Item 1.
Business.
This Annual Report on Form 10-K, including the following discussion, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve substantial risks and uncertainties. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, the words “projected”, “anticipated”, “planned”, “expected”, and similar expressions are intended to identify forward-looking statements. In particular, statements regarding retail store expansion and business growth are forward-looking statements. Forward-looking statements are not guarantees of our future financial performance, and undue reliance should not be placed on them. Our actual results, performance or achievements may differ significantly from the results, performance and achievements discussed in or implied by the forward-looking statements. Factors that could cause such a difference include material changes to Dover Saddlery, Inc.’s business or prospects, in consumer spending, fashion trends or consumer preferences, or in general political, economic, business or capital market conditions and other risks and uncertainties, including but not limited to the other factors that are detailed in “Item 1A.
Item 1A.
Risk Factors.
An investment in our common stock involves a high degree of risk. You should carefully consider these risk factors before buying or trading shares of our stock. Any such risks may materialize, and additional risks not known to us, or that we now deem immaterial, may arise. In such event, our business, financial condition, results of operations or prospects could be materially adversely affected. If that occurs, the market price of our common stock could fall, and you could lose all or part of your investment.
This Annual Report on Form 10-K includes or incorporates forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can identify these forward-looking statements by the use of the words “believes”, “anticipates”, “plans”, “expects”, “may”, “will”, “would”, “intends”, “estimates”, and other similar expressions, whether in the negative or affirmative. We cannot guarantee that we actually will achieve the plans, intentions or expectations disclosed in the forward-looking statements made. We have included important factors in the cautionary statements below that we believe could cause actual results to differ materially from the forward-looking statements contained herein. The forward-looking statements do not reflect the potential impact of any future acquisitions, mergers or dispositions. We do not assume any obligation to update any forward-looking statements contained herein.
Our market is highly competitive and we may not continue to compete successfully.
We compete in a highly competitive marketplace with a variety of retailers, dealers and distributors. The equestrian products market is highly fragmented with approximately 10,000 retail store locations nationwide. Many of these are small businesses that have a loyal customer base. We may, therefore, not be able to generate sufficient sales to support our new retail store locations. There are also a significant number of sporting goods stores, mass merchandisers and other better funded companies that could decide to enter into or expand their equestrian products offerings. Liquidating inventory sales by our former competitors may cause us temporarily to lose business and perhaps even to lose customers. In addition, if our continuing competitors reduce their prices, we may have to reduce our prices in order to compete. We may also be forced to increase our advertising or mail a greater number of catalogs in order to generate the same or even lower level of sales. Any one of these competitive factors could adversely affect our revenues and profitability. It is possible that increased competition or improved performance by our competitors may reduce our market share, may reduce our profit margin, and may adversely affect our business and financial performance in other ways.
If we cannot successfully execute our planned retail store expansion, our growth and profitability would be adversely impacted.
We currently have ten retail stores and have identified additional locations throughout the U.S. where we plan to open new stores over the next several years. A significant percentage of our projected future growth is expected to be generated from these new locations. If we experience delays in opening new stores, fail to select appropriate sites, encounter problems in opening new locations, or have trouble achieving anticipated sales volume in new locations, our growth and profitability will be adversely impacted. Four of our six retail stores opened in areas previously served only by direct sales and so our experience observing the effects of new stores on our overall sales revenues is limited Any one or more of the new stores we intend to open may not be profitable, in which event our operating results may suffer.
Our ability to expand our retail presence depends in part on the following factors:
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our ability to identify suitable locations in key markets with attractive demographics and which offer attractive returns on our investments;
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the availability of suitable locations at price points consistent with our expansion model;
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our ability to negotiate favorable lease and construction terms for such locations;
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our ability to execute sale/leaseback transactions on satisfactory terms, if at all;
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competition for such locations;
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the timely construction of such retail stores;
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our ability to receive local and state government permits and approvals in connection with such locations;
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our ability to attract, train, and retain skilled and knowledgeable store personnel;
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our ability to provide a product mix that meets the needs of our customers; and
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favorable economic conditions.
In addition, each retail store is expected to require approximately $0.9 to $1.5 million of capital, including start up costs, leasehold improvements and inventory, and excluding the cost of the real estate. If actual costs are higher than expected or if sales in such stores are lower than expected, we may not be able to open as many retail stores as anticipated or we will need to raise additional capital in order to continue our growth.
We may be unable to continue to open new stores and enter new markets successfully.
An important part of our business plan is to increase our number of stores and enter new geographic markets. Since the IPO, we have opened two new stores and remodeled, expanded and converted four stores from the Dominion Saddlery acquisition. In the future, we plan to open additional stores. For our growth strategy to be successful, we must identify and lease or buy favorable store sites, hire and train associates and adapt management and operational systems to meet the needs of our expanded operations. These tasks may be difficult to accomplish successfully, and may also be restricted by covenants and conditions in our loan agreements. If we are unable to open new stores as quickly as planned, our future sales and profits could be materially adversely affected. Even if we succeed in opening new stores, these new stores may not achieve the same sales or profit levels as our existing stores. Also, our expansion strategy includes opening new stores in markets where we already have a presence so we can take advantage of economies of scale in marketing, distribution and supervision costs. However, these new stores may result in the loss of sales in existing stores in nearby areas.
Our operating results may be impacted by changes in the economy.
Our operating results are directly impacted by the health of and confidence in the North American economy. Current economic conditions may adversely affect our business and our results of operations.
A decline in discretionary consumer spending and related externalities could reduce our revenues.
Our revenues depend to a degree on discretionary consumer spending, which may decrease due to a variety of factors beyond our control. These include unfavorable general business conditions, increases in interest rates, increases in inflation, stock market uncertainty, war, terrorism, fears of war or terrorism, increases in consumer debt levels and decreases in the availability of consumer credit, adverse or unseasonable weather conditions, adverse changes in applicable laws and regulations, increases in taxation, adverse unemployment trends and other factors that adversely influence consumer confidence and spending. Any one of these factors could result in adverse fluctuations in our revenues generally. Our revenues also depend on the extent to which discretionary consumer spending is directed towards recreational activities generally and equestrian activities and products in particular. Reductions in the amounts of discretionary spending directed to such activities would reduce our revenues.
Our customers’ purchases of discretionary items, including our products, may decline during periods when disposable income is lower, or periods of actual or perceived unfavorable economic conditions. If this occurs, our revenues would decline, which may have a material adverse effect on our business.
Our stock price may fluctuate based on market expectations.
The public trading of our stock is based in large part on market expectations that our business will continue to grow and that we will achieve certain levels of net income. If the securities analysts that regularly follow our stock lower their ratings or lower their projections for future growth and financial performance, the market price of our stock is likely to drop significantly. In addition, if our quarterly financial performance does not meet the expectations of securities analysts, our stock price would likely decline. The decrease in the stock price may be disproportionate to the shortfall in our financial performance.
The future sale of shares of our common stock and limited liquidity may negatively impact our stock price.
When our shareholders sell substantial amounts of our common stock, the market price of our common stock could fall. A reduction in ownership by our controlling shareholders or any other large shareholders could cause the market price of our common stock to fall. Similarly, the market may disfavor the adoption of Rule 10b5-1 trading plans by one or more of the Company’s Officers or Directors, perceiving that such a plan represents a decline in management’s confidence about the Company’s prospects or that the parameters for and trading under a Rule 10b5-1 sales plan could cause downward pressure on the stock price. In addition, the average daily trading volume in our stock is relatively low. The lack of trading activity in our stock may lead to greater fluctuations in our stock price. Low trading volume may also make it difficult for shareholders to make transactions in a timely fashion.
Technology failures and privacy and security breaches could adversely affect the company’s business.
A significant part of our overall revenues derives from our website sales. The success of our online business depends in part on factors over which we have limited control. These factors include changing customer preferences, changing buying trends related to Internet usage, changes in technology interfaces, technology failures or human errors, security breaches and consumer privacy concerns. Any failure to respond successfully to these risks and uncertainties might adversely affect sales through our websites, impair our reputation and increase our operating costs.
If our information technology systems fail to perform as designed or if we need to make system changes in order to support our growing direct and retail store businesses, there may be disruptions in operations.
The efficient operation of our business is dependent on our information technology systems and our point of sale, or POS, systems. Our information technology systems are located in Littleton, MA, and our POS systems are located in each retail store. These systems, which operate our website, process transactions, respond to customer inquiries, manage inventory, purchase, sell and ship goods on a timely basis, and maintain cost-effective operations, are subject to damage from natural disasters, power failures, hardware and software failures, security breaches, network failures, computer viruses and operator negligence. The failure of our information technology systems and our POS systems to perform as designed, even if temporary, could adversely affect inventory levels, shipments to customers and customer service. Any such event would have a material adverse effect on our operating results.
We may experience operational problems with our information systems as a result of system failures, viruses, computer “hackers” or other causes. Any material disruption or slowdown of our systems could cause information, including data related to customer orders, to be lost or delayed, which could hurt our business, financial condition and results of operations. Moreover, we may not be successful in developing or acquiring technology that is competitive and responsive to the needs of our customers and might lack sufficient resources to make the necessary investments in technology to compete with our competitors. Accordingly, if changes in technology cause our information systems to become obsolete, or if our information systems are inadequate to handle our anticipated growth, we could lose customers.
While we believe that our systems are adequate to support our planned opening of additional retail stores over the next several years and the future growth of our direct sales business, we may need to upgrade and modify our information technology capabilities. Any upgrades to our information technology systems and our POS systems may not be successful or may cause substantial expenses. In addition, there are inherent risks associated with upgrading our core systems, including disruptions
that affect our ability to deliver products to our customers. If we were unable to adequately handle these disruptions, it could adversely affect inventory levels, shipments to customers and customer service. Any such event would have a material adverse effect on our operating results.
Material changes in cash flow and debt levels may adversely affect our growth and credit facilities, require the immediate repayment of all our loans, and limit the ability to open new stores.
During seasonal and cyclical changes in our revenue levels and to fund our retail growth strategy and increases in our direct business, we make use of our credit facilities, which are subject to EBITDA, total debt and related covenants. In four of the previous five fiscal quarters, we failed to comply with one or more of these covenants. If we are out of compliance with these covenants at the end of a fiscal period, it may adversely affect our growth prospects, require the consent of our lenders to open new stores, or in the worst case, trigger default and require the repayments of all amounts then outstanding on our loans. In the event of our insolvency, liquidation, dissolution or reorganization, the lenders under our revolving credit facility would be entitled to payment in full from our assets before distributions, if any, were made to our stockholders. However, we were in compliance with our new loan covenants for the fiscal quarter ending December 31, 2007, and we anticipate compliance with all new covenants under our new credit facilities in each of the next four quarters.
In order to execute our retail store expansion strategy, we may need to borrow additional funds, raise additional equity financing or finance our planned expansion from profits. We may also need to raise additional capital in the future to respond to competitive pressures or unanticipated financial requirements. We may not be able to obtain additional financing, including the extension or refinancing of our revolving credit facility, on commercially reasonable terms or at all. A failure to obtain additional financing or an inability to obtain financing on acceptable terms could require us to incur indebtedness at high rates of interest or with substantial restrictive covenants, including prohibitions on payment of dividends.
We may obtain additional financing by issuing equity securities that will dilute the ownership interests of existing shareholders. If we are unable to obtain additional financing, we may be forced to scale back operations or be unable to address opportunities for expansion or enhancement of our operations.
Our growth may strain operations, and finances, which could adversely affect our business and financial results.
Our business has grown and continues to grow through organic growth and acquisitions. Accordingly, sales, number of stores, number of countries in which we conduct business, and number of associates have grown and will likely continue to grow. This growth places significant demands on management and operational systems, and may be limited by covenants and conditions in our loan agreements. If we are not successful in continuing to support our operational and financial systems, expanding our management team and increasing and effectively managing our associate base, or managing our finances, this growth is likely to result in operational inefficiencies and ineffective management of the business and associates, or financial constraints or, in the worst case, default, any one or more of which may in turn adversely affect our business and financial performance.
Our quarterly operating results are subject to significant fluctuation.
We experience seasonal fluctuations in our revenues and operating results. We typically realize a higher portion of our revenues and operating results during the fourth quarter. As a result of this seasonality, we believe that quarter to quarter comparisons of our operating results are not necessarily meaningful and that these comparisons cannot be relied upon as indicators of future performance. Our operating results have fluctuated from quarter to quarter in the past, and we expect
that they will continue to do so in the future. Our earnings may not continue to grow at rates similar to the growth rates achieved in recent years and may fall short of either a prior fiscal period or investors’ expectations. Factors that could cause these quarterly fluctuations include the following: the extent to which sales in new stores result in the loss of sales in existing stores; accrual or pre-opening store expenses in one or more new store locations, resulting in higher operating expenses without a corresponding increase in revenues; the transaction costs and goodwill associated with acquisitions; the mix of products sold; pricing actions of competitors; the level of advertising and promotional expenses; and seasonality, primarily because the sales and profitability of our stores are typically slightly lower in the first and second quarters of the fiscal year than in other quarters. Most of our operating expenses, such as rent expense, advertising expense and employee salaries, do not vary directly with the amount of sales and are difficult to adjust in the short-term. As a result, if sales in a particular quarter are below expectations for that quarter, we may not proportionately reduce operating expenses for that quarter, and, therefore, this sales shortfall would have a disproportionately negative effect on our net income for the quarter.
If businesses we acquire do not perform as well as we expect or have liabilities that we are not aware of, we could suffer consequences that would substantially reduce our revenues, earnings and cash flows.
Our business strategy includes growth of our retail sales channel, both through the development and opening of new Dover-branded store sites and the acquisition and conversion of existing retail stores to the Dover brand. Our financial performance may be adversely affected as the result of such acquisitions by such factors as: (1) difficulty in assimilating the acquired operations, and employees; (2) inability to successfully integrate the acquired inventory and operations into our business and maintain uniform standards, controls, policies, and procedures; (3) lower-than-expected loyalty of the customer base of the acquired business to Dover-branded stores, and products; (4) post-acquisition variations in the product mix offered by the stores of the acquired business, resulting in lower revenues, and gross margins; and (5) declines in revenues of stores of the acquired business from historical levels and those projected. Further, businesses we acquire may have unknown or contingent liabilities that are in excess of the amounts that we have estimated. Although we have obtained indemnification, we may discover liabilities greater than the contractual limits or the financial resources of the indemnifying party. In the event that we are responsible for liabilities substantially in excess of any amounts recovered through rights to indemnification, we could suffer severe consequences that would substantially reduce our revenues, earnings and cash flows.
Our shareholders may experience dilution in their ownership positions.
We have historically granted options to employees as a significant part of our overall compensation package. As of December 31, 2007, our employees and non-employee directors held vested options in the aggregate to acquire 389,661 shares of common stock, all of which were exercisable at a weighted average exercise price of $5.32 per share. To the extent that option holders exercise vested outstanding options to purchase common stock, there may be further dilution. Future grants of stock-based compensation to employees may also result in dilution. We may raise additional funds through future sales of our common stock. Any such financing may result in additional dilution to our shareholders.
In addition to causing dilution, stock option grants increase compensation expense and may negatively impact our stock price.
Pursuant to current accounting rules, the Company has been required to take a current charge, beginning in the fourth quarter of fiscal 2005, for compensation expense associated with our grant of stock options. As of December 31, 2007, we recognized $102,000 of non-cash stock-based compensation expense. This charge has the effect of decreasing our net income and earnings per
share, which may negatively impact our stock price. To the extent the Company makes future grants of stock-based compensation to employees, this charge will increase.
If we cannot continue to successfully manage our direct sales channel, it would negatively impact our growth and profitability.
Our direct sales generated 75.6% of our revenues in 2007, and we expect such operations to continue to represent a majority of our sales for at least the next several years. Our success depends on our ability to market, advertise and sell our products effectively through our various catalogs and Internet sites. We believe that the success of our direct sales depends on:
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our ability to offer a product mix that is attractive to our customers;
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the price point of our products relative to our competitors;
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our ability to achieve adequate response rates to our mailings;
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our ability to add new customers in a cost-effective manner;
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timely delivery of catalog mailings to our customers;
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an efficient Internet interface;
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a seamless buying experience for our customers across each of our channels; and
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cost effective and efficient order fulfillment.
Catalog production, mailings and paper-based packing products, such as shipping cartons, entail substantial paper, postage, human resource and other costs, including costs of catalog development. We incur most of these costs prior to the mailing of each catalog. Increases in costs of mailing, paper or printing would increase our costs and adversely affect our earnings if we are unable to pass such cost increases on to our customers. The success of our direct sales hinges on the achievement of adequate response rates to mailings, merchandising, catalog and website presentations that appeal to our customers, and the expansion of our potential customer base in a cost-effective manner. Lack of consumer response to particular catalog or flier mailings or Internet marketing efforts may increase our costs and decrease the profitability of our business.
Our retail store rollout could cannibalize existing sales from our direct sales channel or existing retail locations.
Our strategy to increase the number of retail store locations is based on finding optimal locations where demand for equestrian products is high. When we open a retail store in an area that has a high concentration of our existing customers, we expect that such customers will purchase products in the retail location as well as through our catalogs and websites, ultimately increasing their total purchases as multi-channel customers. Direct sales in the geographic area surrounding our Hockessin, DE store declined 4% in the first year of such store’s operation. In the future, in areas where we open retail stores, the customers located within the area of such store may not spend more than they would have from the catalog and websites and therefore there may be a transfer of sales from our direct sales business to our retail stores. In such case, we may incur significant costs associated with opening a store and mailing catalogs while not generating incremental revenue.
With a significant portion of our growth strategy dependent upon our planned retail store expansion, our quarterly revenues and earnings could be variable and unpredictable and inventory levels will increase.
We plan to increase the rate at which we open new stores. As we open new stores, (i) revenues may fluctuate, and (ii) pre-opening expenses are incurred which may not be offset by a
corresponding increase in revenues during the same financial reporting period. These factors may contribute to variable operating results.
Some of the expenses associated with openings of our new retail stores, such as headcount and lease occupancy, will increase. Additionally, as we increase inventory levels to provide stores with merchandise, we may not be able to manage this inventory without incurring additional costs. If retail store sales are inadequate to support these new costs, our earnings will decrease.
We rely on service providers to operate our business and any disruption of their supply of services could have an adverse impact on our revenues and profitability.
We rely on a number of service providers to operate our business such as:
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a printer and a database processor to produce and mail our catalogs;
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a website hosting service provider to host and manage our websites;
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telephone companies to provide telephone and fax service to our customer service centers and to communicate between locations; and
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shipping companies such as DHL, UPS, FedEx, the U.S. Postal Service and common carriers for timely delivery of our catalogs, shipment of merchandise to our customers and delivery of merchandise from our suppliers, including foreign suppliers, to us and from our warehouse to our retail stores.
Any disruption in these services may have a negative impact on our ability to market and sell our products and serve our customers and could result in increased costs to us.
We rely on merchandise suppliers to operate our business and any disruption of their supply of products could have an adverse impact on our revenues and profitability.
We rely on merchandise suppliers to supply our products in saleable condition, in sufficient quantities, at competitive prices and in a timely manner. In 2007, our single largest merchandise supplier accounted for less than 15% of our sales. Our current merchandise suppliers may not be able to accommodate our anticipated needs in a timely matter or at all. If we are unable to acquire suitable merchandise in a timely manner or lose one or more key merchandise suppliers, we may not be able to offer products that are important to our merchandise assortment, which would have a material adverse effect on our business. While we believe our merchandise supplier relationships are satisfactory, we have no contractual arrangements providing for continued supply from our key merchandise suppliers and our merchandise suppliers may discontinue selling to us at any time or may raise the cost of merchandise and we may be unable to pass such price increases along to our customers.
If we do not properly manage our inventory levels, our operating results and available funds for future growth will be adversely affected.
We currently maintain a high level of inventory and have a broad depth of products for our customers. The investment associated with this high level of inventory is substantial. If we fail to adequately predict the amount or mix of our inventory, we will incur costs associated with stocking inventory that is not being sold or fails to meet the demands of our customers or we may be required to write- off or write-down inventory which would hurt our operating results. If we do not meet the needs of our customers, they may decide to purchase products from our competitors. Although we have some ability to return merchandise to our suppliers, we incur additional costs in doing so and we may not be able to return merchandise in the future.
A natural disaster or other disruption at our Littleton, MA warehouse fulfillment center could cause us to lose merchandise and be unable to deliver products to our direct sales customers and our retail stores.
We currently rely on our Littleton, MA warehouse to handle our fulfillment needs. Any natural disaster or other serious disruption to this center due to fire, flood, tornado, earthquake or any other calamity could damage a significant portion of our inventory, and materially impair our ability to adequately stock our retail stores, deliver merchandise to customers, and process returns to merchandise suppliers and could result in lost revenues and increased costs.
If we lose key members of management or are unable to retain the talent required for our business, our operating results could suffer.
Our future success depends to a significant degree on the skills, experience and efforts of Stephen Day, our President and Chief Executive Officer, Jonathan Grylls, our Chief Operating Officer, and other key personnel including our senior executive management. We currently maintain four million dollars of key-man life insurance on Mr. Day, the proceeds of which are required to pay down outstanding debt. Effective as of September 1, 2005, we have entered into employment agreements with Mr. Day and Mr. Grylls, which contain provisions for non-competition, non-solicitation and severance. In addition, our future success depends upon our ability to attract and retain highly-skilled and motivated, full-time and temporary sales personnel with appropriate equestrian products industry knowledge and retail experience to work in management and in our retail stores. The loss of the services of any one of these individuals or the inability to attract and retain qualified individuals for our key management and retail sales positions may have a material adverse effect on our operating results.
We may need additional financing to execute our growth strategy, which may not be available on favorable terms or at all, which could increase our costs, limit our ability to grow and dilute the ownership interests of existing shareholders.
Our current revolving credit facility is due in full on January 31, 2011, which may limit our ability to finance the opening of all of our planned additional stores over the next several years. In order to satisfy our revolving credit facility when due and to execute our retail store expansion strategy, we may need to borrow additional funds, raise additional equity financing or finance our planned expansion from profits. We may also need to raise additional capital in the future to respond to competitive pressures or unanticipated financial requirements. We may not be able to obtain additional financing, including the extension or refinancing of our revolving credit facility, on commercially reasonable terms or at all. A failure to obtain additional financing or an inability to obtain financing on acceptable terms could require us to incur indebtedness at high rates of interest or with substantial restrictive covenants, including prohibitions on payment of dividends.
We may obtain additional financing by issuing equity securities that will dilute the ownership interests of existing shareholders. If we are unable to obtain additional financing, we may be forced to scale back operations or be unable to address opportunities for expansion or enhancement of our operations.
We rely on foreign sources for many of our products, which subjects us to various risks.
We currently source approximately one quarter of our products from foreign manufacturers located in Europe, Asia and South America. As such, we are subject to risks and uncertainties associated with changing economic and political conditions in foreign countries. These risks and uncertainties include currency rate fluctuations, import duties and quotas, work stoppages, economic uncertainties including inflation, foreign government regulations, wars and fears of war, acts of terrorism and fear of acts of terrorism, political unrest and trade restrictions. Additionally, countries in
which our products are currently manufactured or may be manufactured in the future may become subject to trade restrictions imposed by the U.S. or foreign governments. Any event affecting prices or causing a disruption or delay of imports from foreign merchandise suppliers, including the imposition of additional import restrictions, currency rate fluctuations, restrictions on the transfer of funds or increased tariffs or quotas, or both, could increase the cost or reduce the supply of merchandise available to us and adversely affect our operating results.
We do not currently, and we do not plan to, hedge against increases or decreases in the value of the U.S. dollar against any foreign currencies. Our product sourcing from foreign merchandise suppliers means, in part, that we may be affected by declines in the value of the U.S. dollar relative to other foreign currencies. Specifically, as the value of the U.S. dollar declines relative to other currencies, our effective cost of products increases. As a result, declines in the value of the U.S. dollar relative to foreign currencies would adversely affect our operating results.
Our retail store expansion strategy may result in our direct sales business establishing a nexus with additional states, which may cause our direct sales business to pay additional income and sales tax and have an adverse effect on the revenues and cash flows of our direct sales business.
As we open retail stores in additional states, the necessary relationship between the retail stores and our direct sales business may be deemed by certain state tax authorities to create a nexus for state income and sales taxation of our direct sales business in those states. This could result in an increase in the tax collection and payment obligations of our direct sales business, which would have an adverse effect on the profitability and cash flows of our direct sales business and our overall business. Such sales tax collection obligations, if any, would increase the total cost of our products to our customers. This increased cost to our customers could negatively affect the revenues of our direct sales business if we are required to reduce the underlying prices for the products sold through our direct sales channel. The occurrence of either of these events would have an adverse effect on the revenues, costs and cash flows of our direct sales business. This area of law is uncertain and changing and we could be subject to paying back taxes and penalties.
If we fail to adequately protect our trademarks, our brand and reputation could be impaired or diluted and we could lose customers.
We have, or have rights to, four trademarks that we consider to be material to the successful operation of our business: Dover Saddlery, Smith Brothers, Miller’s Harness and The Source. We currently use all of these marks in our direct sales business. We also have several additional pending trademark applications. We also regard our copyrights, service marks, trade dress, trade secrets and similar intellectual property as critical to our success. In addition to our registered marks and pending applications, our principal intellectual property rights include copyrights in our catalogs, rights to our domain names and our databases and information management systems. As such, we rely on trademark and copyright law, trade secret protection and confidentiality agreements to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights may be inadequate. Our trademark applications may not be granted, and we may not be able to secure significant protection for our marks. Our competitors or others may adopt trademarks or service marks similar to our marks or try to prevent us from using our marks, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets or other proprietary rights for any reason, our brand and reputation could be impaired or diluted and we may lose customers.
We may have disputes with, or be sued by, third parties for infringement or misappropriation of their proprietary rights, which could have a negative impact on our business.
Other parties may assert claims with respect to patent, trademark, copyright or other intellectual property rights that are important to our business, such as our Dover Saddlery, Smith Brothers and Miller’s Harness trademarks. Other parties might seek to block the use of, or seek monetary damages or other remedies for the prior use of, our intellectual property or the sale of our products as a violation of their trademark, patent or other proprietary rights. Defending any claims, even claims without merit, could be time-consuming, result in costly settlements, litigation or restrictions on our business and could damage our reputation.
In addition, there may be prior registrations or use of intellectual property in the U.S. or foreign countries (including, but not limited to, similar or competing marks or other proprietary rights) of which we are not aware. In all such countries, it may be possible for any third-party owner of a trademark registration in that country or other proprietary right to enjoin or limit our expansion into those countries or to seek damages for our use of such intellectual property in such countries. In the event a claim against us were successful and we could not obtain a license to the relevant intellectual property or redesign or rename our products or operations to avoid infringement, our business, financial condition or results of operations could be harmed. In addition, securing registrations does not fully insulate us against intellectual property claims, as another party may have rights superior to our registration or our registration may be vulnerable to attack on various other grounds.
Any such claims of infringement or misappropriation, whether meritorious or not, could:
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be expensive and time consuming to defend;
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prevent us from operating our business, or portions of our business;
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cause us to cease selling certain products;
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result in the loss of customers;
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require us to re-label or re-design certain products, if feasible;
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result in significant monetary liability;
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divert management’s attention and resources;
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potentially require us to enter into royalty or licensing agreements in order to obtain the right to use necessary intellectual property; and
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force us to stop using valuable trademarks under which we market our products.
Third parties might assert infringement claims against us in the future with respect to any of our products. Any such assertion might require us to enter into royalty arrangements or litigation that could be costly to us. Any of these events could have a material adverse effect on our business.
We are subject to numerous regulations and regulatory changes that could impact our business or require us to modify our current business practices.
We are subject to numerous regulations governing the Internet and e-commerce, retailers generally, the importation, promotion and sale of merchandise, and the operation of retail stores and warehouse facilities. These regulations include customs, privacy, truth-in-advertising, consumer protection, shipping and zoning and occupancy laws and ordinances. Many of these laws and regulations may specifically impede the growth of the Internet or other online services. If these laws were to change, or are violated by our management, employees, suppliers, buying agents or trading companies, we could experience delays in shipments of our goods or be subject to fines or other penalties which could hurt our business, financial condition and results of operations.
The growth and demand for online commerce has resulted, and may continue to result, in more stringent consumer compliance burdens on companies that operate in the e-commerce segment. Specifically, certain states have enacted various legislation with respect to consumer privacy. In addition, the Federal Trade Commission and certain state agencies have been investigating various Internet companies regarding their use of personal information. The costs of compliance with federal and state privacy laws and the costs that might be incurred in connection with any federal or state investigations could have a material adverse affect on our business and operating results. Our direct mail operations are subject to regulation by the U.S. Postal Service, the Federal Trade Commission and various state, local and private consumer protection and other regulatory authorities. In general, these regulations govern the manner in which orders may be solicited, the form and content of advertisements, information which must be provided to prospective customers, the time within which orders must be filled, obligations to customers if orders are not shipped within a specified period of time and the time within which refunds must be paid if the ordered merchandise is unavailable or returned. From time to time, we have modified our methods of doing business and our marketing operations in response to such regulation. To date, such regulation has not had a material adverse effect on our business or operating results. However, future regulatory requirements or actions may have a material adverse effect on our business or operating results.
Legal requirements are frequently changed and subject to interpretation, and we are unable to predict the ultimate cost of compliance with these requirements or their effect on our operations. We may be required to make significant expenditures or modify our business practices to comply with laws and regulations. Compliance with existing or future laws and regulations may materially limit our ability to operate our business and increase our costs.
Our 100% satisfaction guarantee exposes us to the risk of an increase in our return rates which could adversely affect our profitability.
Part of our marketing and advertising strategy focuses on allowing customers to return products ordered from our catalogs at any time if they are not satisfied and obtain a refund of the purchase price. As we expand our sales, our return rates may not remain within our historically low levels and could significantly impair our profitability.
Our marketing expenditures may not result in increased sales or generate the levels of product and brand name awareness we desire and we may not be able to manage our marketing expenditures on a cost-effective basis.
A significant component of our marketing strategy involves the use of direct marketing to generate sales. Future growth and profitability will depend in part on the effectiveness and efficiency of our marketing expenditures, including our ability to:
•
create greater awareness of our products and brand name;
•
determine the appropriate creative message and media mix for future marketing expenditures;
•
effectively manage marketing costs, including creative and media, to maintain acceptable costs per inquiry, costs per order and operating margins; and
•
convert inquiries into actual orders.
Our marketing expenditures may not result in increased sales or generate sufficient levels of product and brand name awareness and we may not be able to manage such marketing expenditures on a cost effective basis.
Item 1B.
Item 1B.
Unresolved Staff Comments.
The Company is not an accelerated filer, a large accelerated filer, or a well-known seasoned issuer, and we have not received written comments from the SEC Staff regarding our periodic or current reports.
Item 2.
Item 2.
Properties.
We currently lease an approximately 100,000 square foot facility in Littleton, MA for our corporate headquarters, main call center, warehouse, and fulfillment center. Approximately 92,000 square feet is for warehouse space and the remaining is for office space. The lease expires in September 2011 and we have two five-year options to renew thereafter at market rates.
We lease approximately 1,800 square feet of space in North Conway, NH for use as a satellite call center and for our creative offices. We lease approximately 5,100 square feet of space in Denton, TX for use as a satellite call center and additional offices.
Currently, we lease approximately 70,000 square feet of space for our ten retail stores located in Massachusetts (1), Virginia (3), New Hampshire (1), Maryland (2), Delaware (1) and Texas (2).
Item 3.
Item 3.
Legal Proceedings.
From time to time, we are exposed to litigation relating to our products and operations. Except as described below, we are not currently engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material, adverse affect on our financial condition or results of operations.
The Company has been named as a defendant in litigation brought by one of its customers against the manufacturer of a riding helmet for injuries sustained in an equestrian accident. To the best of our knowledge, the product was designed and manufactured by our vendor to industry standards. The claim against Dover is covered by our insurance, and we vigorously deny liability.
On March 24, 2006, Goldsmith, Agio, Helms, and Linner, LLC (GAH) filed a demand for arbitration with the American Arbitration Association for $2.1 million, plus interest, seeking a success fee purportedly due in connection with the Company’s Initial Public Offering. In May 2007, we finalized the settlement with GAH and agreed to pay $700,000 in order to avoid the burden on management, the costs of preparation and trial, and risks of a potential adverse outcome. This charge was recorded in the first quarter of 2007. As of December 31, 2007, $478,000 of this settlement had been paid under the agreement. The remaining $222,000, plus interest, is scheduled to be paid in installments through April 1, 2009.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of our security holders during the fourth quarter of fiscal year 2007.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity and Related Stockholder Matters.
Market Information.
Our common stock trades on The NASDAQ Stock Market LLC under the symbol “DOVR”. As of March 10, 2008, the number of holders of record of our common stock was 29 and the approximate number of beneficial owners was 820.
The following table sets forth, for the periods indicated, the high and low sales prices for our common stock for each full quarterly period as reported on The NASDAQ Stock Market LLC since our common stock commenced trading on NASDAQ Stock Market LLC on November 18, 2005:
We have never declared or paid any cash dividends on our common stock. We currently intend to retain any earnings for use in the operation and expansion of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future. Moreover, our current revolving credit facility contains provisions which restrict our ability to pay dividends.
The information required to be disclosed by Item 201(d) of Regulation S-K, “Securities Authorized for Issuance Under Equity Compensation Plans,” and by Item 201(e) of Regulation S-K, “Performance Graph”, is included under Item 12 of Part III of this Annual Report on Form 10-K.
Recent Sales of Unregistered Securities; Uses of Proceeds from Registered Securities.
In August 2007, the Company issued 30,974 new, unregistered shares of the Company’s common stock upon the exercise of the warrant issued to Patriot Capital Funding, Inc., yielding proceeds of $235. The Company used all of the proceeds from the exercise of the Patriot warrant for general working capital purposes.
On December 11, 2007, the Company entered into a new senior revolving credit facility with RBS Citizens Bank N.A., under which it can borrow up to $18.0 million, including $2.0 million for letters of credit. Interest accrues at a variable rate on either prime or published LIBOR rates. The credit facility expires on January 31, 2011, at which time all advances will be immediately due and payable. Subsequent to the transaction, on December 12, 2007, the revolving credit facility borrowing limit was $18.0 million and the amount outstanding under the credit facility was $8.9 million at a rate of 7%, and the unused amount available was $9.1 million. Borrowings are secured by substantially all of the Company’s assets. Under the terms of this credit facility, the Company is subject to various covenants. The $8.9 million in proceeds of this senior credit facility were applied to pay off the prior senior debt obligations due to Bank of America, N.A. As of December 31, 2007, the Company had $6.3 million outstanding on the revolving credit facility, which bore interest at the net revolver rate of 7%.
On October 26, 2007, the disinterested members of the Audit Committee of the Board of Directors approved a $5.0 million subordinated debt financing facility as part of a plan to refinance the Company’s current subordinated debt with Patriot Capital. The new sub-debt facility was led by BCA
Mezzanine Fund, L.P., which participated at $2.0 million (in which Company Board member Gregory Mulligan holds a management position and indirect economic interest). On December 11, 2007, the Company closed the new mezzanine loan agreement with BCA Mezzanine Fund, LP, Cephas Capital Partners, LP, and SEED Ventures, LP (jointly, the “Subordinated Holders”), which provided for the Company’s issuance of a senior subordinated note payable, which is due in full on December 11, 2012 for aggregate proceeds of $5.0 million. Of such proceeds, $3.0 million was used to pay off a previously existing subordinated note payable to Patriot Capital Funding, Inc., and $0.15 million was used to pay a prepayment fee. The note is a general senior subordinated obligation, subordinated in right of payment to existing and future senior debt, ranks equal in right of payment with any future senior subordinated debt and is senior in right of payment to any future subordinated debt. Interest accrues at an annual rate of 14%, of which 12% is payable quarterly in arrears on the fifth business day of the following month. The remaining 2% per annum is deferrable, and if deferred, shall be compounded annually and due in full on December 11, 2012. Prepayment on the principal amount due under the note may voluntarily be made at any time, plus accrued and unpaid interest and a prepayment fee of 5% of the prepaid amount if paid prior to the first anniversary, 4% if paid prior to the second anniversary, 3% if paid prior to the third anniversary, and 0% if paid after December 11, 2010. Under the terms of this senior subordinated credit facility, the Company is subject to various covenants. Simultaneously with the issuance of this note, the Company issued warrants on a pro rata basis to the Subordinated Holders, exercisable at any time after December 11, 2007, for an initial number of 118,170 shares of the Company’s common stock at an initial exercise price of $3.96 per share. The number of shares to be received for the warrant is subject to change in the event of additional equity issuances and/or stock splits.
The issuances of securities described above were deemed to be exempt from registration under the Securities Act of 1933 in reliance on Section 4 (2) of the Securities Act of 1933 as transactions by an issuer not involving any public offering and, in the case of bank debt, in reliance on the straight debt definitional exemption. The recipients of securities in each such transaction represented their intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and appropriate legends were affixed to the share certificates and other instruments issued in such transactions. The sales of these securities were made without general solicitation or advertising.
For history of the Company’s debt and equity financing activity prior to January 1, 2007, see Part II, Item 5 of the Company’s Annual Report on Form 10-K for the fiscal year ending December 31, 2006, as filed with the SEC on April 2, 2007.
Issuer Purchases of Equity Securities
Except as set forth above in the section above entitled, “Recent Sales of Unregistered Securities”, during the fiscal quarter ended December 31, 2007, there were no repurchases made by us or on our behalf, or by any “affiliated purchasers” of shares of our common stock.
Item 6.
Item 6.
Selected Financial Data.
The selected historical financial data shown below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and our Consolidated Financial Statements and related notes included elsewhere in this Form 10-K. We have derived our Consolidated Statements of Operations Data and certain of our Other Consolidated Financial Data for the years ended December 31, 2003, 2004, 2005, 2006 and 2007 and Consolidated Balance Sheet Data as of December 31, 2003 through December 31, 2007 from our audited Consolidated Financial Statements. Historical results do not necessarily indicate the results you should expect for future periods. The historical financial information gives retroactive effect to a 1.3179 for 1 stock split, which was effected on November 22, 2005 concurrent with the completion of our public offering.
(1)
2007 stores includes the new Dover stores in Chantilly, VA, and Lexington, VA opened in Q1 2007, and the Charlottesville, VA store opened in Q2 2007, and the Dallas, TX store opened in Q3 2007.
(2)
When we use the term “EBITDA”, we are referring to net income minus interest income plus interest expense, income taxes, non-cash stock-based compensation, depreciation and amortization. We present EBITDA because we consider it an important supplemental measure of our performance and believe it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry.
EBITDA has some limitations as an analytical tool and you should not consider it in isolation or as a substitute for net income, operating income, cash flows from operating, investing or financing activities or any other measure calculated in accordance with US generally accepted accounting principles. Some of the limitations are:
•
EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or capital commitments;
•
EBITDA does not reflect changes in, or cash requirements for, our working capital needs;
•
EBITDA does not reflect the interest expense or cash requirements necessary to service interest or principal payments on our debt;
•
although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA does not reflect any cash requirements for such replacements; and
•
other companies in our industry may calculate EBITDA differently than we do, limiting its usefulness as a comparative measure
The following table reconciles EBITDA to net income (in thousands).
(1)
Certain of these amounts may not properly sum due to rounding.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
This Annual Report on Form 10-K, including the following discussion, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve substantial risks and uncertainties. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, the words “projected”, “anticipated”, “planned”, “expected”, and similar expressions are intended to identify forward-looking statements. In particular, statements regarding retail store expansion and business growth are forward-looking statements. Forward-looking
statements are not guarantees of our future financial performance, and undue reliance should not be placed on them. Our actual results, performance or achievements may differ significantly from the results, performance and achievements discussed in or implied by the forward-looking statements. Factors that could cause such a difference include material changes to Dover Saddlery, Inc.’s business or prospects, in consumer spending, fashion trends or consumer preferences, or in general political, economic, business or capital market conditions and other risks and uncertainties, including but not limited to the other factors that are detailed in “Item 1A. Risk Factors.” We disclaim any intent or obligation to update any forward-looking statements.
We are a leading specialty retailer and the largest direct marketer of equestrian products in the U.S. For over 20 years, Dover Saddlery has been a premier upscale marketing brand in the English-style riding industry. We sell our products through a multi-channel strategy, including catalogs, the Internet and retail stores. This multi-channel strategy has allowed us to use catalogs and our proprietary database of nearly two million names of equestrian enthusiasts as a primary marketing tool to increase catalog sales and to drive additional business to our e-commerce websites and retail stores.
Historical Development
Our business was started in 1975 by top-ranked English-style riding champions, Jim and David Powers. Our Wellesley, MA retail store opened in 1975 and our catalog operations began in 1982. In September 1998, Stephen Day, our current President and Chief Executive Officer and a veteran of the equestrian products direct marketing industry, and certain other investors acquired a controlling interest in Dover. In 2000, we launched our main website, www.doversaddlery.com. In 2002, we opened our second Dover Saddlery store in Hockessin, DE and we expanded into the Western-style market by acquiring the Smith Brothers catalog and website, www.smithbrothers.com. In 2003, we acquired rights to the Miller’s Harness brand for use in catalog and Internet sales to target entry-level and lower-cost equestrian products customers. We opened a Smith Brothers store in Denton, TX in 2004 and our third Dover Saddlery store in Plaistow, NH in 2005. In September 2006, we opened our Hunt Valley, MD store. In addition, we acquired Dominion Saddlery and over the next nine months, remodeled, expanded and converted the four stores into Dover Saddlery stores. In 2007, we opened or converted four stores to the Dover brand and now operate nine Dover stores and one Smith Brothers store.
We offer a comprehensive selection of products required to own, train and compete with a horse, selling from under $1 to over $6,000. Our products fall into the following three main categories:
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Saddles and tack;
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Specialized apparel; and
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Horse care and stable products.
We have historically focused on the English-style riding market. Dover is known for providing the highest quality products for English-style riding, including premier brands such as Hermes, Ariat, Grand Prix, Mountain Horse, Passier and Prestige. We offer what we believe is the largest selection of exclusive and semi-exclusive equestrian products in the industry. To further broaden our offerings, we began selling into the Western-style riding market in 2002 under the Smith Brothers name.
We have carefully built a multi-channel platform for growth by developing an extensive consumer database of equestrian enthusiasts and Dover customers. We have positioned ourselves to capitalize on the synergies of combining catalog and Internet operations with a retail store channel. By marketing our products across integrated, multiple sales channels, we have strengthened our brand visibility and brand equity, expanded our customer database and increased revenues, profits and market share. While our catalog acts as the primary marketing vehicle to increase Internet and store traffic, each of our channels reinforces the other and generates additional customers. Because
we sell equestrian products through multiple channels to the same customer base, we operate in one reportable business segment.
Consolidated Performance and Trends
In 2007, net income was $0.8 million or $0.16 per diluted share compared to $1.4 million or $0.26 per diluted share in 2006 and $0.8 million or $0.18 per diluted share in 2005. Net income decreased 41% in 2007 and increased 69% in 2006. The decrease in net income in 2007 was primarily attributed to a charge for the strategic settlement and related legal costs of the GAH litigation, which had an after-tax impact of $0.6 million, as well as increased interest expense attributable to our operational growth.
Our direct sales channel revenues increased 2.1% in 2007 through catalog and Internet initiatives to both existing and new customers. This trend of increased direct sales channel revenue is dependent upon the continued response of our customers to these initiatives. We respond to fluctuations in direct revenues by adjusting the quantities of catalogs mailed and other marketing strategies in order to maximize revenue opportunity and manage costs. Our retail sales channel revenues increased 55.3% in 2007, due primarily to our strategic expansion of retail stores. This trend of increased revenue and profitability is dependent upon our ability to continue to execute our expansion strategy by opening new store locations and our customers’ continued support of new retail stores. We respond to fluctuations in retail revenues by adjusting marketing efforts and operations to support our retail stores and manage costs, as well as continuing to focus on our proprietary store optimization modeling to determine the rate and location of new store openings.
Revenues
We market and sell the most comprehensive selection of products in the equestrian industry. We currently derive our revenues from product sales through three integrated distribution channels: catalog, Internet and our retail stores. Our direct sales consist of product sales generated from both catalog mailings and Internet marketing, and our retail store sales consist of products sold through our retail stores. We sell to the English-style riding market through our Dover Saddlery brand and to the Western-style riding market through our Smith Brothers brand.
In 2007, approximately 75.6% of our revenues resulted from sales through our direct channel, and 24.4% resulted from sales at our ten retail stores which increased from the 17.5% of retail sales in 2006, due primarily to the success of our retail rollout plan. All revenues are recorded net of product returns.
Revenues from our product sales are seasonal. In addition, our revenues can be affected by the timing of our catalog mailings. In 2007, 28.2% of our revenues were generated in the fourth quarter.
Cost of Revenues
The most significant components of our cost of revenues are product costs, purchasing, handling and transportation costs to obtain the products and ship them to our customers. We manage our integrated merchandising efforts by forming positive relationships with over 600 suppliers to ensure competitive costs and the most up-to-date and complete product offering for our customers. We have implemented procedures to promote labor efficiencies in the handling of our products. In addition, we work closely with transportation companies in negotiating competitive rate structures to manage our freight costs.
Gross Profit
Our gross profit as a percentage of revenues varies according to the season of the year and the mix of products sold. Our gross profit may not be comparable to other specialty retailers, as some companies include all of the costs related to distribution in cost of revenues while others, like us, exclude all or a portion of the costs related to distribution from cost of revenues and include them in selling, general and administrative expenses.
Selling, General and Administrative Expenses
Our selling, general and administrative expenses consist primarily of:
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advertising, marketing and other brand-building costs, primarily associated with developing, printing and distributing our catalogs and internet advertising;
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labor and related costs for order processing, and salaries and related costs for marketing, creative and executive personnel;
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infrastructure costs and information system costs;
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credit card processing fees;
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occupancy and other overhead costs;
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store pre-opening costs;
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public company, professional fees and other legal, accounting and related costs; and
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non-cash, stock-based compensation.
As we focus on increasing our market penetration and continuing to build brand awareness, we anticipate that selling, general and administrative expenses will continue to increase in absolute dollars for the foreseeable future. Total selling, general and administrative costs as a percentage of our revenues are not likely to decrease in the foreseeable future as we intend to continue to take advantage of our market-leading position in the equestrian industry by building on the Dover Saddlery and Smith Brothers brands. We also expect our general and administrative expenses will increase due to our operations as a public company.
Fiscal Periods
Our fiscal year ends on December 31 and our fiscal quarters end on March 31, June 30, September 30 and December 31.
Results of Operations
The following table sets forth results of operations for the periods shown (dollars in thousands)(1):
(1)
Applies to dollar references both in line item description and in tabular column.
(2)
When we use the term “EBITDA”, we are referring to net income minus interest income plus interest expense, income taxes, non-cash stock-based compensation, and depreciation and amortization. We present EBITDA because we consider it an important supplemental measure of our performance and believe it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry. Refer to section 6 in which we discuss the limitations of EBITDA and the reconciliation to net income.
The following table sets forth our results of operations as a percentage of revenues for the periods shown:
(1)
Certain of these amounts may not sum properly due to rounding.
Comparison of Years Ended December 31, 2007 and 2006
Revenues
Our total revenues increased to $81.4 million for the year ended December 31, 2007, from $73.0 million for the corresponding period in 2006, an increase of $8.4 million or 11.4%. Revenues in our direct sales channel increased $1.3 million, or 2.1% to $61.5 million. Revenues in our retail sales channel were $19.9 million, an increase of $7.1 million, or 55.3%. The increase in revenues from our retail sales channel was due primarily to the opening of new stores. Same store sales were flat in 2007 due primarily to the cannibalization in the Maryland market. Comparable stores not impacted by cannibalization increased 3.4% for the year.
Gross Profit
Gross profit for the year ended December 31, 2007 increased 13.4% to $30.9 million, from $27.3 million for the corresponding period in 2006. Gross profit, as a percentage of revenues, increased for the year ended December 31, 2007 to 38%, from 37.3% of revenues for the corresponding period in 2006. The increase of $3.6 million in gross profit was due primarily to increased revenues in our retail sales channel. The increase in gross profit as a percentage of revenues was attributable to variations in overall product mix.
Selling, General and Administrative
Selling, general and administrative expenses increased for the year ended December 31, 2007 to $27.3 million, compared to $24.0 million in 2006. The $3.3 million increase included $1.4 million in labor and related costs and $0.8 million in facility costs due primarily to increased number of retail stores and corresponding revenues. Marketing costs, primarily catalog and new store support, increased $0.3 million and professional fees increased $0.2 million due to litigation costs.
Litigation Settlement Expense
The litigation settlement expense of $0.7 million for the year ended December 31, 2007, is a charge for the final settlement of the GAH litigation, which we incurred in the first quarter of 2007 to avoid additional costs of preparation and trial, the burden on management, and the risk of a large adverse award.
Interest Expense
Interest expense, including amortization of deferred financing costs attributed to our subordinated debt and revolving credit facility, increased 63% to $1.6 million in 2007, compared to $1.0 million in 2006. Our debt levels increased due primarily to new store development and inventories, as well as increased warehouse inventories, in order to fulfill growing demand across a greater number of retail stores. In 2007, we also incurred $96,000 of additional interest expense associated with the accelerated amortization of previous deferred financing costs related to debt paid off in 2007.
Income Tax Provision
The provision for income taxes was $0.5 million for the year ended December 31, 2007, reflecting an effective tax rate of 38.6%, as compared to a provision of $0.9 million for the corresponding period in 2006, which reflected an effective tax rate of 39.6%. The decrease of $0.4 million was primarily attributable to the decrease in taxable income.
Net Income
The net income for the year ended December 31, 2007 was $0.8 million, a decrease from the $1.4 million achieved in 2006. The decrease in net income was primarily attributed to a charge for the strategic settlement and related legal costs of the GAH litigation, which had an after-tax impact of $0.6 million, as well as increased interest expense attributable to our growth and refinancing. Resulting net income per diluted share, for the year ended 2007 was $0.16, versus net income per diluted share of $0.26 for the corresponding period in 2006.
Comparison of Years Ended December 31, 2006 and 2005
Revenues
Our total revenues increased 17% to $73.0 million in the year 2006, from $62.7 million in 2005, a total increase of $10.3 million. Revenues in our direct sales channel increased $6.9 million, or 13% to $60.2 million, and revenues in our retail sales channel increased $3.5 million, or 38% to $12.8 million. The increase in revenues from our direct sales channel was due to higher unit volumes through both catalog and the Internet, and from both the Dover Saddlery and the Smith Brothers brands. The increase in our retail revenues was attributable to two new Dover stores, the Dominion acquisition and growth in same store sales.
Gross Profit
Gross profit increased 17% to $27.3 million for the year, from $23.4 million in 2005. Gross profit as a percentage of revenues was held constant at 37.3% for the year. The increase of $3.9 million in gross profit was due to increased revenues in both our retail and direct sales channels. The consistency in gross profit as a percentage of revenues was attributable to positive variations in both overall product mix and the sales mix of our catalogs, partially offset by increased freight costs.
Selling, General and Administrative
Selling, general and administrative expenses increased to $24.0 million (33% of revenues) for the year ended in 2006, from $19.8 million (32% of revenues) in 2005. The $4.2 million increase includes $1.4 million in marketing costs, primarily catalog expense, Internet advertising and new store support, to drive increased revenues. Labor and related costs increased approximately $0.5 million to support the new retail stores, increased direct channel sales and increased merchandising support functions. Facility costs for new retail store space increased $0.1 million in the fourth quarter of 2006. New public company costs, consisting of legal, audit, investor relations, and insurance fees increased by $1.0 million over the prior year.
Interest Expense
Interest expense, including amortization of deferred financing costs attributed to our subordinated debt and revolving credit facility, decreased 58% to $0.9 million for the year ended in 2006, compared to $2.3 million in 2005. Our debt levels were reduced substantially as the result of the interim application of the company proceeds from the IPO, resulting in decreased interest expense for both senior and remaining subordinated debt.
Income Tax Provision
The provision for income taxes was $0.9 million for the year ended in 2006, reflecting an effective tax rate of 39%, as compared to $0.5 million in 2005, reflecting an effective tax rate of 37%.
Net Income
Net income for the year ended in 2006 was $1.4 million, an increase of 69%, or $0.6 million over the $0.8 million net income achieved in 2005. This substantial increase is due to the growth in our direct and retail revenues and gross profits, as well as reduced interest costs, all partially offset by our investment in marketing, increased freight costs, and the costs of being a public company. Our 2006 earnings per share, fully diluted, increased to $0.26 per share from the prior year of $0.18 per share.
Seasonality and Quarterly Fluctuations
Since 2001, our quarterly product sales have ranged from a low of approximately 20% to a high of approximately 32% of any calendar year’s results. In fiscal 2007, 28.2% of our revenues were generated in the fourth quarter. The beginning of the spring outdoor riding season in the northern half of the country has typically generated a slightly stronger second quarter of the year, and the holiday buying season has generated additional demand for our normal equestrian product lines in the fourth quarter of the year. Revenues for the first and third quarters of the calendar year have tended to be somewhat lower than the second and fourth quarters. We anticipate that our revenues will continue to vary somewhat by season. The timing of our new retail store openings has had and is expected to continue to have a significant impact on our quarterly results. We will incur one-time expenses related to the opening of each new store. As we open new stores, (i) revenues may spike and then settle and (ii) pre-opening expenses, including such expenses as occupancy and management overhead, are incurred, which may not be offset by correlating revenues during the same financial reporting period. As a result of these factors, new retail store openings may result in temporary declines in operating profit, both in dollars and as a percentage of sales.
The following tables presenting our un-audited quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes contained elsewhere in this report. We have prepared the un-audited information on the same basis as our audited consolidated financial statements. You should also keep in mind, as you read the following tables, that our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year.
The following table presents our un-audited quarterly results of operations for the eight fiscal quarters ended December 31, 2007. This table includes all adjustments, consisting only of normal
recurring adjustments, that we consider necessary for a fair statement of our financial position and operating results for the quarters presented.
Fiscal Quarter Ended
Liquidity and Capital Resources
We generated $0.2 million of cash for the year ended December 31, 2007 while pursuing our growth strategy of increasing revenues, opening new retail locations and providing inventory for those new stores. Cash was utilized for general working capital requirements, capital expenditure requirements and third-party debt service requirements. The sources for the cash generated related to proceeds from the refinancing of our subordinated debt and increased availability under our revolving credit facility. We successfully completed the refinancing of our senior and subordinated debt agreements in December 2007. As a result, the Company anticipates compliance with all new covenants under these new credit facilities in each of the next four quarters. We plan in the future to obtain additional financing from banks, or through public offerings or private placements of debt or equity securities, strategic relationships, or other arrangements. In the event we fail to meet our financial covenants with our banks, we may not have access through our line of credit to sufficient working capital to pursue our growth strategy, or if our covenant non-compliance triggers a default, our loans may be called requiring the repayment of all amounts on our loans.
Operating Activities
Cash utilized in our operating activities for the year ended December 31, 2007 was $0.6 million compared to $0.1 million for the corresponding period in 2006. For the year ended December 31, 2007, cash outflows consisted primarily of inventory increases of $2.0 million attributable to retail growth and increased buying. Cash outflows also consisted of decreases in accounts payable, and short-term borrowings of $1.3 million, and increases in receivables, partially offset by net income, non-cash expenses of $0.6 million, increases in accrued expenses of $0.8 million, and reductions in prepaid catalogs of $0.7 million. In 2006, cash utilized by our operating activities was $0.1 million, comprised of $2.2 million of net income and non-cash expenses, increased by accounts payables and accrued expenses of $2.9 million. Cash was decreased by additional
inventory of $4.1 million, primarily for new retail stores and support of increased revenues, higher seasonal prepaid catalog costs, and receivables generated by higher year-end sales levels.
Investing Activities
Cash used in our investing activities was $0.9 million for the year ended December 31, 2007, consisting primarily of retail store build-out and equipment costs. In 2006, cash utilized in our investing activities was $3.4 million with $1.9 million in retail store build-out and equipment costs, and an additional $1.5 million in the Dominion acquisition, primarily acquired inventory. Investment activities throughout these periods represent the purchase of capital equipment in support of our growth, including leasehold improvements, computer equipment, furniture and fixtures, and the purchase of other assets and related deposits. Increases in investment activities can be expected in future years to outfit our new retail stores.
Financing Activities
Net cash provided by our financing activities was $1.7 million for the year ended December 31, 2007, compared to $0.7 million provided in the corresponding period in 2006. Cash used in our financing activities included increases of $5.0 million in proceeds for the issuance of new senior subordinated notes and decreases consisting of $3.15 million in the settlement of our previous senior subordinated note, and $0.4 million in payments related to commitment and financing fees. Additionally, in 2007, we funded our seasonal operating activities and investing activities with net borrowings of $0.4 million under our revolving credit facility. In 2006, net cash provided by our financing activities was $0.7 million, consisting primarily of $0.9 million in additional utilization of our revolving debt facility.
Revolving Credit Facility
On December 11, 2007, the Company entered into a new senior revolving credit facility with RBS Citizens Bank N.A., under which it can borrow up to $18.0 million, including $2.0 million for letters of credit. Interest accrues at a variable rate based on either prime rate or published LIBOR rates. The credit facility expires on January 31, 2011, at which time all advances will be immediately due and payable. As of December 31, 2007, the revolving credit facility borrowing limit was $18.0 million and the amount outstanding under the credit facility was $6.3 million at a rate of 7%, and the unused amount available was $11.7 million. Borrowings are secured by substantially all of the Company’s assets. Under the terms of this credit facility, the Company is subject to various covenants. At December 31, 2007, we were in compliance with our new loan covenants under the credit facility, and we anticipate compliance with all new covenants under our new credit facilities in each of the next four quarters.
Senior Subordinated Note and Warrant
On December 11, 2007, the Company entered into a mezzanine loan agreement with BCA Mezzanine Fund, LP, Cephas Capital Partners, LP, and SEED Ventures, LP (jointly, the “Subordinated Holders”), which provided for the issuance of a senior subordinated note payable, which is due in full on December 11, 2012 for aggregate proceeds of $5.0 million. Of such proceeds, $3.15 million was used to pay off the previously existing subordinated note payable, which included a $0.15 million prepayment fee. The note is subordinated in right of payment to existing and future senior debt, ranks equal in right of payment with any future senior subordinated debt and is senior in right of payment to any future subordinated debt. Interest accrues at an annual rate of 14%, of which 12% is payable quarterly in arrears on the fifth business day of the following month. The remaining 2% per annum is deferrable, and if deferred, shall be compounded annually and due in full on December 11, 2012. As of December 31, 2007, the Company had deferred $5,833 of interest. Prepayment on the principal amount due under the note may voluntarily be made at any time, plus accrued and unpaid interest
and a prepayment fee of 5% of the prepaid amount if paid prior to the first anniversary, 4% if paid prior to the second anniversary, 3% if paid prior to the third anniversary, and 0% if paid after December 11, 2010. Under the terms of this senior subordinated credit facility, the Company is subject to various covenants. At December 31, 2007, we were in compliance with our new loan covenants under the credit facility, and we anticipate compliance with all new covenants under our new credit facilities in each of the next four quarters.
Simultaneously with the issuance of this note, we issued warrants to the Subordinated Holders, exercisable at any time after December 11, 2007, for an initial 118,170 shares of the registrant’s common stock at an initial exercise price of $3.96 per share. The number of shares to be received for the warrant is subject to change in the event of additional equity issuances and/or stock splits.
Working Capital and Capital Expenditure Needs
We believe our existing cash, cash equivalents, expected cash to be provided by our operating activities, and funds available through our revolving credit facility will be sufficient to meet our currently planned working capital and capital expenditure needs over at least the next twelve months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our marketing and sales activities, the expansion of our retail stores, the acquisition of new capabilities or technologies and the continuing market acceptance of our products. To the extent that existing cash, cash equivalents, cash from operations and cash from our revolving credit facility under the conditions and covenants of our credit facilities are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. Although we are currently not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, businesses, services or technologies which could require us to seek additional equity or debt financing, we may enter into these types of arrangements in the future. Additional funds may not be available on terms favorable to us or at all.
Contractual Obligations
We generally do not enter into binding purchase commitments. Our principal commitments consist of obligations under our revolving credit facility and leases for our headquarters and distribution facility, as well as our retail stores and miscellaneous office space. The following table describes our commitments to settle contractual obligations in cash as of December 31, 2007, unless otherwise noted:
(1)
Payments include principal and interest due under capital lease obligations
Off-Balance Sheet Arrangement
As of December 31, 2007, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of the Securities and Exchange Commission’s Regulation S-K.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses, and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates.
We believe that of our significant accounting policies, which are described in the notes to our consolidated financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, we believe that the following accounting policies are the most critical to fully understanding and evaluating our consolidated financial condition and results of operations.
Revenue Recognition
Revenues from product sales are recognized at the time of shipment to catalog and Internet customers and at the point of sale to retail store customers. At the time of recognition, we provide a reserve for projected product returns based on prior return experience. For the periods presented, merchandise returns have been consistent; resulting in period-end reserves of $822,000 and $713,000 for the years ended December 31, 2007 and 2006, respectively. We do not anticipate changes to the future trends of our merchandise returns.
Shipping and handling fees charged to the customer are recognized at the time the products are shipped to the customer and are included in net revenues. Shipping costs are included in cost of goods sold.
Inventory Valuation
Inventory consists of finished goods in our warehouse and retail stores. Our inventory is stated at the lower of cost, with cost determined by the first-in, first-out (FIFO) method, or net realizable market value. We continuously monitor the costs allocated to ensure adequate valuation of the related products. Our reserve for inventory obsolescence for the years ended December 31, 2007 and 2006 was $95,000 and $70,000, respectively. Inventory valuation charges have remained consistent throughout each period presented. We do not foresee any change to this trend which currently recognizes annual valuation charges below that of the period end reserve balances.
Advertising Costs and Catalog Expenses
The costs of direct-response advertising materials, primarily catalog production and distribution, are deferred in accordance with Statement of Position (SOP) 93-7, Reporting on Advertising Costs. These costs are recognized over the period of expected future revenues, which is less than one year. Advertising costs not related to our direct response catalogs and marketing activities are expensed as incurred.
Income Taxes
The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial statement and tax basis of assets and liabilities and net operating loss and credit carry forwards using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when it is more likely than not that some portion of the deferred tax assets will not be realized.
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting and disclosure for uncertainty in tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. The Company was subject to the provisions of FIN 48 as of January 1, 2007, and has analyzed filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, as well as all open tax years in these jurisdictions. The adoption of FIN 48 had no impact on the consolidated financial statements.
Stock-based Compensation
The Company adopted SFAS No. 123(R), which is a revision of SFAS No. 123, as of January 1, 2006, using the modified prospective method. Therefore, the results for the year ended December 31, 2005 have not been restated. Throughout 2006 and 2007, in connection with SFAS No. 123(R), all share-based payments to employees, and Directors, including grants of employee stock options, are recognized in the income statement based on their fair values.
Impairment of Long-lived Assets
We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to discounted future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. We do not believe that any of our long-lived assets were impaired as of December 31, 2007 and 2006.
We account for goodwill in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, which requires that goodwill be reviewed for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If the carrying amount of a reporting unit exceeds its estimated fair value, goodwill is evaluated for potential impairment. Management has determined, based on the guidance of SFAS No. 142, there is one reporting unit, the Company as a whole. We performed our annual test of impairment of goodwill as of December 31, 2007. We have determined that no impairment had occurred, as the fair value of the reporting unit exceeded the respective carrying value.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“Statement 157”). This Statement provides a common fair value hierarchy for companies to follow in determining fair value measurements in the preparation of financial statements and expands disclosure requirements relating to how such fair value measurements were developed. The Statement clarifies the principle that fair value should be based on the assumptions that the marketplace would use when pricing an asset or liability, rather than company-specific data. This Statement is effective for fiscal years beginning after November 15, 2007. However, on February 12, 2008, the FASB issued Staff Position 157-2 which delays the effective date of Statement 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. For items within its scope, this Staff Position defers the effective date of Statement 157 to fiscal years beginning after November 15, 2008. The Company is currently assessing the impact that the adoption of this statement will have on its results of operations and financial position.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 allows companies to measure many financial assets and liabilities at fair value. It also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The adoption of SFAS No. 159 is not expected to have a material impact on our financial position, results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“Statement 141R”) and SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements - an amendment of Accounting Research Bulletin No. 51 (“Statement 160”). Statement 141R will change how business acquisitions are accounted for and will impact financial statements both on the acquisition date and in subsequent periods. Statement 160 will change the accounting and reporting for minority interests, which will be re-characterized as non-controlling interests and classified as a component of equity. Statements 141R and 160 are effective for fiscal years beginning after December 15, 2008. Early adoption is not permitted. The Company is currently evaluating the impact, if any, these statements will have on its consolidated financial statements.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk.
Foreign Currency Risk
Nearly all of our revenues are derived from transactions denominated in U.S. dollars. We purchase products in the normal course of business from foreign manufacturers. As such, we have exposure to adverse changes in exchange rates associated with those product purchases, but this exposure has not been significant.
Impact of Inflation
We believe the effects of inflation, if any, on our results of operations and financial condition have not been material in recent years.
Interest Rate Sensitivity
We had cash and cash equivalents totaling $0.3 million at December 31, 2007. The unrestricted cash and cash equivalents are held for working capital purposes. We do not enter into investments for trading or speculative purposes. Some of the securities in which we invest, however, may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investments to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, debt securities and certificates of deposit. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. As of December 31, 2007, all of our investments were held in money market and other short-term investment accounts.
Our exposure to market risk also relates to the increase or decrease in the amount of interest expense we must pay on our outstanding debt instruments, primarily certain borrowings under our revolving credit facility. The advances under this revolving credit facility bear a variable rate of interest determined as a function of the prime rate and the published LIBOR rate at the time of the borrowing. If interest rates were to increase by one percent, the additional interest expense as of December 31, 2007 would be approximately $63,000 annually. At December 31, 2007, $6.3 million was outstanding under our revolving credit facility.
Item 8.
Item 8.
Financial Statements.
DOVER SADDLERY, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of Dover Saddlery, Inc.
We have audited the accompanying consolidated balance sheets of Dover Saddlery, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006 and the related consolidated statements of income, redeemable convertible preferred stock, stockholders’ equity and comprehensive income and cash flows for each of the three years in the period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Dover Saddlery, Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
As discussed in Note 2 to the consolidated financial statements, effective January 1, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes.
/s/ Ernst & Young LLP
Boston, Massachusetts
March 27, 2008
DOVER SADDLERY, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
DOVER SADDLERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes.
DOVER SADDLERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK,
STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
See accompanying notes.
DOVER SADDLERY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Operations and Organization
Dover Saddlery, Inc., a Delaware corporation (the “Company”), is a leading specialty retailer and the largest direct marketer of equestrian products in the United States. The Company sells products through a multi-channel strategy, including catalogs, the Internet, and retail stores located in Massachusetts, New Hampshire, Delaware, Texas, Virginia and Maryland. The Company provides a complete line of products, as well as specially developed private label offerings from its direct marketing headquarters, warehouse, and call center facility in Littleton, Massachusetts.
The accompanying consolidated financial statements comprise those of the Company and its wholly owned subsidiaries, Dover Saddlery, Inc., a Massachusetts corporation, Smith Brothers, Inc., a Texas corporation, Dover Saddlery Retail, Inc., a Massachusetts corporation, Old Dominion Enterprises, Inc., a Virginia corporation, and Dover Saddlery Direct, Inc., a Massachusetts corporation. All inter-company accounts and transactions have been eliminated in consolidation.
2.
Summary of Significant Accounting Policies
The accompanying financial statements reflect the application of certain accounting policies described in this note and elsewhere in the accompanying notes to financial statements.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Segment Information
Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information of those segments to be presented in interim financial reports issued to stockholders. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision-maker, or decision-making group, in making decisions on how to allocate resources and assess performance. The Company views its operations and manages its business as one operating segment utilizing a multi-channel distribution strategy.
Revenue Recognition
Revenues from merchandise sales, including shipping and handling, are recognized at the time of shipment to catalog and Internet customers and at the point of sale to retail store customers. Revenues are recorded net of local sales tax collected. At the time of recognition, the Company provides a reserve for projected merchandise returns. The reserve, which is based on prior return experience, is recorded in accrued expenses and other current liabilities (see Note 9).
Shipping and Handling Costs
The Company has classified amounts billed to customers for shipping and handling as revenue, and shipping and handling costs as cost of revenue in the accompanying statements of income.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Cost of Revenues and Selling, General and Administrative Expenses
The Company’s consolidated cost of revenues primarily consists of merchandise costs, purchasing, handling and transportation costs to obtain the merchandise and ship it to customers. The Company’s consolidated selling, general and administrative expenses primarily consist of selling and marketing expenses, including amortization of deferred catalog costs, retail occupancy cost, depreciation, amortization, and general and administrative expenses.
Cash and Cash Equivalents
The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents. Un-presented checks net of cash balances in a single bank account are classified as short-term bank borrowings.
Property and Equipment, Depreciation, and Amortization
Property and equipment are recorded at cost. Expenditures for additions, renewals, and betterments of property are capitalized and depreciated over the estimated useful life. Expenditures for repairs and maintenance are charged to expense as incurred.
The Company provides for depreciation and amortization of assets recorded, including those under capitalized leases, using the straight-line method by charges to operations in amounts that allocate the cost of the assets over their estimated useful lives as follows:
Depreciation and amortization of leasehold improvements and assets recorded under capital leases were approximately $710,000, $557,000, and $484,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
Inventory
Inventory consists of finished goods in the Company’s mail-order warehouse and retail stores. The Company’s inventories are stated at the lower of cost, with cost determined by the first-in, first-out method, or net realizable value. The Company maintains a reserve for excess and obsolete inventory. This reserve as of December 31, 2007 and 2006 was $95,000 and $70,000, respectively. The Company continuously monitors the salability of its inventories to ensure adequate valuation of the related merchandise.
Advertising
The costs of direct-response advertising materials, primarily catalog production and distribution, are deferred in accordance with Statement of Position (SOP) 93-7, Reporting on Advertising Costs. These costs are recognized over the period of expected future revenue, which is less than one year. Deferred costs as of December 31, 2007 and 2006 were $1,427,000 and $2,133,000, respectively. The combined marketing and advertising costs charged to selling, general, and administrative expenses for the years ended December 31, 2007, 2006 and 2005 were approximately $10,089,000, $9,783,000 and $8,415,000, respectively.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Goodwill
The Company accounts for its goodwill in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, which requires that goodwill be reviewed for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If the carrying amount of a reporting unit exceeds its estimated fair value, goodwill is evaluated for potential impairment.
Management has determined, based on the guidance of SFAS No. 142, that there is one reporting unit, the Company as a whole. The Company performed its annual test of impairment of goodwill as of December 31, 2007. Based on the results of the goodwill impairment test, the Company has determined that no impairment had occurred, as the fair value of the reporting unit exceeded the respective carrying value.
Accounting for Impairment of Long-Lived Assets
The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to discounted future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. The Company does not believe any of its long-lived assets have been impaired as of the periods presented.
Pre-opening Store Expenses
All non-capital costs associated with the opening of new retail stores are expensed as incurred.
Financial Instruments
SFAS No. 107, Disclosures About Fair Value of Financial Instruments, requires disclosure about fair value of financial instruments. The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, line of credit advances, and notes payable. The carrying value of cash and cash equivalents, accounts receivable, and accounts payable reflects fair value due to their short-term nature. The carrying value of the line of credit reflects fair value due to variable interest rates. The carrying value of the subordinated notes payable, as of December 31, 2007, is considered to be fair value as the notes were executed near year end.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk are principally cash equivalents and accounts receivable. The Company places its cash and cash equivalents in highly rated financial institutions. In addition, accounts receivable consists primarily of customer credit card transactions that are fully authorized with payment in transit as of period end and therefore no allowance for doubtful accounts is deemed necessary. For the periods presented, there were no customers that comprised more than 10%.
Derivative Instruments and Hedging Activities
In 2003, the Company entered into an interest rate swap agreement to hedge a portion of the variable cash flows resulting from fluctuations in the benchmark interest rate on its outstanding
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
revolving credit facility. This agreement involved the exchange of variable interest rates for fixed interest rates over the life of the agreement without an exchange of the notional amount upon which the payments were based. The differential received or paid was recorded as a change to stockholders’ equity. The instrument expired in December 2006.
Comprehensive Income
SFAS No. 130, Reporting Comprehensive Income, establishes standards for reporting and displaying comprehensive income and its components in the consolidated financial statements. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Other than reported net income, the only other item of comprehensive income is the effectively hedged interest rate swap adjustment, which expired in December 2006. Comprehensive income for the years ended December 31, 2007, 2006 and 2005 was $825,000, $1,344,000 and $906,000, respectively.
Income Taxes
The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial statement and tax basis of assets and liabilities and net operating loss and credit carry forwards using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when it is more likely than not that some portion of the deferred tax assets will not be realized.
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting and disclosure for uncertainty in tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. The Company was subject to the provisions of FIN 48 as of January 1, 2007, and has analyzed filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, as well as all open tax years in these jurisdictions. The adoption of FIN 48 had no impact on the consolidated financial statements.
Net Income Per Share
Basic and diluted net income per share is presented in conformity with SFAS No. 128, Earnings per Share. In accordance with SFAS No. 128, basic net income per share is determined by dividing net income available to common stockholders’ by the weighted average common shares outstanding during the period. Diluted net income per share is determined by dividing net income by the dilutive weighted average common shares outstanding. The dilutive weighted average common shares outstanding assumes a full conversion of preferred shares, if any, and includes the potential incremental common shares from the exercise of stock options and warrants using the treasury stock method, if dilutive.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A reconciliation of the number of shares used in the calculation of basic and diluted net income per share is as follows:
In 2007 and 2006, respectively, approximately 472,000 and 170,000 options to acquire common stock were excluded from the diluted weighted average shares calculation as the effect of such options are anti-dilutive.
A reconciliation of the net income available to common stockholders’ used in the calculation of basic net income per share is as follows:
Stock-based Compensation
Through December 31, 2005, the Company accounted for its stock-based awards to employees using the intrinsic value method prescribed in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under the intrinsic value method, compensation expense was measured on the date of grant as the difference between the deemed fair value of the Company’s common stock and the stock option exercise price. The Company recorded deferred compensation of $671,000 related to options granted in 2004. The Company fully recognized these costs in 2004 and 2005. Approximately $141,000 was charged to operations in the year ended December 31, 2005.
The Company’s Board of Directors authorized the accelerated vesting of 183,658 outstanding stock options on December 30, 2005. The options had a range of exercise prices of $1.56 to $10.00 and a weighted average exercise price of $8.55. The closing price of the Company’s common stock on December 29, 2005, the last trading day before approval of acceleration, was $9.19. The purpose of the accelerated vesting was to enable the Company to avoid recognizing future compensation expense associated with these options upon adoption of FASB Statement No. 123(R). The aggregate pre-tax expense that, absent the vesting acceleration, would have been reflected in the Company’s consolidated financial statements beginning in fiscal 2006 is estimated to be approximately $360,000.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Of the 183,658 accelerated options, 152,029 were valued below the exercise price, and therefore, no compensation expense was recorded. The remaining 31,632 were held by executives with considerable service to the Company. Accordingly, the Company assumed a zero forfeiture rate and therefore, no compensation expense was recorded in 2005 for those options.
On January 1, 2006 the Company adopted SFAS No. 123(R), which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes APB Opinion No. 25. Generally, the approach under SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Refer to Note 7 for further discussion of stock-based compensation recognized in 2006 and 2007 under SFAS 123(R).
In accordance with SFAS No. 123(R), the results for the year ended December 31, 2005 were not restated. The December 31, 2005 option awards were valued using the Black-Scholes option pricing model. The weighted average risk-free interest rate for these awards was 4.5%, with an expected life of 4 years, volatility of 20%, and no expected dividend yield. This generated a weighted average fair value of $8.55. If the stock-based compensation expenses for the Company’s stock option plan had been determined based upon the fair value at the grant date for the 2005 awards, the Company’s 2005 net income would have been as follows:
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“Statement 157”). This Statement provides a common fair value hierarchy for companies to follow in determining fair value measurements in the preparation of financial statements and expands disclosure requirements relating to how such fair value measurements were developed. The Statement clarifies the principle that fair value should be based on the assumptions that the marketplace would use when pricing an asset or liability, rather than company-specific data. This Statement is effective for fiscal years beginning after November 15, 2007. However, on February 12, 2008, the FASB issued Staff Position 157-2 which delays the effective date of Statement 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. For items within its scope, this Staff Position defers the effective date of Statement 157 to fiscal years beginning after November 15, 2008. The Company is currently
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
assessing the impact that the adoption of this statement will have on its results of operations and financial position.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 allows companies to measure many financial assets and liabilities at fair value. It also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The adoption of SFAS No. 159 is not expected to have a material impact on our financial position, results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“Statement 141R”) and SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements - an amendment of Accounting Research Bulletin No. 51 (“Statement 160”). Statement 141R will change how business acquisitions are accounted for and will impact financial statements both on the acquisition date and in subsequent periods. Statement 160 will change the accounting and reporting for minority interests, which will be re-characterized as non-controlling interests and classified as a component of equity. Statements 141R and 160 are effective for fiscal years beginning after December 15, 2008. Early adoption is not permitted. The Company is currently evaluating the impact, if any, these statements will have on its consolidated financial statements.
3.
Acquisition
On June 29, 2006 the Company executed a stock purchase agreement with the sole shareholder of Old Dominion Enterprises, Inc., doing business as Dominion Saddlery, to acquire all of the outstanding share capital of Old Dominion Enterprises, Inc. for a net price of $1.5 million. Of the original $0.3 million, $150,000 remains in escrow to cover certain contingencies and indemnity obligations. The Dominion acquisition has been accounted for in accordance with SFAS No. 141, Business Combinations. The values of the acquired assets and assumed liabilities were based upon management’s estimates of fair value. The excess of the purchase price over the fair value of the net assets acquired was recorded as goodwill.
The purchase price allocation was as follows (in thousands):
The following table sets forth the un-audited pro forma results of operations of the Company for the year ended December 31, 2006 and 2005 as if the Company had acquired Dominion as of January 1, 2005. These pro forma amounts do not purport to be indicative of the results that would
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
have actually been obtained if the acquisition had occurred as of January 1, 2005 or that may be obtained in the future.
4.
Financing Agreements
In December 2007, the Company completed a refinancing of its outstanding debt obligations with new lenders, increasing the revolving credit facility and senior subordinated notes to $18,000,000 and $5,000,000, respectively. In connection with the refinancing, the Company recognized a $96,000 loss on extinguishment of debt, which was primarily due to the accelerated recognition of the remaining unamortized deferred financing charges.
Revolving Credit Facility
The $18,000,000 revolving credit facility, of which up to $2,000,000 can be in the form of letters of credit, bears interest at the base rate, announced from time to time by the bank, plus an applicable margin determined by the Company’s funded debt ratio. As of December 31, 2007, the bank rate was 7.25% and the applicable margin was (0.25%). Interest is payable monthly on the last business day of each month. At its option, the Company may have all or a portion of the unpaid principal under the credit facility bear interest at various LIBOR rate options.
The Company is obligated to pay commitment fees of 0.125% per annum on the average daily, unused amount of the line of credit during the preceding quarter. All assets of the Company collateralize the revolving credit facility. Under the terms of the credit facility, the Company is subject to certain covenants including, among others, maximum funded debt ratios, operating cash flows, current asset ratios, and capital expenditures. At December 31, 2007, the Company was in compliance with all covenants. The revolving line of credit is due in full in January 2011.
At December 31, 2007, the Company had the ability to borrow $18,000,000 on the revolving line of credit, of which $6,300,000 was outstanding, bearing interest at the net revolver rate of 7%. At December 31, 2006, under the previous facility, the Company had the ability to borrow $16,000,000, of which $5,900,000 was outstanding, bearing interest at 8.25%.
Subordinated Notes Payable
In December 2007, the Company issued $5.0 million in senior subordinated notes payable. Of these proceeds, $3.15 million was used to repay the previously existing subordinated note payable, which included a $0.15 million prepayment fee. The notes are subordinated in right of payment to existing and future senior debt, ranks equal in right of payment with any future senior subordinated debt and is senior in right of payment to any future subordinated debt. Interest accrues at an annual rate of 14%, of which 12% is payable quarterly in arrears. The remaining 2% per annum is deferrable, and if deferred, shall be compounded and due in full on December 11, 2012. As of December 31,
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2007, the Company had deferred $5,833 of interest. Prepayment on the principal amount due under the notes may voluntarily be made at any time, plus accrued and unpaid interest and a prepayment fee of 5% of the prepaid amount if paid prior to the first anniversary, 4% if paid prior to the second anniversary, 3% if paid prior to the third anniversary, and 0% if paid after December 11, 2010.
In connection with the issuance of the subordinated notes, the Company issued warrants to the note holders, exercisable at any time after December 11, 2007 for an initial 118,170 shares of the registrant’s common stock at an exercise price of $3.96 per share. The number of shares to be received for the warrant is subject to change in the event of additional equity issuances and/or stock splits. The warrants were estimated to have a fair value of $272,000, which has been reflected as a discount of the proceeds. The discount is amortized through interest expense over the life of the notes. The warrants were valued using a Black-Scholes calculation with a risk free interest rate of 4.3%, an expected life of 9 years (which reflects the contractual term), a volatility of 43.4% and a dividend yield of 0%.
As of December 31, 2007, the net $4,738,000 subordinated notes, on the consolidated balance sheet, reflects the $5.0 million face value, plus the $5,833 in deferred interest less the net discount of $267,000.
Under the terms of the subordinated note agreements, the Company is subject to certain covenants, including, among others, maximum funded debt ratios, operating cash flows, current asset ratios and capital expenditures. At December 31, 2007, the Company was in compliance with all covenants.
Debt Payments
The estimated aggregate principal payments under our combined financing agreements as of December 31, 2007 for each of the next five fiscal years are as follows:
5.
Commitments
The Company leases its facilities and certain fixed assets that may be purchased for a nominal amount on the expiration of the leases under non-cancelable operating and capital leases that extend through 2017. These leases, which may be renewed for periods ranging from one to five years, include fixed rental agreements as well as agreements with rent escalation clauses.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Property and equipment includes the following cost and related accumulated depreciation associated with equipment remaining under capital lease:
The amortization expense for the assets recorded under capital leases is included in the depreciation expense.
Future minimum commitments as of December 31, 2007 are as follows:
Total rental expense under the operating agreements included in the accompanying consolidated statements of income for the years ended December 31, 2007, 2006 and 2005 was $1,682,000, $1,292,000, and $1,108,000, respectively.
In connection with retail locations, the Company enters into various operating lease agreements, with escalating rental payments. The effects of variable rent disbursements have been expensed on a straight-line basis over the life of the lease in accordance with SFAS No. 13, Accounting for Leases. As of December 31, 2007, there was approximately $110,000 of deferred rent recorded in other current liabilities. As of December 31, 2006, there was approximately $97,000 of deferred rent recorded in other current liabilities.
6.
Income Taxes
Income taxes are provided for in accordance with SFAS No. 109, Accounting for Income Taxes. Accordingly, a deferred tax asset or liability is recorded based on the differences between the financial reporting and tax bases of assets and liabilities and is measured by the enacted tax rates
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
expected to be in effect when these differences reverse. The deferred income tax provision results from the net change during the year of deferred income tax assets and liabilities. The income tax provision is as follows:
Deferred income taxes relate to the following temporary differences as of:
Valuation allowances are established when it is more likely than not that some portion of the deferred tax asset will not be realized. The valuation allowance as of December 31, 2006 was due to certain state net operating losses that were not likely to be realized. In 2007, laws were enacted that impaired the related net operating losses. As a result, the deferred tax asset and related valuation allowance of $115,488 were written off in 2007. This had no impact on the 2007 statements of income.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The effective income tax rate varies from the amount computed using the statutory U.S. income tax rate as follows:
Effective January 1, 2007, the Company adopted FIN 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109. The application of the Interpretation’s provisions did not change our liability for unrecognized tax benefits. At January 1, 2007 and December 31, 2007, the Company had a $25,000 liability recorded for unrecognized tax benefits. Of this amount, $18,000 would affect the tax rate if recognized, although the Company does not currently expect to recognize this amount. In the next twelve months, the Company expects to make payments that will reduce the liability to zero.
The Company has reviewed its tax positions to determine whether the positions are more likely than not to be sustained upon examination by regulatory authorities. If a tax position meets the more-likely-than-not standard, then the related tax benefit is measured based on a cumulative probability analysis of the amount that is more-likely-than-not to be realized upon ultimate settlement or disposition of the underlying issue.
Although the Company believes it has adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. The Company adjusts these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.
The Company records interest and penalties related to income taxes as a component of income tax expense. The Company did not recognize any interest and penalty expense for the year ended December 31, 2007.
Tax years 2004 through 2007 remain subject to examination by the IRS, and 2003 through 2007 tax years remain subject to examination by Massachusetts and various other jurisdictions that are not material to the financial statements, although no examinations are currently in progress.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
An analysis of activity related to unrecognized tax benefits follows for year ended December 31, 2007:
7.
Stockholders’ Equity
Preferred Stock
The Company currently has authorized 1,000,000 shares of Preferred Stock, none of which were issued or outstanding at December 31, 2007.
Stock Option Plans
In August 2005, our Board of Directors approved the 2005 Equity Incentive Plan, which became effective on November 17, 2005, concurrent with our public offering. The 2005 Equity Incentive Plan provides for the grant of incentive stock options to employees and non-qualified stock options, awards of common stock and opportunities to make direct purchases of common and other stock to our employees and directors.
The aggregate number of shares of our common stock that may be issued under the 2005 Equity Incentive Plan is 623,574. The aggregate number of shares of common stock that may be granted in any calendar year to any one person pursuant to the 2005 Equity Incentive Plan may not exceed 50% of the aggregate number shares of our common stock that may be issued pursuant to the 2005 Equity Incentive Plan.
The 2005 Equity Incentive Plan is administered by the compensation committee of our Board of Directors, which has been granted the discretion to determine when awards are made, which directors or employees receive awards, whether an award will be in the form of an incentive stock option, a nonqualified stock option or restricted stock, the number of shares subject to each award, vesting, and acceleration of vesting. Generally, options granted to employees under the 2005 Equity Incentive Plan are expected to vest over a five year period from the date of grant.
Stock options issued under the 2005 Equity Incentive Plan generally expire within ten years or, in the case of incentive stock options issued to 10% or greater shareholders, within five years.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes all stock option activities.
Prior to the adoption of the 2005 Plan, the Company had issued 513,981 options under the 1999 Plan, which was the maximum the plan permitted. Under the 2005 Plan, the Company has reserved a total of 623,574 shares of common stock for issuance under the Plan. As of December 31, 2007, 151,718 shares were available for future grants, and as of December 31, 2006, 298,516 shares were available for future grants.
The following table sets forth the intrinsic value at December 31, 2007, for outstanding options:
(1)
The aggregate intrinsic value was calculated based on the difference between the fair value of the Company’s common stock on December 31, 2007 and the weighted average exercise price of the underlying options.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock-based Compensation
The Company utilizes the Binomial Lattice option pricing model to determine the fair value of stock-based compensation. The Binomial Lattice model requires the Company to make subjective assumptions regarding the volatility of the underlying stock. The estimated volatility of the Company’s common stock price is based on the median of the fluctuations in the historical price of the Company’s common stock. The Binomial Lattice model also requires a risk-free interest rate, which is based on the U.S. Treasury yield curve in effect at the time of the grant, and the dividend yield on the Company’s common stock, which is assumed to be zero since the Company does not pay dividends and has no current plans to do so in the future. Changes in these assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related expense recognized on the consolidated statement of operations.
In November 2007 and 2006, the Company granted 162,523 and 166,029 options, respectively, to acquire common stock to Company employees and directors. Using the Binomial Lattice model (with assumptions disclosed below), the 2007 and 2006 awards had weighted average fair value of $1.78 and $2.85 per option, respectively. The fair value of awarded options recognized was $102,000 and $17,000 for the years ended December 31, 2007 and 2006, respectively. The fair value of these awards was recorded as stock-based compensation expense included in general and administrative expense. The remaining unrecognized stock-based compensation expense related to unvested awards at December 31, 2007, was approximately $643,000 to be recognized on a straight-line basis over the employee’s weighted average vesting period of 4.5 years.
The following table illustrates the assumptions used in the Binomial Lattice calculation used to value to the option awards recognized in the 2007 and 2006 income statements:
Common Stock Warrants
In connection with the issuance of the senior subordinated debt in 2005, the Company issued a warrant to the Patriot Capital Funding, Inc. to purchase 30,974 common shares at $0.00759 per share. The warrant was exercised by Patriot Capital Funding, Inc. in August 2007. On the date of exercise, August 13, 2007, the fair value of the common stock was $5.38 per share, resulting in an aggregate intrinsic value of approximately $166,000. The Company recognized proceeds of $235 related to the exercise.
In connection with the refinancing completed in December 2007, the Company issued warrants to the lenders to purchase an initial 118,170 common shares at $3.96 per share. The warrants had a fair value of $272,000, and are fully exercisable after December 11, 2007. The warrants expire in December 2016. The warrants had an intrinsic value of approximately $24,000, and remained outstanding as of December 31, 2007. The number of shares to be received for the warrant is subject to change in the event of additional equity issuances and/or stock splits.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
8.
Employee Savings Plan
The Company maintains the Dover Saddlery, Inc. 401k Profit Sharing Plan (the 401k Plan). Employees of the Company may participate in the 401k Plan after three months of service, which allows employees to defer a percentage of their salary under Section 401k of the Internal Revenue Code. The 401k Plan also allows for the Company to make discretionary contributions determined annually based on a percentage of the employee’s compensation. No employer contributions were made during the periods presented.
9.
Accrued Expenses and Other Current Liabilities
Accrued expenses and other current liabilities consisted of the following:
10.
Intangibles and Other Assets
Intangibles and other assets consist of the following:
Deferred financing costs are amortized over the shorter of the contractual or estimated life of the related debt. In connection with the debt refinance discussed in Note 4, the Company recognized all
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
previously unamortized deferred financing costs associated with the extinguished facilities. Purchased catalog and related assets are amortized on a straight-line basis over the estimated useful lives of the underlying assets, extending through 2011. Amortization expense for the Company’s intangible assets for the years ended December 31, 2007, 2006 and 2005 was $89,000, $137,000 and $788,000, respectively.
The estimated aggregate of intangible and deferred financing expense for each of the next five years is as follows:
11.
Related Party Transactions
On October 26, 2007, the disinterested members of the Audit Committee of the Board of Directors approved a $5.0 million subordinated debt financing facility as part of a plan to refinance the Company’s current subordinated debt with Patriot Capital. The new sub-debt facility was led by BCA Mezzanine Fund, L.P., which participated at $2.0 million (in which Company Board member Gregory Mulligan holds a management position and indirect economic interest). The subordinated loans were consummated as of December 11, 2007. Except as noted above with respect to Mr. Mulligan, there is no relationship, arrangement or understanding between the Company and any of the Subordinated Holders or any of their affiliates, other than in respect of the loan agreement establishing and setting forth the terms and conditions of this mezzanine loan agreement.
In October of 2004, the Company entered into a lease agreement with a minority stockholder. The agreement, which relates to the Plaistow, NH retail store, is a five year lease with options to extend for an additional fifteen years. For the years ended December 31, 2007 and 2006, the Company paid and expensed $200,000 in connection with the lease, respectively. In addition, a related deposit of $18,750 is recorded as prepaid expenses and other current assets.
In order to expedite the efficient build-out of leasehold improvements in its new retail stores, the Company utilizes the services of a real estate development company owned by a non-executive Company employee and minority stockholder to source construction services and retail fixtures. Total payments for the year ended December 31, 2007, consisting primarily of reimbursements for materials and outside labor, for the fit-up of four stores were $395,000. Reimbursements for the year ended December 31, 2006 were $525,000.
12.
Contingencies
From time to time, we are exposed to litigation relating to our products and operations. Except as described below, we are not currently engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material, adverse affect on our financial condition or results of operations.
The Company has been named as a defendant in litigation brought by one of its customers against the manufacturer of a riding helmet for injuries sustained in an equestrian accident. To the best of our knowledge, the product was designed and manufactured by our vendor to industry standards. The claim against Dover is covered by our insurance, and we vigorously deny liability.
DOVER SADDLERY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On March 24, 2006, GAH filed a demand for arbitration with the American Arbitration Association for $2.1 million, plus interest, seeking a success fee purportedly due in connection with the Company’s Initial Public Offering. In May 2007, we finalized the settlement with GAH and agreed to pay $700,000 in order to avoid the burden on management, the costs of preparation and trial, and risks of a potential adverse outcome. This charge was recorded in the first quarter of 2007. As of December 31, 2007, $478,000 of this settlement had been paid under the agreement. The remaining $222,000, plus interest, is scheduled to be paid in installments through April 1, 2009, and is recorded in accrued expenses and other current liabilities within the accompanying consolidated balance sheet.
13.
Quarterly Financial Data (un-audited)
The following tables contain selected quarterly consolidated financial data for fiscal 2007 and fiscal 2006 that were prepared on the same basis as the audited consolidated financial statements and include all adjustments necessary to present fairly, in all material respects, the information set forth therein on a consistent basis.
The sum of the quarterly EPS amounts may not equal the full year amount since the computations of the weighted average shares outstanding for each quarter and the full year are made independently.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Not applicable.
Item 9A.
Item 9A.
Controls and Procedures.
Not applicable.
Item 9A(T).
Controls and Procedures.
Our management has responsibility for establishing and maintaining adequate internal control over financial reporting for the Company.
With the participation of our chief executive officer and chief financial officer, we evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2007. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under 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 controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2007, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
With the participation of our chief executive officer and chief financial officer, we also evaluated the effectiveness of our internal controls over financial reporting (as defined in § 240.13a - 15(f) or § 240.15d - 15(f) under the Securities Exchange Act of 1934, as amended) as of December 31, 2007 against the control framework for internal controls specified by The Internal Control - Integrated Framework (1992), created by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), as supplemented by (i) the guidance of the U.S. Securities and Exchange Commission (SEC) in SEC Interpretive Release No. 34-55929 (June 27, 2007), and (ii) COSO’s Internal Control over Financial Reporting - Guidance for Smaller Public Companies (2006). Based on the foregoing evaluation, management concluded that the Company’s internal controls over financial reporting were effective as of December 31, 2007 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
No change in our internal control over financial reporting occurred during the fiscal quarter ended December 31, 2007 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the company to provide only management’s report in this annual report.
The report in this Item 9A(T) shall be deemed to be furnished to the Securities and Exchange Commission, and shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.
Item 9B.
Item 9B.
Other Information.
Not applicable.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance.
The information set forth under the captions “Directors, Executive Officers” and “Corporate Governance”, “Section 16(a) Beneficial Ownership Reporting Compliance” and “Code of Ethics” appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 7, 2008, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2007, is incorporated herein by reference.
Item 11.
Item 11.
Executive Compensation.
The information set forth under the caption “Remuneration of Executive Officers and Directors” appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 7, 2008, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2007, is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information set forth under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plans” appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 7, 2008, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2007, is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence.
The information set forth under the captions “Certain Relationships and Related Transactions” and “Director Independence”, appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 7, 2008, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2007, is incorporated herein by reference.
Item 14.
Item 14.
Principal Accounting Fees and Services.
The information set forth under the captions “Principal Accounting Fees and Services” appearing in our definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on May 7, 2008, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2007, is incorporated herein by reference.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules.
(a)(1) Financial Statements
The index to the consolidated financial statements follows:
(a)(2) Financial Statement Schedule
The information required by this Item has been included in the Financial Statements and related notes in Item 8 above.
(b) Exhibits
Number
Description
*1
.1
Form of Underwriting Agreement
*3
.1
Amended and Restated Certificate of Incorporation of the Company
*3
.2
Certificate of Amendment to Certificate of Incorporation of the Company
*3
.3
Second Amended and Restated Certificate of Incorporation of the Company to be filed upon completion of this offering
*3
.4
By-laws of the Company
*3
.5
Amended and Restated By-laws of the Company to be effective upon completion of this offering
***3
.6
Amendment to By-Laws of the Company
*4
.1
Shareholders Agreement, dated as of September 17, 1998, by and among the Company, Stephen L. Day, Jonathan A.R. Grylls, David Post, Donald Motsenbocker, Thomas Gaines, David J. Powers, James F. Powers, and Michele R. Powers
*4
.2
First Amendment to Shareholders Agreement, dated as of August 29, 2003, by and among the Company, Stephen L. Day, Jonathan A.R. Grylls, David Post, Thomas Gaines, David J. Powers, James F. Powers, and Michele R. Powers
*4
.3
Second Amendment to Shareholders Agreement, dated as of August 25, 2005, by and among a majority in interest of the Purchasers (as defined therein) and a majority in interest of the Sellers (as defined therein)
*4
.4
Instrument of accession, dated as of September 16, 2005, signed by Citizens Ventures, Inc. and accepted by the Company, to that certain Shareholders Agreement, dated as of September 17, 1998, by and among the Company and the Shareholders referenced therein, as amended
*4
.5
Form of Common Stock Certificate
*4
.6
Warrant to purchase common stock of the Company issued to Patriot Capital Funding, Inc.
*4
.7
Amended and Restated 11.50% Senior Secured Subordinated Note, dated September 16, 2005, issued jointly by the Company, Dover Massachusetts and Smith Brothers, Inc. to Patriot Capital Funding, Inc.
^
Filed herewith
*
Incorporated by reference herein to the exhibits to the Company’s Registration Statement on Form S-1 (File No. 333-127888)
**
Filed with the Company’s Form 8-K Current Report on December 14, 2007
***
Filed with the Company’s Form 8-K Current Report on December 28, 2007
+++
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2007 on November 13, 2007
^^^
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2007 on August 14, 2007
###
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2007 on May 15,
#
Filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 on April 2, 2007
##
Filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 on March 30, 2006
++
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2006, on May 15, 2006
^^
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2006 , on August 14, 2006
+
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2006, on November 13, 2006

Indicates a management contract or compensatory plan or arrangement
(1)
Amends Employment Agreement filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.30
(2)
Amends Employment Agreement filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.31
(3)
Amends and restates Code of Conduct and Ethics filed with the Company’s Registration Statement on Form S-1/A on October 2, 2005 as Exhibit 14.1
(4)
Amends Amended and Restated Loan Agreement dated as of December 11, 2003, with Fleet National Bank, filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.18
(5)
Amends Amended and Restated Senior Subordinated Note and Warrant Purchase Agreement dated as of September 16, 2005, with Patriot Capital Funding, Inc., filed with the Company’s Registration Statement on Form S-1/A on October 5, 2005 as Exhibit 10.32
(6)
Pertains to Amended and Restated Loan Agreement dated as of December 11, 2003, with Fleet National Bank, filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.16
(7)
Amends Lease dated as of May 29, 1997, by and between Dover Massachusetts and CE Holman LLP, filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.6
(8)
Pertains to Amended and Restated Senior Subordinated Note and Warrant Purchase Agreement dated as of September 16, 2005, with Patriot Capital Funding, Inc., filed with the Company’s Registration Statement on Form S-1/A on October 5, 2005 as Exhibit 10.32
(9)
Amends and renews Lease Agreement for Shopping Center Space between Sequel Investors Limited Partnership and Old Dominion Enterprises, Inc. dated as of May 20, 1997, as filed on August 14, 2006 with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2006 as Exhibit 10.42
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dover Saddlery, Inc.
Dated March 31, 2008
By:
/s/ Stephen L. Day
President, Chief Executive Officer
and Director (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
DOVER SADDLERY, INC.
Form 10-K
For the Year Ended December 31, 2007
EXHIBIT INDEX
^
Filed herewith
*
Incorporated by reference herein to the exhibits to the Company’s Registration Statement on Form S-1 (File No. 333-127888)
**
Filed with the Company’s Form 8-K Current Report on December 14, 2007
***
Filed with the Company’s Form 8-K Current Report on December 28, 2007
+++
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2007 on November 13, 2007
^^^
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2007 on August 14, 2007
###
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2007 on May 15,
#
Filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 on April 2, 2007
##
Filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 on March 30, 2006
++
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2006, on May 15, 2006
^^
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2006 , on August 14, 2006
+
Filed with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2006, on November 13, 2006

Indicates a management contract or compensatory plan or arrangement
(1)
Amends Employment Agreement filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.30
(2)
Amends Employment Agreement filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.31
(3)
Amends and restates Code of Conduct and Ethics filed with the Company’s Registration Statement on Form S-1/A on October 2, 2005 as Exhibit 14.1
(4)
Amends Amended and Restated Loan Agreement dated as of December 11, 2003, with Fleet National Bank, filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.18
(5)
Amends Amended and Restated Senior Subordinated Note and Warrant Purchase Agreement dated as of September 16, 2005, with Patriot Capital Funding, Inc., filed with the Company’s Registration Statement on Form S-1/A on October 5, 2005 as Exhibit 10.32.
(6)
Pertains to Amended and Restated Loan Agreement dated as of December 11, 2003, with Fleet National Bank, filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.16.
(7)
Amends Lease dated as of May 29, 1997, by and between Dover Massachusetts and CE Holman LLP, filed with the Company’s Registration Statement on Form S-1 on August 26, 2005 as Exhibit 10.6
(8)
Pertains to Amended and Restated Senior Subordinated Note and Warrant Purchase Agreement dated as of September 16, 2005, with Patriot Capital Funding, Inc., filed with the Company’s Registration Statement on Form S-1/A on October 5, 2005 as Exhibit 10.32
(9)
Amends and renews Lease Agreement for Shopping Center Space between Sequel Investors Limited Partnership and Old Dominion Enterprises, Inc. dated as of May 20, 1997, as filed on August 14, 2006 with the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2006 as Exhibit 10.42