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ITEM 2.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
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FORWARD LOOKING STATEMENTS
This quarterly report on Form 10-Q contains
various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended,
and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), which represent our expectations or
beliefs concerning future events. Forward-looking statements generally include words such as “anticipates,” “believes,”
“expects,” “planned,” “scheduled,” or similar expressions and statements. Although we believe
these forward-looking statements are based on reasonable assumptions, statements made regarding future results are subject to a
number of assumptions, uncertainties, and risks that could cause future results to be materially different from the results stated
or implied in this document. Uncertainties, risks, and other factors that may cause actual results or performance to differ materially
from any results of performance expressed or implied by forward-looking statements in this Form 10-Q include: (1) our ability
to manage our operating expenses and realize operating efficiencies; (2) our ability to maintain and grow our sales with existing
and new customers; (3) our ability to retain existing members of our senior management team and to attract additional management
employees; (4) our ability to manage fluctuations in the availability and cost of key materials and tools of production; (5) general
economic conditions that might impact demand for our products; (6) competition from existing or new participants in the pet
products industry; (7) our ability to design and bring to market new products on a timely and profitable basis; (8) challenges
to our patents or trademarks on existing or new products; (9) our ability to secure access to sufficient capital on favorable
terms to manage and grow our business; or (10) our ability to manage and fund claims resulting from our self-insurance program.
We caution that these risk factors are not exclusive. Additionally, we do not undertake to update any forward-looking statements
that may be made from time to time by or on behalf of us except as required by law.
OVERVIEW
We develop and market products for improving
the health, safety, comfort and enjoyment of pets. Our mission is “to exceed pet and pet parent/owner expectations with innovative
solutions.” Our dual-brand strategy is focused on OurPets® for the Pet Specialty channel and PetZone® for the food,
drug and mass retail channel. The products sold have increased from the initial Big Dog Feeder® to approximately 1,000 products
for dogs, cats and birds. Products are marketed under the OurPet’s®, Pet Zone®, Flappy®, SmartScoop®, Ecopure
Naturals®, Play-N-Squeak®, Durapet®, Clipnosis®, Go! Cat!Go!®, Festiva®, Cosmic Pet™, Intelligent
Pet Care®, and Switchgrass BioChar® Natural Cat Litter labels to domestic and international customers. The manufacturing
of these products is subcontracted to other entities, both domestic and international, based upon price, delivery and quality.
Packaged Facts, a leading publisher
in the United States of market studies on consumer products, recently published its report of the “U.S. Pet Market Outlook,
2017-2018.” It estimates the overall pet products and services market totaled $81.43 billion in 2016. The report expects
the industry to exceed the $100 billion mark in 2021. The pet supplies segment (OurPet’s segment) was the third-largest segment
in 2016 with $16.45 billion in revenue. This segment showed an increase of 7.5% from the previous year. U.S. retail channel sales
of pet products, which includes pet food and pet supplies, were estimated at $47.8 billion in 2016, up 5.4% over 2015 (U.S. Pet
Market Outlook, 2017-2018).
Packaged Facts cites higher income households
as crucial to the success of the pet industry. It also identifies the human/animal bond, humanization of pets, and health and wellness
as key drivers. As it explains in its outlook study, “Humanization of pets is a natural expression of the ‘pets as
family’ trend, whereby pet owners treat their pets like children and are highly receptive to products they use for themselves….
The phenomenon seeps into marketing messages, corporate philosophies, acquisition strategy, packaging and product attributes”
(U.S. Pet Market Outlook, 2017-2018).
As discussed in “Liquidity and Capital
Resources” beginning on page 20, we funded our operations principally from the net cash provided from financing activities
for the nine-month period ended September 30, 2017 and by the cash provided by operating activities for the nine-month period ended
September 30, 2016.
Under the Company’s credit facilities
with our bank, the Company can borrow up to $5,000,000 based on the level of qualifying accounts receivable and inventories. As
of September 30, 2017, we had a balance due of $3,675,166 under the line of credit with our bank at a variable interest rate of
30 Day LIBOR plus 2.25%.
RESULTS OF OPERATIONS
Three Months Ended September 30, 2017, Compared to Three
Months Ended September 30, 2016
In the following discussion, all references
to 2017 are for the three months ended September 30, 2017, and all references to 2016 are for the three months ended September
30, 2016.
Our net revenue is primarily derived from
sales of proprietary products for the retail pet business. In 2015, we completed the conversion of our brands to deliver products
that are specifically marketed to our three main channels. The OurPets® brand is sold to the “Pet Specialty” channel.
The Pet Zone® brand is sold to the “Food, Drug, and Mass Retail” (or “FDM”) and Value channels. Both
brands are sold to the “E-Commerce” channel.
In 2017, net sales declined approximately
4.9% to $6.91 million or $355,000 below third quarter 2016 sales. This slight sales decline was primarily due to decreases in the
Pet Specialty channel of approximately $779,000 (23%) and a decrease of $265,000 (9%) in the Food, Drug and Mass Retail channel,
which were offset by a $340,000 (61%) increase in E-Commerce and an $129,000 (65%) increase in Value channel sales. The traditional
major national Pet Specialty brick and mortar stores as well as the FDM channel are challenged with stemming an eroding customer
base that is migrating to E-Commerce and Value channels which offer user friendly self-help and a tremendous array of products
that can be purchased speedily and competitively. The Pet Specialty decline was also due to an initial stocking order of approximately
$600,000 in 2016 for toys positioned on end caps in in-line space that did not repeat in 2017. The sales decrease in the “Food,
Drug, Mass Retail” channel was due to decreased sales of toys/accessories.
There were also several “timing”
issues such as set up of our European distributor that delayed $300,000 of shipments from the third quarter to the fourth quarter
2017. We also received a large bulk order from a major E-Commerce customer in the third quarter for shipment in the fourth quarter,
reducing that customer’s regular third quarter shipments. Lastly, approximately another $200,000 of orders were pushed into
the fourth quarter due to transportation problems resultant from Harvey and Irma hurricanes’ demand on the trucking industry
for emergency assistance.
The sales increase in the E-Commerce channel
came mainly from our raised feeders category, specifically our Designer Diner® three height adjustable feeder, which comprised
about two-thirds of the growth. The remaining one-third third of the E-Commerce growth came from our toys and accessories led by
our IQ Treat ball, our Catty Whack™ Electronic cat toy and our Play-n-Squeak Mouse Hunter.
Sales in the Value channel increased to
approximately $327,000 in the third quarter from $198,000 for the comparable period a year ago, mainly due to increased sales of
toys and accessories and bowls/feeders. Close-out sales increased over three-fold from about $89,000 to $279,000 over the same
quarter a year ago. Across all channels, sales to new customers provided approximately $64,000 in additional net revenue during
the third quarter of 2017.
Our net sales to international customers
generated about $632,000 in revenue or about 9.1% of total sales for the quarter. International sales increased by approximately
$53,000, or 8.3%, compared to a year ago, with Canadian sales increasing about $72,000 to $388,000 from $316,000 during the same
period a year ago, driven by sales to Food, Drug and Mass retail customers of toys/accessories. Sales to the UK decreased about
$42,000 due to decreased sales of toys/accessories to a major Pet Specialty retailer in the UK. Our sales to Asian countries (China,
Japan and Taiwan) contributed about $105,000 to quarterly sales. We also had about $44,000 of sales to South American countries.
In 2017, “Food, Drug, Mass Retail”
customers accounted for 37% of our sales compared to 39% in 2016; “Pet Specialty” customers accounted for 39% of our
sales compared to 48% in 2016; and “E-Commerce” customers accounted for 13% of our sales, up from 8% of total sales
for the third second quarter of 2017. Sales to the “Value” and “Closeout” channels made up 9% of our sales
in 2017 compared to 4% in 2016. Miscellaneous sales accounted for the other 2% of our revenue in 2017 and 1% of our revenue in
2016.
From a product category perspective, about
$453,000 of revenue growth came from our bowls/feeders’ line with our 3-height adjustable Designer Diner® (Pet Zone brand)/Barking
Bistro® (OurPet’s brand) accounting for about half of our revenue growth in bowls /feeders. Stainless steel bowl sales
accounted for the other $227,000 of our bowls/feeders’ revenue growth.
Offsetting the above product category
revenue growth were declines in three categories. Toys and Accessories were down about $711,000 (17%) to $3.41 million from
$4.13 million for the same quarter a year ago, mainly due as previously noted to a major pet retailer not reordering
an initial stocking order. Waste and odor products decreased about $73,000 (22%) to about $258,000 from sales of about
$331,000 for the same period a year ago, mainly due to decreases in automatic litter box sales as well as litter
box accessory sales. Edibles/Consumable sales decreased about $58,000 to $321,000 from $379,000 for the same period a year
ago, mainly due to decreases in catnip and tuna product sales to Pet Specialty customers.
Some of our top products that generated
significant sales in their respective categories in the third quarter were the Designer Diner®/Barking bistro®, the hybrid
stainless steel bowls with bonded rubber, our PetZone Cat Wands, the Ball of Furry Fury®, and the Mouse Hunter®. Electronic
toy sales grew 29% this past quarter compared to the same period a year ago, led by sales of the Fly By Spinner® electronic
toy, followed by Pet Zone Caged Canary®, the Teaser Teepee® and the Catty Whack®.
Our Private Label sales accounted for about
$962,000 or 14% of total sales vs. about $1,521,000 or 21% of last year’s sales with the decrease mainly due to decreased
sales of toys/accessories to the Pet Specialty channel.
Sales of new products in the third quarter
of 2017 not sold previously were approximately $168,000, or 2.4% of total sales for the quarter. Most of these sales were from
products in the toys and accessories category, consisting of our Holiday Mice and Stocking assortments as well as our Mouse In
a Pouch® Electronic action cat toy.
The reduced sales resulted in our “cost
of goods sold” decreasing by approximately $101,000 (2.1%) from $4,816,434 in 2016 to $4,715,881 in 2017. While our “cost
of goods sold” decreased in total, our operating costs as a percentage of net sales increased by approximately 2.0%. Our
freight costs for shipping product out increased by approximately $37,000 due to general price increases from freight carriers
and a change in the sales mix of customers with freight prepaid vs. freight collect. Salaries and payroll related items increased
by approximately $11,000 due to increased health insurance costs and pay increases. Depreciation related to operating fixed assets
increased by approximately $12,000. Outside warehouse expenses for the quarter were up by approximately $12,000. Offsetting some
of these increases: property insurance expenses decreased by approximately $7,000 due to a refund received on our flood insurance
policy; repair costs were down by approximately $6,000; and warehouse supply costs were also down by approximately $6,000.
Our gross margin percentage decreased to
31.7% from 33.7% mainly due to increased close out sales as well as the increased freight out and operating costs. Our warehouse
overhead costs increased by approximately $7,000, or 1.0%, from the comparable three months in 2016. The largest items were the
increased expenses for payroll related items and depreciation.
Due to the decreased sales and lower gross
profit margin percentage, our gross profit margin dollars decreased from $2,443,470 in 2016 to $2,189,279 in 2017 (a decrease of
$254,191 or 10.4%).
Selling, general and administrative expenses
in 2017 were $1,623,231, a decrease of 1.6% or $26,275 from $1,649,506 in 2016. The decrease was the net result of: (1) a decrease
in salaries, payroll taxes, and benefits of approximately $41,000 from decreased accruals for bonus and profit sharing arrangements
as well as a change in staffing; (2) a decrease in the amount accrued for bad debt expense of approximately $15,000; (3) a decrease
in legal expenses of approximately $10,000; (4) a decrease in selling expenses of approximately $5,000 from decreased commissions
offset by increased expenditures for customer incentives and promotional programs; (5) a decrease in depreciation expenses of approximately
$3,000; (6) an increase of approximately $3,000 for travel and entertainment expenses; (7) an increase in business and product
development expenses of approximately $4,000; (8) an increase in IT (Information Technology) expenses of approximately $4,000;
(9) an increase in expenses for investor relations of approximately $9,000; (10) an increase in marketing costs of approximately
$10,000 from increased spending on e-commerce advertising; (11) an increase in fees of approximately $21,000 related to the establishment
of the subsidiary to self-insure against business losses; and (12) a net decrease of $3,000 in all other selling, general and administrative
expenses.
The decrease in selling, general, and administrative
expenses was not great enough to offset the decrease in gross profit dollars and resulted in our income from operations decreasing
by $227,916 (or 28.7%) from $793,964 in 2016 to $566,048 in 2017.
We earned “other income” of
approximately $5,000 in 2017 and $24,000 in 2016. The $5,000 earned in 2017 was the net result of royalty income from favorable
patent litigation settlements as well as gain on investments less royalty payments owed. The $24,000 earned in 2016 was from royalty
income because of favorable patent litigation settlements.
Interest expense for 2017 was $30,003, an
increase of $6,553, from $23,450 in 2016. Approximately $6,400 of this increase was due to an increase of interest owed on our
line of credit due to the rate on the line increasing as well as an increased loan balance. The rate on the line (30 day LIBOR
plus 2.25%) increased by approximately 0.7% due to an increase in the LIBOR rate. Our average line of credit balance increased
by about $300,000 (approximately $2,500,000 from approximately $2,200,000 a year ago) from increased usage. Interest owed on a
new capital lease resulted in the rest of the increase in interest, offset by the pay-offs of other loans and leases.
We lowered our estimated effective tax rate
based on presumed transactions which will take place at the end of 2017 with our wholly owned subsidiaries, an insurance company
and a DISC. As a result, income tax expense decreased by approximately $191,000 from $298,970 in 2016 to $107,987 in 2017.
Net income for 2017 was $432,907 as compared
to net income of $495,669 for 2016, a decrease of $62,762, or 12.7%. This decrease was a result of the following changes from 2016
to 2017:
Net revenue decrease of 4.9%
|
|
$
|
(354,744
|
)
|
Cost of goods sold decrease of 2.1%
|
|
|
100,553
|
|
Gross profit decrease of 10.4%
|
|
|
(254,191
|
)
|
Selling, general, and administrative expenses decrease of 1.6%
|
|
|
26,275
|
|
Interest expense increase of 27.9%
|
|
|
(6,553
|
)
|
Decrease in other income
|
|
|
(19,276
|
)
|
Income tax expense decrease
|
|
|
190,983
|
|
Decrease in profitability
|
|
$
|
(62,762
|
)
|
Nine Months Ended September 30, 2017, Compared to Nine Months
Ended September 30, 2016
In the following discussion, all references
to 2017 are for the nine months ended September 30, 2017, and all references to 2016 are for the nine months ended September 30,
2016.
In 2017, net sales grew approximately 4.0%
to $19.63 million or $753,000 above revenues of $18.87 million for the first nine months of 2016. This sales growth was primarily
driven by a substantial revenue increase of about $1.13 million (68.0%) in the E-Commerce channel over the comparable period a
year ago. As noted in the previous quarterly report, the consumer’s buying patterns have clearly shifted from “Big
Box”/“Brick and Mortar” to the E-Commerce/internet platform. We also had a $263,000 (39%) revenue increase in
the Value channel and a $217,000 (56%) increase in close out sales which offset decreases of about $652,000 (8%) in Pet Specialty
sales to about $7.24 million in 2017 from about $7.89 million for the same period a year ago and a decrease of about $443,000 in
Food, Drug, Mass Retail sales to about $7.50 million from about $7.95 million for the same period a year ago.
The sales increase of approximately $1.13
million in the E-Commerce channel came primarily from our raised feeder category, specifically the Designer Diner® which comprised
over 50% of this revenue growth. The other major growth category was Toys & Accessories which accounted for about $421,000
or 37% of the E-Commerce growth. The main products that drove revenue growth in the E-Commerce toys and accessories category were
the Pet Zone Fly By Spinner® electronic toy, the IQ Treat Ball and the Catty Whack®.
About 70% of the sales decrease in the FDM
channel was primarily due to decreased sales of toys/accessories with the remaining 30% decrease coming from lower sales of and
bowls/feeders.
The sales increase in the Value channel
to about $946,000 in 2017 from $682,000 for the comparable period a year ago was all due to increased sales of toys and accessories,
notably increased cat scratcher and scratching posts. Close-out sales increased approximately 56% over the same nine-month period
a year ago. Across all channels, sales to new customers provided approximately $553,000 in additional net revenue during the first
nine months of 2017.
Our net sales to international customers
generated about $1.88 million in revenue or about 9.6% of total sales for the first nine months of 2017 as compared to about $1.60
million for the same period in 2016. International sales increased by approximately $281,000, or 15%, compared to a year ago. Canadian
sales increased about $239,000 from the same period a year ago spurred by sales to Food, Drug, and Mass retail customers of toys/accessories
and bowls/feeders. Sales to the United Kingdom (UK) decreased about $94,000 due to decreased sales of toys/accessories and edibles/consumables
to a major Pet Specialty retailer in the UK. Sales to all other countries increased by about $136,000 led by Japan with a $95,000
sales increase over last year.
In 2017, “Food, Drug, Mass Retail”
customers accounted for 38% of our sales vs. 42% in 2016; “Pet Specialty” customers accounted for 37% of our sales
vs. 42% in 2016; and “E-Commerce” customers accounted for 14% of our sales, up from 9% of total sales for the first
nine months of 2016. Sales to the “Value” and “Closeout” channels made up 8% of our sales in 2017 vs. 6%
in 2016. Miscellaneous sales accounted for the other 3% of our revenue in 2017 and 1% in 2016.
From a product category perspective, about
$867,000 of our revenue growth came from our bowls/feeders line with our 3-height adjustable Designer Diner® (Pet Zone brand)/Barking
Bistro® (OurPet’s brand) accounting for almost 75% of that product category’s revenue growth. Bowls/feeders revenue
grew about 12% in 2017 over the same nine-month period in 2016. The toys/accessories category declined about $434,000 or 4%, over
last year’s comparable first nine months due mainly to a large 2016 initial stocking order by a major national Pet Specialty
retailer not repeating in 2017. Waste and odor product sales accounted for about $104,000 of our revenue growth, the driving product
continuing to be our Switchgrass® BioChar natural cat litter. Offsetting our revenue growth was a decrease in the edibles/consumables
product category of about $96,000 which declined about 8% from the same quarter last year as one of our major Pet Specialty customers
discontinued some tuna flake and catnip SKU’s.
Our two main product categories remain toys/accessories
which account for 48% of sales (down from 52% last year), and bowls/feeders which account for 40% of sales (up from 36% last year).
The other 12% of our sales is comprised of edible/consumable tuna and catnip products (5%), waste/odor products (5%), and health/wellness
products and dog houses (2%).
Some of our top products that generated
significant sales in their respective categories in the first nine months of 2017 were the Pet Zone hybrid stainless steel bowls,
Designer Diner®, the Ball of Furry Fury®, the Pet Zone Wands, the Mouse Hunter®, the IQ Treat Balls, Snag-able™
Cat/Fish Door and Floor Scratcher, and our PetZone SmartScoop™ automatic litter box. Electronic toy sales grew 75% during
the first nine months of 2017 compared to the same period a year ago led by sales of the Fly By Spinner® electronic toy, followed
by the Catty Whack®, the Pet Zone Teaser Teepee, the OurPet’s Bird in a Cage®, the OurPet’s Pounce House®
and the Whirling Wiggler®.
Our Private Label sales accounted for about
12% of total sales for the first nine months of 2017 vs. about 16 % of last year’s sales for the comparable period with the
decrease mainly due to decreased sales of toys/accessories and stainless steel bowls.
Sales of new products in the first
nine months of 2017 not sold previously were approximately $1.72 million or 8.7% of total sales for the first nine months.
Most of these sales were from products in the toys and accessories category, including our Pet Zone Cat Scratcher Post and
Snag-able ™Cat/Fish Door and Floor Scratchers, our Pet Zone electronic action toys Caged Canary® and our Bird in a
Cage®.
Due to the increased sales, our “cost
of goods sold” increased by approximately $392,000 (3.0%) from $13.03 million in 2016 to $13.42 million in 2017. However,
we maintained our costs as a percentage of net sales, which decreased by approximately 0.6% from a year ago. Part of this favorable
result was due to reducing the deductions taken between gross and net sales by our customers, which allowed our margins to improve.
We also kept control over our material costs even though we experienced price increases from our suppliers. For instance, we negotiated
favorable purchase discounts (approximately $176,000 more than last year) based on exchange rate gains of the U.S. Dollar against
the Chinese Yuan Renminbi. Further we decreased operating expenses in several areas. Repair and maintenance expenses decreased
by about $12,000, and depreciation related to operating fixed assets provided another approximately $29,000 in savings. We also
accrued approximately $16,000 less for expected write-offs of excess and obsolete inventory. Some of these savings were offset
with increased freight-out expenses (due to customer mix and freight allowance agreements), which increased by approximately $220,000,
and rent for outside warehouse space, which increased by approximately $22,000.
By decreasing our “cost of goods sold”
as a percentage of net sales, our gross margin percentage increased to 31.6% from 31.0%. Our warehouse overhead costs decreased
by approximately $29,000, or 1.4%, from the comparable nine months in 2016. The largest items were the decreased expenditures for
depreciation and repairs/maintenance.
By improving our sales, we increased our
gross profit margin dollars from $5,847,171 in 2016 to $6,207,865 in 2017 (an increase of $360,694 or 6.2%).
Selling, general and administrative expenses
in 2017 were $4.86 million (an increase of 10.3% or $454,509) from $4.41 million in 2016. The increase was the net result of: (1)
an increase in selling expenses of approximately $254,000 from increased expenditures for customer incentives and discounts allowed;
(2) an increase in promotional costs of approximately $106,000; (3) an increase in fees of approximately $61,000 related to the
establishment of the subsidiary to self-insure against business losses; (4) an increase in expenses for investor relations of approximately
$53,000; (5) an increase in IT (Information Technology) expenses of approximately $36,000; (6) an increase in the amount accrued
for potential customer charge-backs of approximately $24,000; (7) an increase in product development expenses of approximately
$15,000; (8) a decrease in salaries, payroll taxes, and benefits of approximately $10,000; (9) a decrease in marketing expenses
of approximately $18,000; (10) a decrease in depreciation expenses of approximately $24,000; (11) a decrease in the amount accrued
for bad debt expense of approximately $36,000; and (12) a net decrease of $6,000 in all other selling, general and administrative
expenses.
Since the increase in selling, general,
and administrative expenses was greater than the increase in gross profit on sales, our income from operations decreased by $93,815
(or 6.5%) from $1.44 million in 2016 to $1.34 million in 2017.
We incurred “other expense”
of approximately $9,000 in 2017 and earned “other income” of approximately $59,000 in 2016. The $9,000 incurred in
2017 was the net result of: $37,000 of royalty expense, a $5,000 loss on the exchange rate related to payments received from one
UK customer, $19,000 of royalty income, $13,000 of investment income, and $1,000 of income related to miscellaneous items. Of the
$59,000 earned in 2016, $20,000 was derived from customer payments for tooling/molds needed in the joint development of new toy
products. The remaining approximately $39,000 of other income in 2016 was mostly from royalty income resulting from favorable patent
litigation settlements.
Interest expense for 2017 was $74,762, a
decrease of $9,444, from $84,206 in 2016. Most of this decrease (approximately $8,000) resulted from us decreasing our average
line of credit balance by about $800,000 to approximately $2,000,000 from approximately $2,800,000 a year ago. The pay-offs of
other loans and leases resulted in the rest of the decrease, offset by interest owed on a new capital lease.
We lowered our estimated effective tax rate
based on presumed transactions which will take place at the end of 2017 with our wholly owned subsidiaries, an insurance company
and a DISC. As a result, income tax expense decreased by approximately $298,000 from $494,440 in 2016 to $196,061 in 2017.
Net income for 2017 was $1,062,902 as compared
to net income of $916,882 for 2016, an increase of $146,020, or 15.9%. This increase was a result of the following changes from
2016 to 2017:
Net revenue increase of 4.0%
|
|
$
|
752,979
|
|
Cost of goods sold increase of 3.0%
|
|
|
(392,285
|
)
|
Gross profit increase of 6.2%
|
|
|
360,694
|
|
Selling, general, and administrative expenses increase of 10.3%
|
|
|
(454,509
|
)
|
Interest expense decrease of 11.2%
|
|
|
9,444
|
|
Decrease in other income
|
|
|
(67,988
|
)
|
Income tax expense decrease
|
|
|
298,379
|
|
Increase in profitability
|
|
|
146,020
|
|
LIQUIDITY AND CAPITAL RESOURCES
Our operating activities provide cash from
the sale of our products to customers. The principal uses of cash are payments to suppliers that manufacture our products and freight
charges for shipments to our warehouses and to our customers. Our investing activities consist of the acquisition of equipment
such as tooling, computers, and software and the investing of excess cash held by Series OP. Our financing activities provide cash,
if needed, under our lines of credit with our bank, which had $1,324,834 in available funds as of September 30, 2017, based upon
the balance of accounts receivable and inventories at that date.
Our short-term and long-term liquidity will
continue to depend on our ability to achieve cash-flow break even on our operations and to increase sales of our products. In the
first nine months of 2016, we funded our operating cash requirements primarily with net income. In the first nine months of 2017,
we relied on the line of credit. During the remainder of 2017, we should be able to continue to fund our operating cash requirements
with net income and possibly the line of credit if needed. Based on our bank’s loan covenants we expect to comply with the
debt service coverage ratio and tangible net worth required by our bank to maintain our line of credit through the end of 2017.
We have no material commitments for capital expenditures.
Outstanding Debt
As of September 30, 2017, we had $4,471,301 in principal
amount of indebtedness consisting of:
Bank line of credit - $5,000,000
|
|
30 day Libor plus 2.25%
|
|
$
|
3,675,166
|
|
Bank term note ($1,000,000 original balance)
|
|
30 day Libor plus 3%
|
|
|
600,000
|
|
Capitalized Lease
|
|
5.44%
|
|
|
96,008
|
|
Lake County Economic Development Loan Program
|
|
5.00%
|
|
|
20,794
|
|
Note Payable to Molor Products
|
|
Non-interest bearing
|
|
|
79,333
|
|
The bank line of credit indebtedness of
$3,675,166 is comprised of a single line of credit under which we can borrow up to a total of $5,000,000 based on the level of
qualifying accounts receivable and inventories. Total eligible collateral at September 30, 2017 was $5,520,371. The line of credit
is a two-year revolver and therefore is classified as a long-term liability on our balance sheet. Currently the line of credit
has been renewed by the bank through June 30, 2018. We are in the process of finalizing the next renewal which will extend
the revolver through November 30, 2020. Under our agreement with the bank we are required to: (1) maintain a debt service
coverage ratio of at least 1.15 to 1.00 measured quarterly on a trailing 12 month basis; (2) maintain a tangible net worth
of no less than $6,000,000 tested at the end of each quarter; and (3) obtain the bank’s permission to incur additional
indebtedness, make any expenditures for property and equipment in excess of $750,000 in any fiscal year, redeem any of our capital
stock, or pay cash dividends (subject to meeting the debt service coverage ratio). As of September 30, 2017, we were in compliance
with our covenant obligations under our agreement with the bank. We had a debt service coverage ratio of 5.40 and a tangible net
worth of $11,170,570.
During the third quarter of 2016, we entered
a commitment to purchase an automatic packaging machine, with a cost of approximately $105,000, to be used at our Mentor facility.
The equipment was installed and the purchase was finalized in March of 2017. To finance the purchase, we signed a capital lease
that has a 60-month term with a $1.00 buyout at the end of the lease resulting in an approximate 5.44% interest rate. The lease
began in March of 2017 with the installation of the equipment. Monthly payments are $2,008.
Besides the capital lease, no changes were
made to the structure of our debt during 2017. All scheduled payments were made on time.
Changes in Cash- First Nine Months of 2017
Net cash used by operating activities for
the nine months ended September 30, 2017 was $164,425. Cash was provided by the net income for the nine months of $1,062,902, as
well as the non-cash charges for depreciation of $398,063, amortization of $45,202, stock option expense of $18,000, unrealized
gain on investments of $12,746, and loss on fixed assets of $995.
Cash was also used by the net change of
$1,676,842 in our operating assets and liabilities as follows:
Accounts Receivable increase
|
|
|
(7,868
|
)
|
Inventories increase
|
|
|
(1,605,973
|
)
|
Prepaid Expenses increase
|
|
|
(204,734
|
)
|
Deposits decrease
|
|
|
72,624
|
|
Amortizable Intangible Assets increase
|
|
|
(61,998
|
)
|
Accounts Payable increase
|
|
|
194,971
|
|
Accrued Expenses decrease
|
|
|
(47,860
|
)
|
Deferred Tax Liability decrease
|
|
|
(16,003
|
)
|
Net Change
|
|
$
|
(1,676,841
|
)
|
Inventories increased due to bringing in
product in preparation for the launch of new products as well as stocking up for holiday seasonal orders. Accounts payable increased
due to the increase in inventory. Accrued expenses decreased from paying bonus and profit sharing amounts related to last year,
offset by increased accruals for salaries and wages owed. Prepaid Expenses increased due to prepayments for royalty advances, income
taxes, commissions, and consulting fees. Amortizable intangible assets increased mostly from additional patent costs and partly
from additional website and licensing costs.
Net cash used for investing activities for
the nine months ended September 30, 2017 was $833,887. We invested $497,358 of the cash held by the wholly owned subsidiary named
Series OP and earned net investment income of approximately $2,600. We spent the following on capital expenditures: approximately
$232,000 on tooling/molds; approximately $67,000 for warehouse equipment; approximately $18,000 on computer software and equipment;
and approximately $21,000 towards leasehold improvements. In addition, we sold a truck that was being used for the transport of
goods between warehouses and that provided $4,000 in cash.
Net cash provided by financing activities
for the nine months ended September 30, 2017, was $1,568,516 and consisted of: (1) issuances of common stock for $188,647; (2)
principal payments on long-term debt of $183,309; (3) net increased borrowing on the bank line of credit of $1,591,200; and (4)
dividends paid on preferred stock of $28,022.
Changes in Cash- First Nine Months of 2016
Net cash provided by operating activities
for the nine months ended September 30, 2016, was $1,278,966. Cash was provided by the net income for the nine months of $916,882,
as well as the non-cash charges for (i) depreciation of $451,411; (ii) amortization of $39,739; (iii) stock option expense of $18,000;
and (iv) loss on fixed assets of $10,853. Cash was used by the net change of $157,919 in our operating assets and liabilities.
Accounts receivable increased due to increased
sales in the third quarter of 2016 compared to the fourth quarter of 2015. Inventories decreased due to close out sales and improved
management of our supply chain. Prepaid expenses increased due to prepayments for shows, royalty advances, and marketing videos,
offset by expense recognized for income taxes prepaid last year. Amortizable intangible assets increased mostly from patent costs
and to a lesser extent from amounts incurred for a Bluetooth® license and website development costs. Deposits increased due
to a down payment made pursuant to a commitment to purchase new packaging equipment. Accrued expenses increased from increased
expenses incurred for commissions, employee bonuses, salaries, and income taxes, offset partly by paying customer incentive payments
related to last year’s programs.
Net cash used for investing activities for
the nine months ended September 30, 2016, was $587,946. Approximately $249,000 was used for tooling/molds and approximately $213,000
was used for Bluetooth
®
technology development with the balance used to purchase various computer/software and various
other asset purchases.
Cash used by financing activities for the
nine months ended September 30, 2016, was $688,794 and consisted of: (1) net increased payments on our bank line of credit of $502,204;
(2) principal payments on long-term debt of $216,481; and (3) issuances of common stock of $29,891.
CRITICAL ACCOUNTING POLICIES/ESTIMATES
We prepare our consolidated financial statements
in accordance with United States generally accepted accounting principles. We have identified the accounting policies below as
critical to our business operations and understanding of our results of operations. For a detailed discussion on the application
of these and other accounting policies, see the summarized significant accounting policies accompanying our audited consolidated
financial statements included in our Form 10-K filed on March 31, 2017. The application of these policies may require management
to make judgments and estimates that affect the reported amount of assets and liabilities, disclosure of contingent assets and
liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period.
Management uses historical experience and all available information to make these estimates and judgments, and different amounts
could be reported using different assumptions and estimates.
In our Form 10-K for the fiscal year ended
December 31, 2016, our most critical accounting policies and estimates upon which our financial status depends were identified
as those relating to: revenue recognition, research and development costs, income taxes, impairment of long lived assets, intangible
assets, product warranties, prepaid expenses, and inventories and inventory reserves. We reviewed our policies and determined that
those policies remain our most critical accounting policies for the nine months ended September 30, 2017.
OFF-BALANCE SHEET ARRANGEMENTS
We have no off-balance sheet arrangements
that have or are likely to have a current or future effect on our financial condition, revenues or expenses, results of operations,
liquidity, capital expenditures, or capital resources.