Description
Summer Infant, Inc. 10% Owner PARTNERS SMALL CAP WYNNEFIELD bought 465,752 shares on 6-22-2012 at $ 2.8
BUSINESS OVERVIEW
Products
We currently sell products in a number of different categories, including nursery audio/video monitors, safety gates, durable bath products, bed rails, infant thermometers, related health and safety products, booster and potty seats, cribs, baby gear, bouncers, swaddling blankets and bottles. No single product generated more than 10% of sales for the year ended December 31, 2011. While a majority of our products are sold under the Summer Infant brand name, we also have several licensing arrangements to sell products under different brand names, including Carter's and Disney. In 2011, we added feeding products to our categories and introduced our new PRODIGY™ car seat and travel system.
Product Development and Design
We believe that product development is a critical element of our strategy and success to date. Our product strategy is to produce proprietary products that provide distinctive benefits, are visually appealing, provide convenience and will appeal to the mid-tier and upper-tier buyers. Our retail customers are strategically motivated to buy innovative products. Our main product development efforts are located at our Rhode Island headquarters, but we also have development efforts in China, Pennsylvania, and the United Kingdom. We also focus on improving existing products based on feedback from our customers. For example, we expect to re-launch our PRODIGY™ travel system in the third quarter of 2012 with new fashion and an improved stroller platform.
Suppliers and Manufacturing
Except for certain injection-molded products, which are manufactured in the U.S., substantially all of our other products are manufactured in Asia (primarily China) and Israel. We use many different suppliers and we own our molds. Therefore, we are not dependent on any one manufacturer. Our Hong Kong subsidiary provides us with a local sourcing presence and the ability to oversee quality, electronic engineering and other issues that may arise during production. Generally, we are buying finished goods from manufacturers and thus are not directly procuring any raw materials related to the ultimate manufacturing of the products. We have not had any significant disruption of supply to date as a result of raw material shortages, but there is the possibility that shortages could occur in the future based on a variety of factors beyond our control.
Transportation of Asia-made goods to our warehouses typically takes three to four weeks, depending on the location of the warehouse. We maintain our inventory at warehouses located in the United States, Canada, Asia, and the United Kingdom. Most of our customers pick up their goods at regional warehouses. We also use UPS and other common carriers to arrange shipments to customers who request such arrangements, primarily smaller retailers and specialty stores. In 2011, our East Coast distribution center was consolidated into our West Coast distribution center. We anticipate this will better enable us to service our customers.
We use several manufacturers in the United States for certain injection molded products, including bath tubs, potty seats and booster seats, which typically account for between 10% and 15% of our annual sales.
Sales and Marketing
Our sales are primarily derived from the sale of juvenile health, safety and wellness products and are recognized upon transfer of title of product to our customers. Our products are marketed and sold through several distribution channels including mass merchant retailers, specialty retailers and direct to consumers.
Sales are made utilizing standard credit terms of 30 to 60 days. We generally accept returns only for defective merchandise.
Competition
The juvenile health, safety and wellness industry has many participants, none of which have dominant market share, though certain companies have disproportionate strength in certain segments. Our largest direct competitors are Dorel Industries (including Safety 1st and Cosco brands), Evenflo (Evenflo, Gerry, and Snugli brands), Kid Brands, Inc., Fisher-Price (part of Mattel, Inc.), The First Years (a subsidiary of Tomy Corporation) and Graco (a subsidiary of Newell Rubbermaid). In addition, we compete in certain of our product lines with a number of private companies, such as KidCo, Inc. and Munchkin.
The primary methods of competition in the industry consist of product innovation, brand positioning, quality, price and other factors such as timely distribution. Our competitive strengths include our experienced product development staff, our ability to develop new products, brand positioning, relationships with major retailers, and the quality and pricing of our products.
Intellectual Property
We rely on a combination of patents, licenses and trade secrets to protect our intellectual property. Our patents currently in effect include various design features related to bedrails, infant seats, bouncers, and potty chairs, with several other patents pending for monitors, baby swings, and other items. The patents expire at various times over the next 20 years. We also have license agreements relating to the use of patented technology owned by third parties in certain of our products.
Customers
Our top seven customers together comprised over 75% of our sales in fiscal 2011. These customers include Babies R Us/Toys R Us, Target, K-Mart, Buy Buy Baby, Amazon.com, Burlington Coat Factory, and Wal-Mart. Of these customers, three generated more than 10% of sales for fiscal 2011: Toys R Us (39%), Walmart (11%) and Target (10%). Because of the concentration of our business with these customers and because we have no long term contracts with these customers, our success depends on our customers' willingness to purchase and provide shelf space for our products.
Seasonality
There are not significant variations in seasonal demand for our products. Sales to our retail customers are generally higher in the time frame when retailers take initial shipments of new products. These orders usually incorporate enough product inventory to fill each store plus additional amounts to be kept at the customer's distribution center. The timing of these initial shipments varies by customer depending on when they finalize store layouts for the upcoming year, and whether there are any mid-year product introductions.
Geographic Regions
In 2011, North America accounted for over 90% of our total net sales; the remaining sales were made in the United Kingdom and all other geographies.
Regulatory Matters
We obtain all necessary regulatory agency approvals for each of our products. In the U.S., these approvals may include, among others, one or more of the Consumer Product Safety Commission ("CPSC"), the American Society of Test Methods ("ASTM"), the Juvenile Products Manufacturing Association ("JPMA"), the Federal Communications Commission ("FCC") and the Food and Drug Administration ("FDA"). We conduct our own internal testing, which utilizes a "foreseeable use and abuse" testing method and is designed to subject each product to the "worst case scenario." Our products are also frequently tested by independent government certified labs.
Insurance
We carry a product liability insurance policy that provides us with $15,000 of liability coverage with a minimal deductible. We consult with our insurers to ascertain appropriate liability coverage for our product mix. We anticipate increasing our insurance coverage in the future in line with our expanding sales and product breadth.
Employees
As of December 31, 2011, we employed a total of 247 full time people, 143 of whom work in the headquarters in Rhode Island. Our employees are not covered by a collective bargaining agreement. We consider our employee relations to be good.
Available Information
We maintain our corporate website at www.summerinfant.com and we make available, free of charge, through this website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports that we file with or furnish to the Securities and Exchange Commission ("SEC"), as soon as reasonably practicable after we electronically file that material with, or furnish it to, the SEC. Our website also includes corporate governance information, including our Code of Ethics and our Board Committee Charters.
CEO BACKGROUND
Mr. Fogelman , a director since March 2007, is an independent consultant and private investor in the juvenile products industry. He was instrumental in the conception and development of the Babies R Us retail chain and served as senior vice president of both Toys R Us and Babies R Us, where he was employed from 1983 to May 2003. From May 2003 until March 2007, Mr. Fogelman was President of Baby Trend, Inc., a manufacturer of infant products. He is currently an investor and board member of KAS, Inc., a private company that manufactures organic household and healthcare products for children, and The Nest Collective, a private company pioneering the manufacturing of organic baby food. Mr. Fogelman currently serves as a member of our Compensation Committee and of our Nominating & Governance Committee. The Board of Directors has determined that Mr. Fogelman meets the applicable independence requirements of SEC and Nasdaq Stock Market rules. In determining that Mr. Fogelman should continue to serve as a director of the Company, the Nominating & Governance Committee considered his extensive experience in the industry, including his experience in creating strategic growth at Toys R Us and Babies R Us, and his knowledge of our Company.
Mr. Wenz , a director since March 2007, is a consultant and private investor. Mr. Wenz served as Chief Executive Officer of Jenny Craig International during 2002 and 2003. From 2000 to 2002, Mr. Wenz was an operating partner/affiliate of DB Capital Partners, LLC, the private equity arm of Deutsche Bank A.G., and served on the boards of directors of a number of portfolio companies, including NewRoads, Inc. and Jenny Craig International. From 1997 to 2000, Mr. Wenz was President and Chief Operating Officer of Safety 1st, Inc., a manufacturer of safety and juvenile products. During 1995 and 1996, Mr. Wenz was the partner in charge of the Chicago office of The Lucas Group, a business-strategy consulting firm. Prior to 1995, Mr. Wenz held senior executive positions with Wilson Sporting Goods Co., Electrolux Corporation, The Regina Company and Professional Golf Corporation. Mr. Wenz began his career in 1971 with Arthur Young & Company (predecessor of Ernst & Young) and left the firm as a partner in 1983. Mr. Wenz is a certified public accountant. Since July 2006, Mr. Wenz has served on the board of directors of Easton-Bell Sports, Inc., a company with publicly-traded debt, , that designs, develops and markets branded sports equipment, and is currently the chairman of its audit committee. Since June 2010, Mr. Wenz has served as a director of Armstrong World Industries, a publicly traded international manufacturer of flooring and ceiling products. He also serves as a director of Coach America, a transportation company, and Pet Supplies “Plus,” a pet retail chain. Mr. Wenz was previously a director of Radica Games (HK), Inc., Hunter Fan Company, Strategic Partners, Inc., The First Years and Safety 1 st , Inc. Mr. Wenz currently serves as Chairman of our Audit Committee, Chairman of our Compensation Committee, and as a member of the Nominating & Governance Committee. The Board of Directors has determined that Mr. Wenz meets the applicable independence requirements of SEC and Nasdaq Stock Market rules. In determining that Mr. Wenz should continue serving as a director of the Company, the Nominating & Governance Committee considered his substantial leadership and financial experience, as well as previous extensive experience in the juvenile products industry at The First Years and Safety 1 st , as well as his background as a certified public accountant and service on other public company boards of directors.
MANAGEMENT DISCUSSION FROM LATEST 10K
Company Overview
We are a designer, marketer, and distributor of branded juvenile health, safety and wellness products which are sold principally to large North American and United Kingdom retailers. We currently market proprietary products in various product categories including nursery audio/video monitors, safety gates, durable bath products, bed rails, infant thermometers, related health and safety products, booster and potty seats, cribs, baby gear, bouncers, feeding items, and swaddling blankets.
Our business has grown organically in all of our markets. We derive our revenues from the sale of health, safety and wellness products for infants and toddlers. Our revenue is driven by our ability to design and market desirable products, identify business opportunities and secure new and renew existing distribution channels. Our income from operations is derived from our ability to generate revenue and collect cash in excess of labor and other costs of providing our products and selling, general and administrative costs.
Our strategy is to grow our sales through a variety of methods, including:
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increased product penetration (more products at each store);
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increased store penetration (more stores within each retail customer);
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new products (at existing and new customers);
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new mass merchant retail customers;
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new distribution channels (food and drug chains, price clubs, home centers, web-based retailers);
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new geographies (international expansion);
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new product categories; and
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acquisitions.
We have been able to grow our annual revenues historically through a combination of all of the above factors. Each year, we have been able to expand the number of products in our main distribution channel (mass merchant retailers) and have also added new customers each year. Therefore, even with limited new product introductions, we could grow our business by simply selling more of our existing product line to existing customers.
In the future, our growth strategy will be to continue to develop and sell new products to our existing customer base, sell new and existing products to new customers (or expand relationships with existing customers) and expand in the United Kingdom and in other geographic regions (including Japan, Mexico and Australia, among others). In addition, there are a number of potential acquisition candidates that could be pursued to obtain new innovative products, new product categories, new retail customers or new sales territories. There are several hundred active juvenile product companies, of which we estimate the majority have less than $10 million in sales.
As we continue to grow through internal initiatives and any future acquisitions, we will incur additional expenses. Two of the key areas in which those increased expenses will likely occur are sales and product development. To grow sales, we will likely hire additional sales personnel to service new geographic territories, focus existing resources on specific parts of the United States market and retain product line specialists to drive sales of new and existing products in specific areas in which we believe we can readily increase sales. Product development expenses will increase as we develop new products in existing and new categories.
If we were to acquire one or more companies as part of our growth strategy, we would face various challenges such as the integration of the acquired companies' product lines, employees, marketing requirements and information systems. Ongoing infrastructure investment also may be required to support realized growth, including expenditures with respect to upgraded and expanded information systems and enhancing our management team.
Sales
Our revenues are primarily derived from the sale of juvenile health, safety and wellness products and are recognized upon transfer of title of product to our customers. Our products are marketed through several distribution channels including chain retailers, specialty retailers and on-line retailers.
A number of large, North American retail customers account for a majority of our sales. Three customers generated more than 10% of sales for the year ended December 31, 2011, Toys R Us (39%), Walmart (11%), and Target (10%). Because of the concentration of our business with these customers and because we have no long term contracts with these customers, our success depends on our customers' willingness to purchase and provide shelf space for our products.
Over 90% of sales are currently made to customers in North America, with the remaining sales primarily made to customers in the United Kingdom. Sales are made utilizing standard credit terms of 30 to 60 days. We generally accept returns only for defective merchandise.
Cost of goods sold and other expenses
Our products are manufactured by third parties, with approximately 85-90% of the dollar value of products being manufactured in Asia with the majority of the balance being manufactured in the United States and Israel. Cost of goods sold primarily represents purchases of finished products from these third party manufacturers. The remainder of our cost of goods sold includes duties on certain imported items, freight-in from suppliers and miscellaneous charges from contract manufacturers. Substantially all of our purchases are made in U.S. dollars; therefore, most of this activity is not subject to currency fluctuations. If our suppliers experience increased raw materials, labor or other costs and pass along those cost increases through higher prices for finished goods, our cost of sales would increase, and to the extent we are unable to pass these price increases along to our customers, our gross margins would decrease.
Selling, general and administrative expenses primarily consist of payroll, insurance, professional fees, royalties, freight out to customers, product development costs, advertising and marketing expenses (including co-op advertising allowances as negotiated with certain customers) and sales commissions. Several of these items fluctuate with sales; some of these variable costs are based on sales to particular customers and others are based on sales of particular products.
There are no significant variations in seasonal demand for our products. Sales to our retail customers are generally higher in the time frame when retailers take initial shipments of new products. These orders usually incorporate enough product to fill each store plus additional amounts to be kept at the customer's distribution center. The timing of these initial shipments varies by customer depending on when they finalize store layouts for the upcoming year, and whether there are any mid-year product introductions.
Summary of critical accounting policies and estimates
This summary of our critical accounting policies is presented to assist in understanding our consolidated financial statements. The consolidated financial statements and notes are representations of our management, which is responsible for their integrity and objectivity. These accounting policies conform to accounting principles generally accepted in the United States of America and have been consistently applied in the preparation of the consolidated financial statements.
We make certain estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses. The accounting policies described below are those we consider critical in preparing our financial statements. Some of these policies include significant estimates made by management using information available at the time the estimates were made. However, these estimates could change materially if different information or assumptions were used.
Revenue recognition
We record revenue when all of the following occur: persuasive evidence of an arrangement exists, product delivery has occurred, the sales price to the customer is fixed or determinable and collectability is reasonably assured. Sales are recorded net of provisions for returns and allowances, cash discounts and markdowns. We base our estimates for discounts, returns and allowances on negotiated customer terms, and historical experience. These estimates are subject to variability, as actual deductions taken by customers may be different from the estimates recorded. Customers do not have the right to return products unless the products are defective. We record a reduction of sales for estimated future defective product deductions based on historical experience.
Sales incentives or other consideration given by us to customers that are considered adjustments of the selling price of its products, such as markdowns, are reflected as reductions of revenue. Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer's national circular ad, are reflected as selling and marketing expenses in the accompanying statements of income.
Trade receivables
Trade receivables are reported at their outstanding unpaid principal balances reduced by an allowance for doubtful accounts. On a periodic basis, we estimate doubtful accounts based on historical bad debt, factors related to specific customers' ability to pay and current economic trends. We write off accounts receivable against the allowance when a balance is determined to be uncollectible.
We do not accrue interest on trade receivables. A receivable is considered past due if payments have not been received within the credit terms on the account, typically 60 days for most customers.
We will turn an account over for collection around 120 days past due. Accounts are considered uncollectible if no payments are received 60 to 90 days after they have been turned over for collection.
Allowance for doubtful accounts
The allowance for doubtful accounts represents adjustments to customer trade accounts receivable for amounts deemed uncollectible. The allowance for doubtful accounts reduces gross trade receivables to their estimated net realizable value. The allowance is based on our assessment of the business environment, customers' financial condition, historical trends, customer payment practices, receivable aging and customer disputes. We will continue to proactively review our credit risks and adjust customer terms to reflect the current environment.
Inventory Valuation
Inventory is comprised of finished goods and is stated at the lower of cost, inclusive of freight and duty, or market (net realizable value) using the first-in, first-out (FIFO) method. Our warehousing costs are charged to expense as incurred. We regularly review slow-moving and excess inventory, and write-down inventories as appropriate. Management uses estimates to record write-downs based on its review of inventory by product category, including length of time on hand and estimates of future orders for each product. Changes in consumer preferences, as well as demand for products, customer buying patterns and inventory management could impact the inventory valuation.
Impairment of Long-Lived Assets
We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. An asset is considered to be impaired when its carrying amount exceeds the sum of the undiscounted future net cash flows expected to result from the use of the asset and its eventual disposition. Long-lived assets include property and equipment. The amount of impairment loss, if any, is charged by the Company to current operations. For each of the years ended December 31, 2011 and 2010, no such impairment existed.
Goodwill and Other Intangible Assets
We account for goodwill and other intangible assets in accordance with accounting guidance that requires that goodwill and intangible assets that have indefinite useful lives and not subject to amortization be tested at least annually for impairment. We evaluate goodwill, at a minimum, on an annual basis and whenever events and changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment of goodwill is tested by comparing the carrying value, including goodwill, to the Company's fair value. If the carrying value exceeds the fair value, a second step is performed to measure the amount of the impairment loss, if any. Under this second step, the implied goodwill value is determined, in the same manner as the amount of goodwill recognized in a business combination, to assess the level of goodwill impairment, if any. We determine the Company's fair value using the income, or discounted cash flows, approach. ("DCF model") and verify the reasonableness of such fair value calculations using the market approach, which utilizes comparable companies' data. The completion of the DCF model requires that we make a number of significant assumptions to produce an estimate of future cash flows. These assumptions include projections of future revenue, costs and working capital changes. In addition, we make assumptions about the estimated cost of capital and other relevant variables, as required, in estimating fair value. The projections that we use in our DCF model are updated annually and will change over time based on the historical performance and changing business conditions. The determination of whether goodwill is impaired involves a significant level of judgment in these assumptions, and changes in our business strategy, government regulations, or economic or market conditions could significantly impact these judgments. We will continue to monitor market conditions and other factors to determine if interim impairment tests are necessary in future periods. As of December 31, 2011, the estimated fair value of the Company exceeded the carrying value of our reporting unit. Management evaluates the remaining useful life of an intangible asset that is not being amortized each reporting period to determine whether evens and circumstances continue to support an indefinite useful life. If an intangible asset that is not being amortized is subsequently determined to have a finite useful life, it is amortized prospectively over its estimated remaining useful life.
Income taxes
Income taxes are computed using the asset and liability method of accounting. Under the asset and liability method, a deferred tax asset or liability is recognized for estimated future tax effects attributable to temporary differences and carryforwards. The measurement of deferred income tax assets is adjusted by a valuation allowance, if necessary, to recognize future tax benefits only to the extent, based on available evidence, it is more likely than not that such benefits will be realized.
Previously, the Company adopted the provisions of a new standard which provides detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in the financial statements. Tax positions must meet a "more-likely-than-not" recognition threshold at the effective date to be recognized upon adoption and in subsequent periods. Upon the adoption, and at December 31, 2011 and 2010, the Company did not have any uncertain tax positions. No interest and penalties related to uncertain tax positions were accrued at December 31, 2011 and 2010.
The tax years 2007 through 2010 remain open to examination by the major taxing jurisdictions in which the Company operates. The Company's federal tax return for the year ended December 31, 2009 is currently being audited by the Internal Revenue Service. The Company expects no material changes to unrecognized tax positions within the next twelve months.
Net sales increased 22% from $194,485 in the year ended December 31, 2010 to $238,172 for the year ended December 31, 2011. This increase was primarily attributable to organic growth resulting from increased distribution of existing products throughout our customer base, introduction of new products and international growth. In addition, the Company acquired Born Free Holdings, Ltd. in March 2011, which added approximately $10,175 to net sales in 2011. While net sales increased in 2011, sales were impacted by lower than expected consumer purchases of our new PRODIGY™ car seat and travel system, reduced inventory levels at retail customers and delays in shipping of certain new products.
Gross profit increased 17% from $69,491 for the year ended December 31, 2010 to $81,385 for the year ended December 31, 2011. This increase was primarily attributable to the 22% increase in net sales. Gross profit percentage decreased to 34.2% of sales for the year ended December 31, 2011 from 35.7% in the prior year due to increased costs of raw materials and labor, plus a change in sales mix.
Selling, general and administrative expenses increased 21.1% from $55,501 for the year ended December 31, 2010 to $67,187 for the year ended December 31, 2011. This increase was primarily attributable to increased variable costs such as co-op advertising allowances as a result of the significant increase in sales. In addition, there were increased expenditures in product development, payroll, professional fees, and warehouse operations. Finally, there were several significant items incurred during 2011 including professional fees and transition costs related to the Born Free acquisition, related to the proposed settlement of outstanding litigation, $482 related to the closure and relocation of our Rhode Island distribution center and $773 of severance for three former senior management employees.
Other expenses increased 40% from $7,403 for the year ended December 31, 2010 to $10,387 for the year ended December 31, 2011. This increase was attributable to an increase in depreciation and amortization in 2011 and higher interest expense.
Liquidity and Capital Resources
We generally fund our operations and working capital needs through cash generated from operations and borrowings under our credit facility.
Our sales have increased significantly over the past several years. This sales growth has led to a substantial increase in working capital requirements, specifically accounts receivable and inventory. The typical cash flow cycle is as follows:
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Inventory is purchased to meet expected demand plus a safety stock. Because the majority of our vendors are based in Asia, inventory takes from three to four weeks to arrive from Asia to the various distribution points we maintain in the United States, Canada and the United Kingdom. Payment terms for these vendors are approximately 30-60 days from the date the product ships from Asia, therefore we are generally paying for the product a short time after it is physically received in the United States. The increased sales we have experienced result in increased levels of inventory and, therefore, an increase in the amount of cash required to fund our inventory level.
Sales to customers generally have payment terms of 60 days. The increased sales have resulted in an increase in the level of accounts receivable, and therefore have increased the amount of cash required to fund working capital.
We have traditionally been able to fund our increased working capital through lines of credit with banks.
The majority of capital expenditures are for tools related to new product introductions. We receive indications from retailers generally around the middle of each year as to what products the retailer will be taking into its product line for the upcoming year. Based on these indications, we will then acquire the tools required to build the products. In most cases the payments for the tools are spread out over a three to four month period.
For the year ended December 31, 2011, net cash provided by operating activities totaled $9,385, which primarily relates to improved working capital management. At December 31, 2010, net cash used in operating activities totaled $8,861. The change in net cash relating to operating activities in 2011 as compared to 2010 is largely attributable to decreases in accounts payable and accounts receivable in 2011.
For the year ended December 31, 2011, net cash used in investing activities was approximately $20,769 which primarily relates to capital expenditures and the Born Free acquisition. At December 31, 2010, net cash used in investing activities was $8,782. The increase in net cash used in investing activities in 2011 was due primarily to the Born Free acquisition.
For the year ended December 31, 2011, net cash provided by financing activities was approximately $11,189 which relates to borrowings from our debt facilities to fund the Born Free acquisition and working capital growth. At December 31, 2010, net cash provided by financing activities was $17,377. The decrease in 2011 in net cash provided by financing activities was due primarily to lower borrowings.
Based primarily on the above factors, the net cash increase for the year ended December 31, 2011 was approximately $77, resulting in a cash balance of approximately $1,215 at December 31, 2011.
We believe that our cash on hand and current banking facilities are sufficient to fund our cash requirements for at least the next 12 months. However, unforeseen circumstances, such as softness in the retail industry or deterioration in the business of a significant customer could create a situation where we cannot access all of the available lines of credit due to not having sufficient assets or consolidated EBITDA (as defined in the credit agreement described below) as required under our loan agreements. There is no assurance that we will meet all of our bank covenants in the future, or that our lender will grant waivers if there are covenant violations. In addition, should we need to raise additional funds through additional debt or equity financings, any sale of additional debt or equity securities may cause dilution to existing stockholders. If sufficient funds are not available or are not available on acceptable terms, our ability to address any unexpected changes in our operations could be limited. Furthermore, there can be no assurance that we will be able to raise such funds if and when they are required. Failure to obtain future funding when needed or on acceptable terms could materially adversely affect our results of operations.
Our strategy for funding our business going forward is a combination of increased profitability, and if necessary, negotiation of increased borrowing lines as required with traditional lenders.
In August 2010, we entered into a secured credit agreement with Bank of America, N.A., as Administrative Agent, and each of the financial institutions that is a signatory to the Agreement. The agreement was amended on March 24, 2011 and on November 9, 2011 (as amended, the "Loan Agreement"). The Loan Agreement provides for an $80,000 working capital revolving credit facility and a $20,000 "accordion" credit facility. The loan matures on June 30, 2013.
Summer and its subsidiaries, Summer Infant (USA), Inc., Summer Infant Europe Limited, Summer Infant Asia Limited and Summer Infant Canada, Limited are the borrowers under the Loan Agreement. This loan agreement replaced Summer's prior line of credit and is being used principally to fund growth opportunities and for working capital purposes.
Our ability to borrow under the Loan Agreement is subject to its ongoing compliance with a number of financial and other covenants, including the following (i) that Summer and its subsidiaries maintain consolidated EBITDA, as defined in the Loan Agreement, of at least $20,000 on a trailing twelve month basis as of December 31, 2011, which escalates to $23,000 by the end of the loan term in 2013, (ii) that Summer and its subsidiaries maintain a ratio of total funded debt to consolidated EBITDA of not greater than 3.25:1.00, and (iii) that Summer and its subsidiaries maintain a ratio of operating cash flow to debt service of not less than 1.50:1.00. Upon utilizing all approved and permitted Add Backs, as defined in the Loan Agreement, the Company is in compliance with these and other covenants at December 31, 2011.
These credit facilities bear interest at a floating rate based on a spread over LIBOR ranging from 200 basis points to 300 basis points, depending upon the ratio of the Company's total funded debt to consolidated EBITDA. The Company has also entered into various interest swap agreements which fixes the interest rates on a portion of the outstanding debt. Only one of these swaps remains active at December 31, 2011. As of December 31, 2011, the rate on these credit facilities averaged 3.69%. In addition, these credit facilities have an unused line fee based on the unused amount of the credit facilities equal to 25 basis points.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Summary of critical accounting policies and estimates
The Company’s critical accounting policies are disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. There have been no material changes to these policies during the first three months of 2012. The policies noted below are presented to assist in understanding the consolidated financial statements appearing in this report. The consolidated financial statements and notes are representations of management, which is responsible for their integrity and objectivity. These accounting policies conform to accounting principles generally accepted in the United States of America (“GAAP”) and have been consistently applied in the preparation of the consolidated financial statements.
Management of the Company is required to make certain estimates and assumptions during the preparation of our consolidated financial statements that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. The accounting policies described below are those that management considers critical in preparing the Company’s financial statements. Some of these policies include significant estimates made by management using information available at the time the estimates were made. The Company’s significant accounting estimates have historically been and are expected to remain reasonably accurate, but actual results could differ materially from those estimates under different assumptions or conditions.
Sales
Our sales are primarily derived from the sale of juvenile health, safety and wellness products and are recognized upon transfer of title of product to our customers. Our products are marketed through several distribution channels including mass merchant retailers, independent specialty retailers, on-line retailers and direct to consumers. There are not significant variations in seasonal demand for our products.
Over 90% of sales are currently made to customers in North America, with remaining sales primarily made to customers in the United Kingdom. Sales are made utilizing standard credit terms of 30 to 60 days. We generally accept returns only for defective merchandise.
Cost of goods sold and other expenses
Our products are manufactured by third parties, principally located in Asia, with approximately 90% of the manufactured cost dollar value occurring in that region. The majority of the balance of our products are manufactured in the United States. Cost of goods sold primarily represents purchases of finished products from these third party manufacturers. The remainder of our cost of goods sold includes duties on certain imported items, freight-in from suppliers and miscellaneous charges from contract manufacturers. Substantially all of our purchases are made in US dollars; therefore, most of this activity is not subject to currency fluctuations. If our suppliers experience increased raw materials, labor or other costs and pass along such cost increases through higher prices for finished goods, our costs of sales would increase, and to the extent we are unable to pass such price increases along to our customers, our gross margins would decrease, and therefore, adversely affect our profitability.
Selling, general and administrative expenses
Selling, general and administrative expenses primarily consist of payroll, insurance, professional fees, royalties, freight out to customers, product development costs, advertising and marketing expenses (including co-op advertising allowances as negotiated with certain customers) and sales commissions. Several of these items fluctuate with volume based on sales to particular customers and or sales of particular products.
Company Overview
We are a designer, marketer, and distributor of branded juvenile health, safety and wellness products (for ages 0-3 years) which are sold principally to large North American and United Kingdom retailers. We currently market products in various product categories including nursery audio/video monitors, safety gates, durable bath products, bed rails, nursery products, booster and potty seats, bouncers, travel accessories, high chairs, swings, feeding products, car seats, and nursery furniture. Our business has grown organically in all our markets. Our revenue is driven by our ability to design and market desirable products, identify business opportunities and secure new and renew existing distribution channels. Our income from operations is derived from our ability to generate revenue and collect cash in excess of labor and other cost of providing our product and selling, general and administrative costs.
Our strategy is to grow our sales through a variety of methods, including:
•increased product penetration (more products at each store);
•increased store penetration (more stores within each retail customer);
•new products (at existing and new customers);
•new mass merchant retail customers;
•new distribution channels (food and drug chains, price clubs, home centers, and web-based retailers);
•new geographies (international expansion);
•new product categories; and
•acquisitions.
We have has been able to grow our annual revenues historically through a combination of all of the above factors. Each year we have been able to expand the number of products in our main distribution channel, (mass merchant retailers) and have also added new customers each year.
For 2012 and beyond, our growth strategy will be to continue to develop and sell new products to our existing customer base, sell new and existing products to new customers (or expand relationships with existing customers), and to expand in the United Kingdom and in other geographic regions (including Japan, Mexico and Australia, among others).
In addition, in the past we have pursued and we expect to continue to pursue potential acquisition candidates to obtain new innovative products, acquire product categories in which we currently do not participate, gain shelf space by adding retail customers or expand distribution with the addition of new sales territories.
As we continue to grow through internal initiatives and potential future acquisitions, we will incur additional expenses. Two of the key areas in which such increased expenses will likely occur are sales and product development. To grow sales, we will likely hire additional sales personnel to service new geographic territories, focus existing resources on specific parts of the United States market and retain product line specialists to drive sales of new and existing products in specific areas in which we believe we can readily increase sales. Product development expenses are expected to increase as we develop new products in existing and new categories. As a result of our acquisition strategy, we will face various challenges such as the integration of the acquired companies’ product lines, employees, marketing requirements and information systems. Ongoing infrastructure investment may be required to support realized growth, including expenditures with respect to upgraded and expanded information systems and enhancing the Company’s management team.
Recent Developments
As further described in Item 5 of Part II of this report and in the “Liquidity and Capital Resources” section below, on May 11, 2012, we entered into an amendment to our existing credit facility with our senior lenders. Among other things, this amendment extended the maturity date of loans under the agreement to December 31, 2013 and revised financial covenants with which the Company must comply during the term of the agreement.
Outlook
Our business, financial condition and results of operations have and may continue to be affected by various economic factors. We expect the retail environment in the second quarter of 2012 to remain challenging due to a heightened promotional environment. We believe we have a sound plan in place for 2012 to achieve our goals, which includes the introduction of our new PEEK monitoring system, the re-launch of our PRODIGY car seat and travel system, and other new product initiatives and marketing programs, as well as initiatives to expand our gross margins in the second half of 2012 through price increases and product cost improvements. Although other factors will likely impact us, including some we do not foresee and those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011, we believe our performance in 2012 may be affected by the following:
• Economic Climate . Periods of global economic uncertainty, such as the recession experienced in 2008 and much of 2009, as well as recent market disruptions, can lead to reduced consumer and business spending. The current economic climate continues to affect our business in direct and indirect ways, including reduced consumer demand for our products, tighter inventory management by retailers, reduced profit margins due to pricing pressures and a sales mix favoring lower margin products. In addition, reduced access to credit has and may continue to adversely affect consumers who desire to purchase our products from retailers and the ability of our own customers to pay us. A continuing decline in U.S. birth rates, attributable in part to recent economic conditions, could also contribute to lower sales of our products.
• Retail Market Conditions . Our industry is very competitive, with increasing pressure from mass merchant retailers on pricing in reaction to perceived lack of consumer confidence. These customers continue to seek favorable pricing from us and we expect this trend will continue in 2012. As a result, we expect continued pricing pressures throughout 2012. We are addressing the difficult retail environment by increasing prices and making product cost improvements, among other things.
• Debt Financing . In May 2012, we amended our existing credit facility to extend the maturity date of loans under that agreement to December 31, 2013 and also to modify financial covenants under that agreement. As of March 31, 2012, we had an outstanding principal balance of approximately $68.3 million under the agreement. Because part of our cash flow must go to interest payments on our existing indebtedness, the amount of available cash for working capital, capital expenditures, acquisitions and other general corporate purposes may be limited.
Liquidity and Capital Resources
Our principal sources of liquidity are generated from cash flow from operations and borrowings from availability under our bank credit facility. Cash flow from operations and borrowings under our credit facility are expected to be sufficient to fund the Company’s operating and capital requirement needs for at least the next twelve months.
Our sales have increased significantly over the past several years. This sales growth has led to a substantial increase in working capital requirements, specifically trade receivables and inventory. The typical cash flow cycle is as follows:
• Inventory is purchased to meet expected demand plus a safety stock. Because the majority of our vendors are based in Asia, inventory takes from four to six weeks to arrive from Asia to the various distribution points we maintain in the United States, Canada and the United Kingdom. Payment terms for these vendors are approximately 30-60 days from the date the product ships from Asia, therefore, we are generally paying for the product a short time after it is physically received in the United States, Canada and the United Kingdom. The increased sales we have experienced result in the requirement for increased levels of inventory purchases, and therefore an increase in the amount of cash required to fund our inventory level.
• Sales to customers generally have payment terms of 60 days. The increased sales have resulted in an increase in the level of accounts receivable, and therefore have increased the amount of cash required to fund working capital.
We have traditionally been able to fund our increased working capital needs utilizing the credit facility under the Loan Agreement with our banks.
The majority of our capital expenditures are for tools related to new product introductions. We receive indications from retailers generally around the middle of each year related to product orders they will be taking for the upcoming year. Based on these indications, we will then place tooling capital orders required to build the products. In most cases, the payments for the tools are amortized over a three to four month period.
For the three months ended March 31, 2012, net cash used by operating activities was $5,049 compared to $4,559 at March 31, 2011. In 2012, this was primarily due to an increase in accounts receivable of $9,828. In 2011, the net cash used by operating activities was primarily the result of decreases in accounts payable and accrued expenses offset by a decrease in inventory.
Net cash used in investing activities was $811 compared to $718 at March 31, 2011, which primarily relates to the acquisition of property, plant and equipment in both periods.
Net cash provided by financing activities was $6,549 compared to $17,440 at March 31, 2011, which in both periods relates to borrowings under the Company’s credit facility. The reduction in this amount in 2012 is attributable to the prior year reflecting borrowing to finance the Born Free Holdings, LTD acquisition.
Based on the above factors, the net cash increase for the three months ended March 31, 2012 was $491, resulting in a cash balance of $1,706 at March 31, 2012.
Our strategy for funding our business going forward is to generate cash from increased profitability, and where necessary, utilize borrowing availability under our existing lines of credit. . In the case of needing additional cash required to support potential acquisitions, the Company would need to negotiate for increased funding availability with its current bank group or with other similar traditional lenders.
In August 2010, the Company and its subsidiaries entered into a secured credit facility with Bank of America, N.A., as Administrative Agent, and each of the financial institutions as a signatory to the agreement. The agreement was subsequently amended on March 24, 2011, November 9, 2011 and, as described below, on May 11, 2012 (as amended, the “Loan Agreement”). The Loan Agreement provides for an $80,000 working capital revolving credit facility The amounts outstanding under the revolving credit facility are payable in full upon maturity and the credit facility matures on December 31, 2013. The credit facility under the Loan Agreement is secured by substantially all of the assets of the Company. The amount outstanding on the credit facility at March 31, 2012 was $68,250; our capacity was approximately $71,800.
On May 11, 2012, the Company entered into an amendment (the “2012 Amendment”) that revised the Company’s financial covenants and extended the maturity date an additional six months to December 31, 2013. In addition, the prior $20,000 “accordion” feature was removed and two additional pricing tiers based on the leverage covenant performance were added. Also in connection with the 2012 Amendment, the Bank and waived certain events of default that existed on March 31, 2012. The 2012 Amendment is described in more detail in Item 5 of Part II of this report.
The Company’s ability to borrow under the Loan Agreement is subject to its ongoing compliance with a number of financial and other covenants, as revised in the 2012 Amendment, including that (a) the Company and its subsidiaries maintain and earn on a consolidated basis as of the last day of each fiscal quarter, consolidated EBITDA (as defined in the Loan Agreement) for the twelve month period ending on such date equal to or greater than $17,500 beginning with the quarter ending June 30, 2012, and increasing over the remaining term of the Loan Agreement to $23,000 for each quarter ending on or after June 30, 2013; (b) the Company and its subsidiaries maintain a ratio of total funded debt to consolidated EBITDA of not greater than (i) 4.25:1.00 on June 30, 2012, (ii) 3.75:1.00 on September 30, 2012, (iii) 3.50:1.00 on December 31, 2012, and (iv) 3.25:1.00 on March 31, 2013 and thereafter; and (c) the Company and its subsidiaries maintain a fixed charge ratio of at least 1.50:1.00.
The Loan Agreement allows the Company to borrow under the credit facility at LIBOR or at a base rate, plus applicable margins based on the funded debt to EBITDA leverage ratio for the most recent twelve month rolling quarter end. Applicable margins vary between a 200 to 375 basis point spread over LIBOR and between a zero to 175 basis point spread on base rate loans. The Company has also entered into various interest rate swap agreements which effectively fix the interest rates on a portion of the outstanding debt, of which one is still active at March 31, 2012. As of March 31, 2012, the rate on the credit facility dates averaged 4.03%. In addition, the credit facility has an unused line fee based on the unused amount of the credit facility equal to 25 basis points.
The Loan Agreement also contains customary events of default, including a cross default provision and a change of control provision. In the event of a default, all of the obligations of the Company and its subsidiaries under the Loan Agreement may be declared immediately due and payable. For certain events of default relating to insolvency and receivership, all outstanding obligations become due and payable.
The Company believes that it will be able to comply with the financial covenants of the Loan Agreement, as amended by the 2012 Amendment, and will also have sufficient working capital available to it under the Loan Agreement credit facility to meet its cyclical operational cash flow needs.
We believe that our cash flows from operations, cash on hand, and available borrowings will be sufficient to meet our working capital and capital expenditure requirements and provide us with adequate liquidity to meet anticipated operating needs for at least the next twelve months. Our cash requirements for the period beyond that are expected to be met by the continued use of our bank credit facility to meet working capital requirements. However, unforeseen circumstances, such as softness in the retail industry or deterioration in the business of a significant customer, could create a situation where we cannot access all of the available lines of credit due to not having sufficient assets or consolidated EBITDA as required under our Loan Agreement. There is no assurance that we will meet all of our bank covenants in the future, or that our lender will grant waivers if there are covenant violations.
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Fund Letters
