal to the amount of the undrawn letter of credit (3 million Euros). ). As of November 16, 2006, we obtained a waiver of these conditions and an extension of the borrowing and letter of credit facilities to February 14, 2007. The extension reduces the credit facility to maximum borrowings of $5.0 million. The credit facility can only be used to cover any outstanding letters of credit issued to Sao Paolo IMI. In addition, the line is reduced by 10% of any outstanding foreign exchange forward contracts. The extension also requires us to transfer $1.0 million in cash to Comerica to be used as collateral to secure the credit facility. The credit facility now requires us to maintain a minimum monthly profitability level as well as a minimum balance of eligible accounts receivable. The bank has notified us that they do not intend to further extend the line of credit. As such, we are currently seeking new sources of financing.

Cash provided by or used in operating activities consisted primarily of the net loss adjusted primarily for certain non-cash items including depreciation, amortization, deferred income taxes, provision for bad debts, stock compensation expense and the effect of changes in working capital and other activities. Cash provided for in operating activities for the nine months ended September 30, 2006 was approximately $2.6 million and consisted of a net loss of $3.3 million, adjustments for non-cash items of approximately $2.5 million, and $3.4 million provided by working capital and other activities. Working capital and other activities consisted primarily of a decrease in accounts receivables of $1.4 million, a decrease in inventory of $1.2 million, and an increase in accounts payable and accrued liabilities of $617,000 and a $408,000 decrease in prepaid expenses. This was offset by an increase in income taxes receivable of $271,000.

Cash used in operating activities for the nine months ended September 30, 2005 was $1.2 million and consisted of a net income of $59,000, adjustments for non-cash items of approximately $1.6 million, and $2.9 million used by working capital and other activities. Working capital and other activities consisted primarily of an increase in inventory of $1.2 million due primarily to purchases related to our new product lines, a net increase in prepaid expenses of $832,000 due to prepayments related to point-of purchase displays and production deposits, a net decrease in accounts payable and accrued liabilities of $181,000, a decrease in the income tax payable due primarily to payments related to our U.S. tax liabilities of $385,000, and an increase in accounts receivable of $312,000.

Cash used in investing activities for the nine months ended September 30, 2006 was $2.0 million and was attributable primarily to capital expenditures of $3.8 million, $3.0 million for the acquisition of LEM S.r.l, and $857,000 related to the escrow account required as a result of the LEM S.r.l. acquisition. The uses of cash in investing activities were offset by net cash provided from the maturities of short term investments of $5.5 million. Capital expenditures were primarily for the purchase of retail point-of-purchase displays and software.

Cash used in investing activities for the nine months ended September 30, 2005 was $12.2 million and was attributable primarily to net short-term investments of $9.1 million and capital expenditures of $2.7 million. Capital expenditures were for the purchase of retail point-of-purchase displays, box vans, and other corporate assets.

Cash provided by financing activities for the nine months ended September 30, 2006 was $244,000 and was primarily due to an increase in notes payable of $622,000 related to our purchase of new software packages and $931,000 of notes issued by LEM. This was offset by principal payments of 889,000 on LEM’s long term debt, net repayments of $71,000 on LEM’s short term borrowings and principal payments on capitalized leases of $349,000.

Cash provided by financing activities for the nine months ended September 30, 2005 was $3.9 million and was due primarily to the sale of common stock to cover over allotments as a result of our initial public offering of approximately $4.2 million, offset by payments on the bank term debt of $292,000.

LEM S.r.l. is an Italian Company. In accordance with Italian law, losses incurred by LEM S.r.l. must be covered by capital contributions at the end of each fiscal year. For the fiscal year ending June 30, 2006, LEM S.r.l. incurred a loss of approximately 2.3 million Euro on an Italian accounting basis. During the nine months ended September 30, 2006, we made a capital contribution of 2.3 million Euro.

In addition, from time to time we may have to make loan advances to LEM S.r.l. to cover working capital needs.

 

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In addition, from time to time we may have to make loan advances to LEM S.r.l. to cover working capital needs.

Contractual obligations and commitments

We have summarized our significant financial contractual obligations as of December 31, 2005 in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005. There have been no subsequent material changes to our contractual obligations from that date with the exception of the notes payable assumed as a result of the LEM S.r.l, acquisition and the notes to finance the purchase of software. At September 30, 2006, future minimum payments under the notes are $1.2 million due within one year, $633,000 due within one to three years, and $34,000 due within three to five years.

Credit Facilities

We have financing arrangements with Comerica Bank consisting of a line of credit facility and a foreign exchange facility. At September 30, 2006, we had $3.3 million available under the financing arrangements.

Our line of credit facility allows for borrowings of up to $8 million and matures on December 5, 2006. We also have available letter of credit accommodations, with any payments made by the financial institution to any issuer thereof and/or related parties in connection with the letter of credit accommodations to constitute additional revolving loans to us and the amount of all outstanding letter of credit accommodations not to exceed $4.0 million. The available line of credit is reduced by the amount of outstanding letters of credit and 10% of outstanding foreign exchange forward contracts. At December 31, 2005, amounts outstanding under the line of credit were zero. On April 3, 2006, Comerica Bank issued a letter of credit on behalf of us and LEM S.r.l. to San Paolo IMI in the amount of 3.0 million Euro or $3.8 million. The letter of credit served to allow LEM to consolidate the debt outstanding of LEM with San Paolo IMI. The letter of credit reduces the amounts available to us under the line of credit by $3.8 million at September 30, 2006.

The Company’s foreign exchange facility allows us to purchase up to $20.0 million in currency contracts used primarily to hedge our foreign currency exposure. This foreign exchange facility is due to mature in December 2006. As of September 30, 2006, our total outstanding currency contracts under this facility was $9.2 million. Effective May 2006, 10% of any outstanding foreign exchange forward contracts reduces the amount available to us under the line of credit up to a maximum of $2 million. At September 30, 2006, amounts under available lines of credit would have been reduced by $920,000.

As a result, at September 30, 2006, we had unused lines of credit of $3.3 million.

We also had a term loan with Comerica which was paid in full in June 2005.

All of our loan facilities and term loans with Comerica described above are secured by all of our assets, excluding our intellectual property. We also have agreed to the following material covenants:

 

    We must maintain a ratio of current assets to current liabilities of at least 1.25 to 1;

 

    We must maintain a ratio of total liabilities to tangible net worth of not more than 2 to 1;

 

    We must maintain a ratio of total liabilities to tangible net worth of not more than 1.60 to 1 in order to avoid a borrowing base calculation;

 

    We must maintain a ratio of quick assets to current liabilities of at least 0.50 to 1;

 

    We must maintain a tangible net worth of not less than $34.4 million, to be increased on a quarterly basis by 50% of the aggregate net income of each fiscal quarter and 100% of capital infusions, including any subordinated debt;

 

    We must maintain an annual minimum profit of $500,000 and cannot have more than two consecutive quarterly losses;

 

    We must provide Comerica with periodic financial reports;

 

    We must maintain minimum insurance coverage; and

 

    We cannot pay dividends or make any other distributions or payments without Comerica’s prior written consent.

At December 31, 2005, we were not in compliance with the minimum annual profit and tangible net worth requirements and obtained a waiver of these covenants from the lender. At September 30, 2006, we were not in compliance with the two financial covenants related to maintaining a minimum tangible net worth and not incurring two consecutive quarterly net losses. There were no outstanding letters of credit at December 31, 2005.

On November 3, 2006, we received a letter from Comerica notifying us that we were in default under our credit facility as a result of the failure to be in compliance with the foregoing covenants. In the letter, Comerica notified us that we must make an immediate deposit equal to the amount of the undrawn letter of credit (3 million Euros). As of November 16, 2006, we obtained a waiver of these conditions and an extension of the borrowing and letter of credit facilities to February 14, 2007. The extension reduces the credit facility to maximum borrowings of $5.0 million. The credit facility can only be used to cover any outstanding letters of credit issued to San Paolo IMI. In addition, the line is reduced by 10% of any outstanding foreign exchange forward contracts. The extension also requires us to transfer $1.0 million in cash to Comerica to be used as collateral to secure the credit facility. The credit facility now requires us to maintain a minimum monthly profitability level as well as a minimum balance of eligible accounts receivable. The bank has notified us that they do not intend to further extend the line of credit. As such, we are currently seeking new sources of financing.

In addition to loan facilities, we have historically relied upon loans from private lenders to fund our working capital needs. At both December 31, 2005 and September 30, 2006, there was no private lender debt outstanding.

We are currently seeking a long term borrowing facility with a new lender. Even if our negotiations are not successful, we believe that our cash on hand and our ability to reduce operating expenses will provide sufficient capital to enable us to meet our financing and operating requirements for at least the next 12 months.

 

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Changes in operating plans, lower than anticipated net sales, increased expenses or other events, including those described in Item 1A, “Risk Factors,” may make it difficult for us to seek additional debt or equity financing in the future. Our future capital requirements will depend on many factors, including our rate of net sales growth, financing requirements related to our recent acquisition of LEM S.r.l ,the expansion of our sales and marketing activities and the continuing market acceptance of our product designs. Although currently we are not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, products or technologies, we may enter into these types of arrangements in the future, which could require us to seek additional equity or debt financing. The sale of additional equity securities or convertible debt securities would result in additional dilution of our stockholders. Additional debt would result in increased interest expense and could result in covenants that would restrict our operations.

Deferred Taxes

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 projections for the taxable income for the future, management has determined that it is more likely than not that the deferred tax assets, net of the valuation allowance, will be realized. Accordingly, we have recorded no valuation allowance for our U.S. operations at December 31, 2005 and September 30, 2006. We have recorded a $632,000 and $2,089,000 valuation allowance for our wholly owned subsidiaries, Spy Optic, S.r.l and LEM S.r.l., at December 31, 2005, and September 30, 2006, respectively.

Backlog

Historically, purchases of sunglass and motocross eyewear products have not involved significant pre-booking activity. Purchases of our snow goggle products are generally pre-booked and shipped primarily from August to October. At September 30, 2005, and 2006, excluding backlog related to the acquisition of LEM, we had a backlog, including backorders (merchandise remaining unshipped beyond its scheduled shipping date), of $1.9 million and $2.7 million, respectively. The increase in the backlog was attributable primarily to pre-booking across our product lines and manufacturing and product delivery delays primarily in the second quarter, which manufacturing and product delivery delays could continue in future quarters if we do not improve historical manufacturing procedures at LEM. LEM’s backlog amounted to 1.1 million Euro, or approximately $1.4 million, after eliminating intercompany orders.

We recently have experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2006 and into 2007, and that these delays will continue to have a material effect on our results of operations. In particular, we currently are experiencing delays in our goggle shipments from our manufacturer in China. The delays are significant and may have a material adverse effect on our net sales in the fourth quarter of 2006, and potentially the first quarter of 2007.

Seasonality

Our net sales fluctuate from quarter to quarter as a result of changes in demand for our products. Historically, we have experienced greater net sales in the second half of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products. 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 is likely to 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.

Inflation

We do not believe inflation had a material impact on our operations in the past, although there can be no assurance that this will be the case in the future.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

Market risk represents the risk of loss arising from adverse changes in market rates and foreign exchange rates. At December 31, 2005, we had no debt outstanding under our loan facilities with Comerica. We had unused lines of credit with Comerica of $8 million. On April 3, 2006, Comerica issued a letter of credit on our behalf in the amount of 3.0 million Euro. This letter of credit reduces the amount available to us under the line of credit by $3.8 million, adjusted for changes in the Euro rate. In addition, effective May 2006, our bank agreement was modified such that 10% of any foreign exchange forward contracts outstanding up to a maximum of $2 million reduce the amount available under the line of credit. At September 30, 2006 net foreign exchange forward contracts outstanding amounted to $9.2 million. This reduces the amount available to the Company under its line of credit by $920,000. As a result, at September 30, 2006, we had $3.3 million available for use under our lines of credit. The amounts outstanding under these loan facilities at any time may fluctuate and we may from time to time be subject to refinancing risk. We do not believe that a change of 100 basis points in interest rate would have a material effect on our results of operations or financial condition.

 

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Foreign Currency Risk

In the normal course of business, we are exposed to foreign currency exchange rate risk that could impact our financial position and results of operations. We are exposed to foreign currency exchange rate risk inherent in our sales commitments, anticipated sales, anticipated purchases, assets and liabilities denominated in currencies other than the U.S. dollar. Our risk management strategy with respect to this market risk includes the use of derivative financial instruments. We do not use derivative contracts for speculative purposes. Our risks, risk management strategy and a sensitivity analysis estimating the effects of changes in fair values for these exposures are outlined below.

We operate our business and derive a substantial portion of our net sales outside of the U.S. Excluding LEM S.r.l., in the nine months ended September 30, 2005 and 2006, we derived 24% and 21% of our net sales in the rest of the world. We also purchase a majority of our products in transactions denominated in Euros. As a result, we are exposed to movements in foreign currency exchange rates between the local currencies of the foreign markets in which we operate and the U.S. dollar. Our foreign currency exposure is generally related to Europe. A strengthening of the Euro relative to the U.S. dollar or to other currencies in which we receive revenues could impact negatively the demand for our products, could increase our manufacturing costs and could reduce our results of operations. In addition, we manufacture a substantial amount of our sunglass and goggle products in Italy. Because these purchases are paid in Euros, we face currency risk. A strengthening Euro could negatively affect the cost of our products and reduce our gross profit margins.

We use forward contracts designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in our forecasted purchase of products at prices denominated in Euros. We also use other derivatives not designated as hedging instruments under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” consisting of forward contracts to hedge foreign currency balance sheet exposures and interest rate swaps. We recognize the gains and losses on foreign currency forward contracts not designated as hedging instruments in the same period as the remeasurement losses and gains of the related foreign currency-denominated exposures.

As of September 30, 2006, we had purchased a total of 6.1 million Euro foreign currency contracts designated as cash flow hedges at an average Euro rate of 1.23 Euro to U.S. dollar and sold 900,000 Euro foreign currency contracts not designated as hedging instruments at an average Euro rate of 1.27.

As of September 30, 2006, notional amounts of the interest rate swap were 1 million Euro. This swap was acquired with the purchase of LEM S.r.l. It is not an effective hedge of the Company’s interest rate exposures. In June 2006, one interest rate swap was closed at a loss of approximately 16,000 Euro or $20,000.

As part of our risk management procedure, a sensitivity analysis model is used to measure the potential loss in future earnings of market-sensitive instruments resulting from a change in foreign currency values. The sensitivity analysis model quantifies the estimated potential effect of unfavorable movements of 10% in foreign currencies to which we were exposed at September 30, 2006 through its derivative financial instruments.

The estimated one-day loss from our foreign currency derivative financial instruments, calculated using the sensitivity model described above, is $645,000 at September 30, 2006. We believe that such a hypothetical loss from derivatives would be offset by increases in the value of the underlying transactions being hedged.

The sensitivity analysis model is a risk analysis tool and does not purport to represent actual losses in earnings that we may incur, nor does it consider the potential effect of favorable changes in market rates. It also does not represent the maximum possible loss that may occur. Actual future gains and losses will differ from those estimated because of changes or differences in market rates, hedging instruments and hedge percentages, timing and other factors.

Recently Issued Accounting Pronouncements

In March 2005, the FASB issued Financial Interpretation Number (FIN) 47 to clarify the timing of the recording of certain asset retirement obligations required by SFAS 143. FIN 47 is effective December 31, 2005. The adoption of FIN 47 has not had a material impact on our consolidated results of operations or financial condition.

In May 2005, the FASB issued SFAS 154, which replaces APB Opinion No. 20, Accounting Changes, and SFAS 3, Reporting Accounting Changes in Interim Financial Statements - An Amendment of APB Opinion No. 28. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We will apply SFAS 154 in future periods when it becomes applicable.

In July 2006, the FASB issued Financial Interpretation Number (FIN) 48 “Accounting for Uncertainty in Income Taxes” which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for us beginning January 1, 2007. We are in the process of determining the effect the adoption of FIN 48 will have on our financial statements.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Current Year Misstatements.” SAB No. 108 requires analysis of misstatements using both an income statement (rollover) approach and a balance sheet (iron curtain) approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB No. 108 is effective for our fiscal year 2006 annual financial statements. The Company is currently assessing the potential impact that the adoption of SAB No. 108 will have on our financial statements; the impact is not expected to be material.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for us beginning January 1, 2008. We are currently assessing the potential impact that the adoption of SFAS No. 157 will have on our financial statements.

 

Item 4. Controls and Procedures

Based on their evaluation as of the end of the period covered by this report, under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), our CEO and CFO have concluded that, as of the end of such period, our disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”) were effective in timely making known to them material information relating to the Company required to be disclosed in our reports filed or submitted under the Exchange Act.

There was no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

 

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We are beginning the evaluation of our internal control over financial reporting in order to comply with Section 404 of the Sarbanes-Oxley Act of 2002. Section 404 requires us to evaluate annually the effectiveness of our internal control over financial reporting as of the end of each fiscal year and to include a management report assessing the effectiveness of our internal control over financial reporting in all annual reports. However, in September 2005, the Securities Exchange Commission postponed the Section 404 requirement for those companies not qualifying as accelerated filers as of July 15, 2006. As a result, we do not anticipate having to comply with the Section 404 requirement until our annual report on Form 10-K for the fiscal year ending December 31, 2007.

 

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PART II—OTHER INFORMATION

 

Item 1. Legal Proceedings

See footnote 14 to our unaudited consolidated financial statements.

 

Item 1A. Risk Factors

You should consider each of the following factors as well as the other information in this Quarterly 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 Quarterly Report, including our financial statements and the related notes.

Risks Related to 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, which manufactures a substantial majority of our products, to manufacture our products is dependent upon the availability of raw materials used in the fabrication of eyeglasses. 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 delays in deliveries of our products by our manufacturers of up to several months.

We recently have experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2006 and into 2007, and that these delays will continue to have a material effect on our results of operations. In particular, we currently are experiencing delays in our goggle shipments from our manufacturer in China. The delays are significant and may have a material adverse effect on our net sales in the fourth quarter of 2006, and potentially the first quarter of 2007.

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. 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 these companies, which could harm our results of operations, reputation and demand for our products.

We may not address successfully problems encountered in connection with our acquisition of LEM or any future acquisitions, which could result in operating difficulties and other harmful consequences.

In January 2006, we acquired LEM S.r.l. The aggregate purchase price was 3.3 million Euro or $4.0 million in cash, plus a two year earn-out based on LEM’s future sales. Under the terms of the earn-out, we are obligated to make quarterly payments based on unit sales, up to a maximum of 1.4 million Euro, through December 31, 2007. We expect to continue to consider other opportunities to acquire or make investments in other technologies, products and businesses 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, including LEM, and strategic investments involve numerous risks, including:

 

    Problems assimilating the purchased technologies, products or business operations;

 

    Problems maintaining uniform standards, procedures, controls and policies;

 

    unanticipated costs associated with the acquisition;

 

    diversion of management’s attention from our core business;

 

    harm to our existing business relationships with manufacturers and customers;

 

    risks associated with entering new markets in which we have no or limited prior experience; and

 

    potential loss of key employees of acquired businesses.

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.

In addition, in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets”, we are required to test goodwill for impairment at least annually, or more frequently if events or circumstances exist which indicate that goodwill may be impaired. As a result of changes in circumstances after valuing assets in connection with acquisitions, we may be required to take write-downs of intangible assets, including goodwill, which could be significant.

If we are unable to continue to develop innovative and stylish products, demand for our products may decrease.

The action sports and youth 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 brands. 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 youth 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 Von Zipper, Arnette, Oakley and Smith Optics. We also compete with broader youth lifestyle brands that offer eyewear products, such as Hurley International and 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 Armani, Christian Dior, Dolce & Gabbana, Gucci, Prada and Versace. In both 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 brand by persons ranging in age from 11 to 28 is essential to our future success. Accordingly, we intend to continue an aggressive brand strategy through a variety of marketing techniques, including athlete sponsorship, sponsorship of surfing, snowboarding, skateboarding, wakeboarding, BMX, downhill mountain biking and motocross events, vehicle marketing, internet and print media, action sports industry relationships, sponsorship of concerts and music festivals and celebrity endorsements, to foster an authentic action sports and youth lifestyle company culture. If we are unsuccessful, these expenses may never be offset, and we may be unable to increase net sales. Successful positioning of our brand will depend largely on:

 

    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; and

 

    our ability to continue to provide innovative, stylish and high-quality products to our customers.

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 and may decline.

If we are unable to leverage our business strategy successfully to develop new products, our business may suffer.

We are evaluating potential entries into or expansion of new product offerings, such as handmade fashion sunglasses and prescription eyewear frames. 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 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:

 

    increase awareness and popularity of our existing Spy brand;

 

    establish awareness of any new brands we may introduce or acquire;

 

    increase customer demand for our existing products and establish customer demand for any new product offering;

 

    attract, acquire and retain customers at a reasonable cost;

 

    achieve and maintain a critical mass of customers and orders across all of our product offerings;

 

    maintain or improve our gross margins; and

 

    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 may develop are not received favorably by consumers, our reputation and the value of our brands could be damaged. The lack of market acceptance of new products we may develop or our inability to generate satisfactory net sales from any new products to offset their cost could harm our business.

Our business could be impacted negatively if our sales are concentrated in a small number of popular products.

If sales become concentrated in a limited number of our products, we could be exposed to risk if consumer demand for such products were to decline. Excluding net sales from LEM S.r.l., for the three months ended September 30, 2005 and 2006, 48% and 55% of our net sales were derived from sales of our sunglass products, respectively, and 41% and 39%, respectively, of our net sales were derived from sales of our goggle products. Excluding net sales from LEM S.r.l., for the nine months ended September 30, 2005 and 2006, 65% and 66% of our net sales were derived from sales of our sunglass products, respectively, and 27% for each period, respectively, of our net sales were derived from sales of our goggle products. In addition, excluding LEM S.r.l. net sales, for the three months ended September 30, 2005 and 2006, 13% and 17%, respectively, of our net sales were derived from two sunglass models of our product line. For the nine months ended September 30, 2005 and 2006, 13% and 20%, respectively, of our net sales were derived from two sunglass models of our product line. As a result of these concentrations in net sales, our operating results could be harmed if sales of any of these products were to decline substantially and we were not able to increase sales of other products to replace such lost sales.

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 brand 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

 

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We recently have experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2006 and into 2007, and that these delays will continue to have a material effect on our results of operations. In particular, we currently are experiencing delays in our goggle shipments from our manufacturer in China. The delays are significant and may have a material adverse effect on our net sales in the fourth quarter of 2006, and potentially the first quarter of 2007.

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 brands. We believe that our future success is highly dependent on the contributions of Mark Simo, who became our Chief Executive Officer in October 2006 as well as Jerry Collazo, our new Chief Financial Officer and Jerry Kohlscheen, our new Chief Operating Officer. We have not entered into an employment agreement with Mr. Simo. The loss of the services of Mr. Simo or Messrs. Collazo or Kohlscheen would be very 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 carry key man insurance.

In addition, our senior management is all relatively new to our business, other than Mr. Simo, who is one of our founders and has served on our board of directors. If our new management team is not able to rapidly assimilate themselves into the business, our ability to execute on our business strategy may be harmed, which could adversely impact our branding strategy, product development strategy and net sales.

If we are unable to retain the services of our primary product designer, our ability to design and develop new products likely will be harmed.

We are heavily dependent on our primary product designer, Jerome Mage, for the design and development of our eyewear products. Mr. Mage provides his services to us as an independent consultant through his business, Mage Design, LLC. We cannot be certain that Mr. Mage will not be recruited by our competitors or otherwise terminate his relationship with us. If Mr. Mage terminates his relationship with us, we will need to obtain the services of another qualified product designer to design our eyewear products, and even if we are able to locate a qualified product designer, we may not be able to agree on commercially reasonable terms acceptable to us, if at all. If we were to enter into an agreement with a qualified product designer, we could experience a delay in the design and development of new sunglass and goggle product lines, and we may not experience the same level of consumer acceptance with any such product offerings. Any such delay in the introduction of new product lines or the failure by customers to accept new product lines could reduce our 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 brands and adversely impact our business.

Any interruption or termination of our relationships with our manufacturers could harm our business.

Although our manufacturing relationship with LEM is secure as a result of our acquisition of LEM S.r.l. in January 2006, we do not have long-term agreements with any of our other manufacturers. 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. If our relationship with any of our manufacturers is interrupted or terminated for any reason, including the failure of any manufacturer to be able to perform its obligations under our agreement or the termination of our agreement by any of our manufacturers, we would need to locate alternative manufacturing sources. The establishment of new manufacturing relationships involves numerous uncertainties, and we cannot be certain that we would 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 in the manufacture and shipment of our products and a loss of net sales.

Historically, we have purchased substantially all of our products from two manufacturers, LEM and Intersol. In January 2006, we acquired LEM S.r.l. As a result, we expect in the future that the majority of our sunglass and goggle products will be manufactured by LEM and the portion of our products manufactured by Intersol will decrease.

We recently have experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2006 and into 2007, and that these delays will continue to have a material effect on our results of operations. In particular, we currently are experiencing delays in our goggle shipments from our manufacturer in China. The delays are significant and may have a material adverse effect on our net sales in the fourth quarter of 2006, and potentially the first quarter of 2007.

 

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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 U.S. and internationally through retail locations serviced by us through our direct sales team and a network of independent sales representatives in the U.S., 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 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 are located in Italy, and our primary manufacturers are located in Italy. In addition, we distribute our products from an outsourced facility based in the Netherlands. Excluding the net sales from LEM S.r.l , in the nine months ended September 30, 2005 and 2006, we derived 76% and 79% of our net sales from the U.S., respectively, and 24% and 21% of our net sales from our foreign operations, respectively. We are subject to risks inherent in international business, many of which are beyond our control, including:

 

    difficulties in obtaining domestic and foreign export, import and other governmental approvals, permits and licenses and compliance with foreign laws, including employment laws;

 

    difficulties in staffing and managing foreign operations, including cultural differences in the conduct of business, labor and other workforce requirements;

 

    transportation delays and difficulties of managing international distribution channels;

 

    longer payment cycles for, and greater difficulty collecting, accounts receivable;

 

    ability to finance our foreign operations;

 

    trade restrictions, higher tariffs or the imposition of additional regulations relating to import or export of our products;

 

    unexpected changes in regulatory requirements, royalties and withholding taxes that restrict the repatriation of earnings and effects on our effective income tax rate due to profits generated or lost in foreign countries;

 

    political and economic instability, including wars, terrorism, political unrest, boycotts, curtailment of trade and other business restrictions; and

 

    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.

 

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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, if the U.S. dollar were to weaken against the Euro, our cost of sales could increase substantially. We also are 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 subsidiary, Spy Optic, S.r.l., and due to net sales in Canada. Between January 1, 2005 and September 30, 2006, the Euro to U.S. dollar exchange rate has ranged from 1.16 to 1.37. Between January 1, 2005 and September 30, 2006, the Canadian dollar to U.S. dollar exchange rate has ranged from 0.79 to 0.91. For the three months ended September 30, 2005 and 2006, we had a foreign currency gain of approximately $166,000 and a foreign currency loss of approximately $94,000, representing one percent of our net sales, in both periods. For the nine months ended September 30, 2005 we had a foreign currency gain of approximately $66,000 and for the nine months ended September 30, 2006 we had a foreign currency loss of $47,000, representing zero percent of our net sales, in both periods. As of September 30, 2006, we had purchased a net total of 5.2 million Euro foreign currency contracts at an average Euro rate of 1.22 Euro to U.S. dollar.

The effect of foreign exchange rates on our financial results can be significant. We therefore engage in certain hedging activities to mitigate over time the impact of the translation of foreign currencies on our financial results. Our hedging activities reduce, but do not eliminate, the effects of foreign currency fluctuations. Factors that could affect the effectiveness of our hedging activities include the volatility of currency markets and the availability of hedging instruments. For the effect of our hedging activities during the current reporting periods, see “Quantitative and Qualitative Disclosures about Market Risk.” The degree to which our financial results are affected will depend in part upon the effectiveness or ineffectiveness of our hedging activities.

We may experience conflicts of interest with our significant stockholder, No Fear, Inc., which could harm our other stockholders.

No Fear, Inc. and its affiliates beneficially own approximately 15% of our outstanding common stock. As a result of this ownership interest, No Fear and its affiliates have the ability to influence who is elected to our board of directors each year and, through those directors, to influence our management, operations and potential significant corporate actions. In addition, as a purchaser of our products, No Fear accounted for approximately $724,000 and $806,000 of our net sales for the nine months ended September 30, 2005 and 2006, respectively. No Fear and its affiliates may have interests that conflict with, or are different from, the interests of our other stockholders. These conflicts of interest could include potential competitive business activities, corporate opportunities, indemnity arrangements, registration rights, sales or distributions by No Fear of our common stock and the exercise by No Fear of its ability to influence our management and affairs. Further, this concentration of ownership may discourage, delay or prevent a change of control of our company, which could deprive our other stockholders of an opportunity to receive a premium for their stock as part of a sale of our company, could harm the market price of our common stock and could impede the growth of our company. Our certificate of incorporation does not contain any provisions designed to facilitate resolution of actual or potential conflicts of interest or to ensure that potential business opportunities that may become available to both No Fear and us will be reserved for or made available to us. If these conflicts of interest are not resolved in a manner favorable to our stockholders, our stockholders’ interests may be substantially harmed.

In addition, Mark Simo, our Chief Executive Officer and a Co-Chairman of our board of directors, is a member of the board of directors, and the former Chief Executive Officer, of No Fear and owns approximately 37% of No Fear’s outstanding common stock. As a result of his position in No Fear, Mr. Simo may face conflicts of interest in connection with transactions between us and No Fear.

If we fail to secure or protect 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.

 

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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 extensive. As of the date of this report, 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.

On March 7, 2005, Oakley, Inc, one of our major competitors, filed a lawsuit alleging patent trade dress and trademark infringement, unfair competition, and false designation of origin. The lawsuit specifically identifies three of our product styles which accounted for 5% and 7% of our total net sales for the nine months ended September 30, 2005 and 2006, respectively. While management believes the lawsuit is without merit, litigation is subject to inherent uncertainties and an unfavorable outcome could negatively affect our operating results. This lawsuit has caused our management to divert its attention from normal business operations and has caused us to incur expenses.

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.

We have experienced significant growth, which has placed, and may continue to place, a significant strain on our management and operations. If we continue to 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:

 

    maintaining our cost structure at an appropriate level based on the net sales we generate;

 

    implementing and improving our operational and financial systems, procedures and controls;

 

    Managing operations in multiple locations and multiple time zones; and

 

    ensuring the distribution of our products in a timely manner.

We incur significant expenses as a result of being a public company.

We incur significant legal, accounting, insurance and other expenses as a result of being a public company. The Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and Nasdaq, have required changes in corporate governance practices of public companies. These new rules and regulations have, and will continue, to increase our legal and financial compliance costs and make some activities more time-consuming and costly. These new rules and regulations have also made, and will continue to make, it more difficult and more expensive for us to obtain director and officer liability insurance.

We may not address successfully problems encountered in connection with our acquisition of LEM or any future acquisitions, which could result in operating difficulties and other harmful consequences.

In January 2006, we acquired LEM S.r.l. The aggregate purchase price was 3.3 million Euro or $4.0 million in cash, plus a two year earn-out based on LEM’s future sales. Under the terms of the earn-out, we are obligated to make quarterly payments based on unit sales, up to a maximum of 1.4 million Euro, through December 31, 2007. We expect to continue to consider other opportunities to acquire or make investments in other technologies, products and businesses 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, including LEM, and strategic investments involve numerous risks, including:

 

    Problems assimilating the purchased technologies, products or business operations;

 

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    Problems maintaining uniform standards, procedures, controls and policies;

 

    unanticipated costs associated with the acquisition;

 

    diversion of management’s attention from our core business;

 

    harm to our existing business relationships with manufacturers and customers;

 

    risks associated with entering new markets in which we have no or limited prior experience; and

 

    potential loss of key employees of acquired businesses.

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.

In addition, in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets”, we are required to test goodwill for impairment at least annually, or more frequently if events or circumstances exist which indicate that goodwill may be impaired. As a result of changes in circumstances after valuing assets in connection with acquisitions, we may be required to take write-downs of intangible assets, including goodwill, which could be significant.

Our eyewear products may subject us to product liability claims, which are expensive to defend 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, including claims for serious personal injury. Although we are not involved presently in any product liability claim, successful assertion against us of one or a series of large claims could harm our business.

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.

Because we manufacture a wide variety of eyewear products at our Italian manufacturing facility, we use and generate numerous chemicals and 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. Contaminants have been detected at some of our present facilities, principally in connection with historical practices conducted at LEM. We have undertaken to remediate these contaminants. Although we currently do not expect that these remediation efforts will involve substantial expenditure of resources by us, the costs associated with this remediation could be substantial, which would reduce our cash available for operations, consume valuable management time, reduce our profits or impair our financial condition.

Risks Related to the Market for Our Common Stock

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. 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 half of the fiscal year as a result of the seasonality of our customers and the markets in which we sell our products, and our first and fourth 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 is likely to 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

 

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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. For example, in January we completed the acquisition of our primary manufacturer LEM S.r.l. 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.

Future sales of our common stock in the public market could cause our stock price to fall.

Sales of our common stock in the public market, or the perception that such sales might occur, could cause the market price of our common stock to decline. As of November 6, 2006, we have 8,184,314 shares of common stock outstanding including 90,000 shares of unvested restricted stock . In addition, we have 813,123 shares subject to fully vested unexercised options to purchase shares of common stock. In addition, 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. With the exception of the 90,000 shares subject to restricted share agreements, all of our outstanding shares of common stock may be sold in the open market, subject to certain limitations.

Delaware law and our corporate charter and bylaws contain anti-takeover provisions that could delay or discourage takeover attempts that stockholders may consider favorable.

Provisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:

 

    the establishment of a classified board of directors requiring that not all directors be elected at one time;

 

    the size of our board of directors can be expanded by resolution of our board of directors;

 

    any vacancy on our board can be filled by a resolution of our board of directors;

 

    advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon at a stockholders’ meeting;

 

    the ability of the board of directors to alter our bylaws without obtaining stockholder approval;

 

    the ability of the board of directors to issue and designate the rights of, without stockholder approval, up to 5,000,000 shares of preferred stock, which rights could be senior to those of common stock; and

 

    the elimination of the right of stockholders to call a special meeting of stockholders and to take action by written consent.

In addition, because we reincorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, or Delaware law. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us. The provisions in our charter, bylaws and under Delaware law could discourage potential takeover attempts and could reduce the price that investors might be willing to pay for shares of our common stock in the future, resulting in the market price being lower than it would without these provisions.

We are party to securities litigation that distracts our management, is expensive to conduct and seeks a damage award against us.

We, our directors and certain of our officers have been named as defendants in two stockholder class action lawsuits filed in the United States District Court for the Southern District of California. A consolidated complaint, filed October 11, 2005, purported to seek unspecified damages on behalf of an alleged class of persons who purchased our common stock pursuant to our registration statement we filed in connection with our public offering of stock on December 14, 2004. The complaint alleged that we and our officers and directors violated federal securities laws by failing to disclose in the registration statement material information about plans to make a distribution change in our European operations, our dealings with one of our customers and whether certain of our products infringe on the intellectual property rights of Oakley, Inc. We filed a motion to dismiss the complaint which the court granted on March 29, 2006. The court allowed plaintiffs to file an amended complaint only with respect to their claim about a European distribution change. Plaintiffs filed an amended complaint dated April 7, 2006. On May 7, 2006, the Company filed a motion to dismiss that amended complaint. No discovery has been conducted. However, based on the facts presently known, management believes we have meritorious defenses to this action and intends to vigorously defend the action.

In December 2005, two stockholders filed derivative lawsuits in state court in San Diego, purportedly on our behalf, against eight of our current or former directors and officers and against one of our stockholders, No Fear. A consolidated amended complaint was filed in March 2006 alleging that the defendants breached their fiduciary duties and injured us by allowing us to issue a misleading registration statement and prospectus in connection with our December 2004 public offering and alleging that No Fear

 

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sold Orange 21 stock while having knowledge of material, non-public information. The derivative plaintiffs seek compensatory damages, disgorgement of profits, treble damages and other relief. The case is still in the pretrial stage. On May 4, 2006 the Court granted the defendants’ demurrer and dismissed the consolidated complaint, with leave to file an amended complaint. An amended complaint was filed on May 25, 2006, and on June 29, 2006 defendants filed their demurrer to that amended complaint.

This litigation presents a distraction to our management and is expensive to conduct. This could negatively affect our operating results.

 

Item 5. Other Information.

Effective November 15, 2006, Barry Buchholtz resigned from our’s Board of Directors.

 

Item 6. Exhibits

 

3.2    Restated Certificate of Incorporation (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004).
3.4    Amended and Restated Bylaws (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004).
10.31    Eleventh Modification to Loan and Security Agreement entered July 3, 2006 by and between Orange 21 Inc. and Comerica Bank. (incorporated by reference to Form 8-K filed July 7, 2006).
10.32    Letter Agreement entered July 3, 2006 by and between Orange 21 Inc. and Comerica Bank. (incorporated by reference to Form 8-K filed July 7, 2006).
10.37    Separation and Release Agreement by and between Orange 21 Inc. and Michael Brower, dated August 11, 2006 (incorporated by reference to Form 8-K filed August 17, 2006).
10.38    Letter Agreement entered September 12, 2006 by and between Orange 21 Inc. and Comerica Bank (incorporated by reference to Form 8-K filed September 27, 2006).
31.1    Rule 13a-14(a) certification of Chief Executive Officer.
31.2    Rule 13a-14(a) certification of Chief Financial Officer.
32.1    Certification of Chief Executive Officer and Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.§1350).

+ Indicates management contract or compensatory plan.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

    Orange 21 Inc.
Date: November 20, 2006     By   /s/ Mark Simo
        Mark Simo
        Chief Executive Officer
Date: November 20, 2006     By   /s/ Jerry Collazo
        Jerry Collazo
        Chief Financial Officer

 

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