Rocky Brands - 10-Q quarterly report FY

 

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days. YES þ NO o

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

As of November 2, 2006, 5,405,218 shares of Rocky Brands, Inc. common stock, no par value, were outstanding.

 

 

See notes to the interim unaudited condensed consolidated financial statements.

NOTES TO THE INTERIM UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED
SEPTEMBER 30, 2006 AND 2005

“modified prospective” method, disclosure of pro forma information for periods prior to adoption must continue to be presented. The following table sets forth the effect on net income and earnings per share as if SFAS 123 “Accounting for Stock-Based Compensation” had been applied to the three- and nine-month periods ended September 30, 2005.

No options were granted during the three-month period ended September 30, 2005. The fair value of options granted during the nine-month period ended September 30, 2005 was established at the date of grant using the Black-Scholes pricing model with the weighted average assumptions as follows:

The pro forma amounts may not be representative of the effects on reported net income for future years.

A reconciliation of the shares used in the basic and diluted income per common share computation for the three and nine months ended September 30, 2006 and 2005 is as follows:

We have allocated the purchase price to the tangible and intangible assets and liabilities acquired based upon the fair values and income tax basis. Goodwill resulting from the transaction has been allocated entirely to the wholesale reportable segment and is not tax deductible. The purchase price has been allocated as follows:

During the second quarter of 2006, a net operating loss carry forward recorded in the purchase as a deferred tax asset was reduced by $0.9 million and goodwill was increased by $0.9 million as a result of finalization of the income tax basis of net operating losses of EJ incurred prior to the purchase.

Identified intangibles have been allocated as follows:

The results of operations of EJ are included in the results of operations of the Company effective January 1, 2005, as management determined that results of operations were not significant and no material transactions occurred during the period from January 1, 2005 to January 6, 2005.

Amortization expense for intangible assets was $143,600 and $172,230 for the three-months ended September 30, 2006 and 2005, respectively, and $430,385 and $516,098 for the nine-months ended September 30, 2006 and 2005, respectively. The weighted average amortization period for patents is six years and for customer relationships is five years.

During the nine-month period ending September 30, 2006, a total of 50,575 options were exercised with an intrinsic value of approximately $0.8 million. A total of 114,739 options vested during the nine months ending September 30, 2006 with a fair value of $0.8 million. At September 30, 2006, a total of 418,026 options were vested and exercisable with an intrinsic value of $1.5 million and a fair value of $0.6 million. At September 30, 2006, a total of 125,250 options were unvested with an intrinsic value of $0.2 million and a fair value of $0.1 million.

Our unrecognized benefit obligations existing at the date of transition for the non-union plan are being amortized over twenty-one years. Actuarial assumptions used in the accounting for the plans were as follows:

The following table sets forth, for the periods indicated, information derived from our Interim Unaudited Condensed Consolidated Financial Statements, expressed as a percentage of net sales. The discussion that follows the table should be read in conjunction with our Interim Unaudited Condensed Consolidated Financial Statements.

Net sales. Net sales for the three months ended September 30, 2006 were $78.1 million compared to $94.1 million for the same period in 2005. Wholesale sales for the three months ended September 30, 2006 were $63.4 million compared to $70.7 million for the same period in 2005. The $7.3 million decrease in sales is the result of decreases in sales in our outdoor footwear, outdoor apparel and western footwear categories. Retail sales for the three months ended September 30, 2006 were $14.6 million compared to $14.0 million for the same period in 2005. Military segment sales, which occur from time to time, for the three months ended September 30, 2006 were $0.2 million, compared to $9.4 million in the same period in 2005. Fiscal year 2005 sales reflect shipments under U.S. Military contracts that we held directly. Average list prices for our footwear, apparel and accessories were slightly higher in the 2006 period compared to the 2005 period due to price increases of approximately 2% on certain products.

Gross margin. Gross margin in the three months ended September 30, 2006 was $32.1 million, or 41.1% of net sales, compared to $34.1 million, or 36.2% of net sales, in the same period last year. The 490 basis point increase is primarily attributable to a reduction in lower margin military sales. Wholesale gross margin for the three months ended September 30, 2006 was $24.4 million, or 38.5% of net sales, compared to $25.2 million, or 35.7% of net sales, in the same period last year. The 280 basis point increase reflects an increased mix of sales of work and western products, which carry higher margins than outdoor products. Retail gross margin for the three months ended September 30, 2006 was $7.7 million, or 52.7% of net sales, compared to $7.3 million, or 52.0% of net sales, for the same period in 2005. Military gross margin for the three months ended September 30, 2006 was less than $0.1 million or 17.0% of net sales, compared to $1.6 million, or 16.7% of net sales, for the same period in 2005.

SG&A expenses. SG&A expenses were $22.6 million, or 28.9% of net sales, for the three months ended September 30, 2006, compared to $21.8 million, or 23.2% of net sales for the same period in 2005. The net change reflects higher advertising expenses of $0.5 million and increased professional fees of $0.3 million.

Interest expense. Interest expense was $2.9 million in the three months ended September 30, 2006, compared to $2.5 million for the same period in the prior year. The increase reflects higher interest rates.

Income taxes. Income tax expense for the three months ended September 30, 2006 was $2.5 million, compared to an expense of $3.4 million for the same period a year ago. Our estimated effective tax rate was 37% for the three months ended September 30, 2006, versus 34% for the same period in 2005. The increase in our effective tax rate in 2006 was due primarily to the cessation of income tax incentive programs for our Lifestyle Footwear, Inc. and Five Star Enterprises Ltd. operations.

Net sales. Net sales for the nine months ended September 30, 2006 were $192.9 million compared to $221.1 million for the same period in 2005. Wholesale sales for the nine months ended September 30, 2006 were $147.1 million compared to $158.1 million for the same period in 2005. Gains in sales in our work and western footwear categories were offset by decreases in sales in our outdoor footwear and apparel categories. Retail sales for the nine months ended September 30, 2006 were $44.8 million compared to $44.1 million for the same period in 2005. Military segment sales, which occur from time to time, for the nine months ended September 30, 2006 were $1.1 million, compared to $18.9 million in the same period in 2005. Fiscal year 2005 sales reflect shipments under U.S. Military contracts that we held directly.

Gross margin. Gross margin in the nine months ended September 30, 2006 was $81.1 million, or 42.0% of net sales, compared to $84.0 million, or 38.0% of net sales, in the same period last year. The 400 basis point increase is primarily attributable to a reduction in lower margin military sales. Wholesale gross margin for the nine months ended September 30, 2006 was $57.0 million, or 38.8% of net sales, compared to $57.9 million, or 36.6% of net sales, in the same period last year. The 220 basis point increase reflects an increased mix of sales of work and western products, which carry higher margins than outdoor products. Retail gross margin for the nine months ended September 30, 2006 was $23.9 million, or 53.4% of net sales, compared to $23.3 million, or 52.8% of net sales, for the same period in 2005. Military gross margin for the nine months ended September 30, 2006 was $0.2 million, or 15.1% of net sales, compared to $2.8 million, or 14.8% of net sales, for the same period in 2005.

SG&A expenses. SG&A expenses were $65.2 million, or 33.8% of net sales, for the nine months ended September 30, 2006, compared to $62.0 million, or 28.0% of net sales for the same period in 2005. The net change reflects an increase in payroll and healthcare costs of $2.8 million that includes a $0.4 million pension curtailment charge relating to freezing the non-union pension plan at the end of 2005, higher advertising expenses of $0.7 million, higher trade show expenses of $0.4 million, and additional professional fees $0.7 million. This is offset by the $0.7 million gain on the sale of a company-owned property that was sold in March 2006.

Interest expense. Interest expense was $8.3 million in the nine months ended September 30, 2006, compared to $6.5 million for the same period in the prior year. The increase reflects higher interest rates coupled with a $0.4 million charge relating to deferred financing charges under the initial Note Purchase Agreement with ACAS.

Income taxes. Income tax expense for the nine months ended September 30, 2006 was $2.9 million, compared to $5.4 million for the same period a year ago. Our estimated effective tax rate was 37% for the nine months ended September 30, 2006, versus 34% for the same period in 2005. The increase in our effective tax rate in 2006 was due primarily to the cessation of income tax incentive programs for our Lifestyle Footwear, Inc. and Five Star Enterprises Ltd. operations.

Our principal sources of liquidity have been our income from operations, borrowings under our credit facility and other indebtedness. In January 2005, we incurred additional indebtedness to fund our acquisition of EJ Footwear as described below.

Over the last several years our principal uses of cash have been for our acquisitions of EJ Footwear and certain assets of Gates-Mills, as well for working capital and capital expenditures to support our growth. Our working capital consists primarily of trade receivables and inventory, offset by accounts payable and accrued expenses. Our working capital fluctuates throughout the year as a result of our seasonal business cycle and business expansion and is generally lowest in the months of January through March of each year and highest during the months of May through October of each year. We typically utilize our revolving credit facility to fund our seasonal working capital requirements. As a result, balances on our revolving credit facility will fluctuate significantly throughout the year. Our capital expenditures relate primarily to projects relating to our property, merchandising fixtures, molds and equipment associated with our manufacturing operations and for information technology. Capital expenditures were $4.6 million for the first nine months of 2006, compared to $4.3 million for the same period in 2005. Capital expenditures for all of 2006 are anticipated to be approximately $5.5 million.

In conjunction with the completion of our acquisition of EJ Footwear in January 2005, we entered into agreements with GMAC and ACAS for credit facilities totaling $148 million. The credit facilities were used to fund the acquisition of EJ Footwear and replace our prior $45 million revolving credit facility. Under the terms of the agreements, the interest rates and repayment terms were: (1) a five-year, $100 million revolving credit facility with an interest rate of LIBOR plus 2.5% or prime plus 1.0%; (2) an $18 million term loan with an interest rate of LIBOR plus 3.25% or prime plus 1.75%, payable in equal quarterly installments over three years beginning in 2005; and (3) a $30 million term loan with an interest rate of LIBOR plus 8.0%, payable in equal installments from 2008 through 2011. The total amount available on our revolving credit facility is subject to a borrowing base calculation based on various percentages of accounts receivable and inventory.

In June 2006, we amended our debt agreement with GMAC to include a new three-year, $15 million term loan with an interest rate of (1) LIBOR plus 3.25% or (2) prime plus 1.75%, payable over three years beginning in September 2006. The proceeds from the new term loan were used to pay down the $30 million ACAS term loan. In conjunction with this repayment, we amended the terms of the ACAS term loan, including lowering the interest rate to LIBOR plus 6.5%, adjusting the repayment schedule to reflect the lower loan balance payable in equal installments from August 2009 to January 2011, and modifying certain restrictive loan covenants.

The total amount available on our revolving credit facility is subject to a borrowing base calculation based on various percentages of accounts receivable and inventory. As of September 30, 2006, we had $89.7 million in borrowings under this facility and total capacity of $94.0 million. Our credit facilities contain certain restrictive covenants, which among other things, require us to maintain certain minimum EBITDA and certain leverage and fixed charge coverage ratios. As of September 30, 2006, we were in compliance with all of these loan covenants except for minimum EBITDA, senior and total leverage. We have received waivers from the lending institutions regarding these covenants. Costs associated with the obtaining the waivers totaled $275,000 and will be reflected in our fourth quarter operating results.

In November 2006, we amended the terms of the restrictive covenants through December 2007, pertaining to minimum EBITDA, senior and total leverage, and fixed charges, contained within our debt agreement with GMAC and our term loan agreement with ACAS. Additionally, the amendment to the term loan agreement with ACAS increased the interest rate to LIBOR plus 8.5%.

We believe that our existing credit facilities coupled with cash generated from operations will provide sufficient liquidity to fund our operations for at least the next twelve months. Our continued liquidity, however, is contingent upon future operating performance, cash flows and our ability to meet financial covenants under our credit facilities.

Operating Activities. Cash used in operating activities totaled $18.1 million in the first nine months of 2006, compared to $15.2 million in the same period of 2005. Cash used in operating activities was impacted by a seasonal buildup of both inventories and accounts receivable, and an increase in accounts payable reflecting payments due to overseas vendors.

Investing Activities. Cash used in investing activities was $2.9 million for the first nine months of 2006, compared to a usage of cash of $97.2 million in 2005. Cash used by investing activities in 2006 reflects an investment in property plant and equipment of $4.6 million, offset by the sale of the Harper Street warehouse facility for $1.9 million. Our acquisition of EJ Footwear for $92.9 million and investment in property plant and equipment of $4.3 million impacted 2005 expenditures. Our 2006 expenditures primarily relate to investments in production equipment and expansion of workspace at our office building to accommodate the relocation of the EJ Footwear operations.

Financing Activities. Cash provided by financing activities for the nine months ended September 30, 2006 was $21.7 million, reflecting an increase in net borrowings under the revolving credit facility of $30.2 million, a new $15.0 million term loan, and proceeds from the exercise of stock options of $0.3 million, partially offset by repayments on long-term debt of $23.2 million and debt financing costs of $0.6 million. As described above, the proceeds from the new $15 million term loan were used to repay $15 million of existing debt that bore a higher interest rate. Cash provided by financing activities for the nine months ended September 30, 2005 was $109.4 million, which was comprised of the cash proceeds from debt financing of $111.0 million, primarily used to fund the acquisition of EJ Footwear, and proceeds from the exercise of stock options of $0.8 million, partially offset by debt financing costs of $2.3 million.

We cannot determine the precise effects of inflation; however, inflation continues to have an influence on the cost of materials, salaries, and employee benefits. We attempt to offset the effects of inflation through increased selling prices, productivity improvements, and reduction of costs.

“Management’s Discussion and Analysis of Financial Condition and Results of Operations” discusses our interim condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these interim condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the interim condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. A summary of our significant accounting policies is included in the Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2005.

Our management regularly reviews our accounting policies to make certain they are current and also to provide readers of the interim condensed consolidated financial statements with useful and reliable information about our operating results and financial condition. These include, but are not limited to, matters related to accounts receivable, inventories, pension benefits and income taxes. Implementation of these accounting policies includes estimates and judgments by management based on historical experience and other factors believed to be reasonable. This may include judgments about the carrying value of assets and liabilities based on considerations that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Our management believes the following critical accounting policies are most important to the portrayal of our financial condition and results of operations and require more significant judgments and estimates in the preparation of our interim condensed consolidated financial statements.

Revenue principally consists of sales to customers, and, to a lesser extent, license fees. Revenue is recognized when the risk and title passes to the customer, while license fees are recognized when earned. Customer sales are recorded net of allowances for estimated returns, trade promotions and other discounts, which are recognized as a deduction from sales at the time of sale.

Management maintains allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Management also records estimates for customer returns and discounts offered to customers. Should a greater proportion of customers return goods and take advantage of discounts than estimated by us, additional allowances may be required.

We record a reduction to gross sales based on estimated customer returns and allowances. These reductions are influenced by historical experience, based on customer returns and allowances. The actual amount of sales returns and allowances realized may differ from our estimates. If we determine that sales returns or allowances should be either increased or decreased, then the adjustment would be made to net sales in the period in which such a determination is made.

Management identifies slow moving or obsolete inventories and estimates appropriate loss provisions related to these inventories. Historically, these loss provisions have not been significant as the vast majority of our inventories are considered saleable and we have been able to liquidate slow moving or obsolete inventories through our factory outlet stores or through various discounts to customers. Should management encounter difficulties liquidating slow moving or obsolete inventories, additional provisions may be necessary. Management regularly reviews the adequacy of our inventory reserves and makes adjustments to them as required.

Intangible assets, including goodwill, trademarks and patents are reviewed for impairment at least annually or whenever there is an indication that may create impairment. None of our intangibles were impaired as of September 30, 2006.

Accounting for pensions involves estimating the cost of benefits to be provided well into the future and attributing that cost over the time period each employee works. To accomplish this, extensive use is made of assumptions about inflation, investment returns, mortality, turnover, medical costs and discount rates. These assumptions are reviewed annually.

Pension expenses are determined by actuaries using assumptions concerning the discount rate, expected return on plan assets and rate of compensation increase. An actuarial analysis of benefit obligations and plan assets is determined as of September 30 each year. The funded status of our plans and reconciliation of accrued pension cost is determined annually as of December 31. Further discussion of our pension plan and related assumptions is included in Note 9, “Retirement Plans,” to the unaudited condensed consolidated financial statements for the quarterly period ended September 30, 2006. Actual results would be different using other assumptions. Management records an accrual for pension costs associated with our sponsored noncontributory defined benefit pension plan covering our non-union workers. Future adverse changes in market conditions or poor operating results of underlying plan assets could result in losses or a higher accrual. At December 31, 2005, we froze the non-contributory defined benefit pension plan for all non-U.S. territorial employees. As a result of freezing the plan, we have recognized a charge for previously unrecognized service costs of approximately $0.4 million during the nine-month period ended September 30, 2006.

Currently, management believes that deferred tax assets will, more likely than not, be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance, however, in the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination is made.

Except for the historical information contained herein, the matters discussed in this Quarterly Report on Form 10-Q include certain 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, which are intended to be covered by the safe harbors created thereby. Those statements include, but may not be limited to, all statements regarding our and management’s intent, belief, and expectations, such as statements concerning our future profitability and our operating and growth strategy. Words such as “believe,” “anticipate,” “expect,” “will,” “may,” “should,” “intend,” “plan,” “estimate,” “predict,” “potential,” “continue,” “likely” and similar expressions are intended to identify forward-looking statements. Investors are cautioned that all forward-looking statements contained in this Quarterly Report on Form 10-Q and in other statements we make involve risks and uncertainties including, without limitation, the factors set forth under the caption “Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2005, and other factors detailed from time to time in our other filings with the Securities and Exchange Commission. One or more of these factors have affected, and in the future could affect our businesses and financial results in the future and could cause actual results to differ materially from plans and projections. Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, there can be no assurance that any of the forward-looking statements included in this Quarterly Report on Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. All forward-looking statements made in this Quarterly Report on Form 10-Q are based on information presently available to our management. We assume no obligation to update any forward-looking statements.

There have been no material changes since December 31, 2005.

Disclosure Controls and Procedures. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, our management, with the participation of our chief executive officer and chief financial officer, carried out an evaluation of the effectiveness of our disclosure controls and procedures pursuant to Rules 13a-15 promulgated under the Exchange Act. Based upon this evaluation, our chief executive officer and our chief financial officer concluded that our disclosure controls and procedures were (1) designed to ensure that material information relating to our Company is accumulated and made known to our management, including our chief executive officer and chief financial officer, in a timely manner, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Management believes, however, that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a Company have been detected.

Internal Controls. There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Exchange Act) during our fiscal quarter ended September 30, 2006, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

     None

     There have been no material changes to our risk factors as disclosed in Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005.

     None

     None

     None

     None

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