ROCKY BRANDS, INC. 10-K

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.   This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) describes the matters that we consider to be important to understanding the results of our operations for each of the two years in the period ended December 31, 2020 and 2019, and our capital resources and liquidity as of December 31, 2020 and 2019. Use of the terms “Rocky,” the “Company,” “we,” “us” and “our” in this discussion refer to Rocky Brands, Inc. and its subsidiaries. Our fiscal year begins on January 1 and ends on December 31. We analyze the results of our operations for the last two years, including the trends in the overall business followed by a discussion of our cash flows and liquidity, our credit facility, and contractual commitments. We then provide a review of the critical accounting judgments and estimates that we have made that we believe are most important to an understanding of our MD&A and our consolidated financial statements. We conclude our MD&A with information on recent accounting pronouncements which we adopted during the year, as well as those not yet adopted that are expected to have an impact on our financial accounting practices.   The following discussion should be read in conjunction with the “Selected Consolidated Financial Data” and our consolidated financial statements and the notes thereto, all included elsewhere herein. The forward-looking statements in this section and other parts of this document involve risks and uncertainties including statements regarding our plans, objectives, goals, strategies, and financial performance. Our actual results could differ materially from the results anticipated in these forward-looking statements as a result of factors set forth under the caption “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995” below. The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements made by or on behalf of the Company.   EXECUTIVE OVERVIEW   We are a leading designer, manufacturer and marketer of premium quality footwear and apparel marketed under a portfolio of well recognized brand names including Rocky, Georgia Boot, Durango, Lehigh, and the licensed brand Michelin. In addition, on March 15, 2021, we closed on our acquisition of the performance and lifestyle footwear business of Honeywell International, Inc., which expanded our brand portfolio to include The Original Muck Boot Company, XTRATUF, Servus, NEOS and Ranger brands.   Our products are distributed through three distinct business segments: Wholesale, Retail and Military. In our Wholesale business, we distribute our products through a wide range of distribution channels representing over 10,000 retail store locations in the U.S. and Canada as well as in several international markets. Our Wholesale channels vary by product line and include sporting goods stores, outdoor retailers, independent shoe retailers, hardware stores, catalogs, mass merchants, uniform stores, farm store chains, specialty safety stores, specialty retailers and online retailers. Our Retail business includes direct sales of our products to consumers through our business to business web platform, e-commerce websites, third party marketplaces and our Rocky outlet store. We also sell footwear under the Rocky label to the U.S. military.   Our growth strategy is founded substantially on the expansion of our brands into new footwear and apparel markets. New products that we introduce may not be successful with consumers or one or more of our brands may fall out of favor with consumers. If we are unable to anticipate, identify or react appropriately to changes in consumer preferences, we may not grow as fast as we plan to grow or our sales may decline, and our brand image and operating performance may suffer.   Furthermore, achieving market acceptance for new products will likely require us to exert substantial product development and marketing efforts, which could result in a material increase in our operating expenses and there can be no assurance that we will have the resources necessary to undertake such efforts. Material increases in our operating expenses could adversely impact our results of operations and cash flows.   We may also encounter difficulties in producing new products that we did not anticipate during the development stage. Our development schedules for new products are difficult to predict and are subject to change as a result of shifting priorities in response to consumer preferences and competing products. If we are not able to efficiently manufacture newly-developed products in quantities sufficient to support retail distribution, we may not be able to recoup our investment in the development of new products. Failure to gain market acceptance for new products that we introduce could impede our growth, reduce our profits, adversely affect the image of our brands, erode our competitive position and result in long term harm to our business.   The impact of COVID-19 and the related economic, business and market disruptions were wide-ranging. These impacts have had and may continue to cause disruptions from both a manufacturing and distribution standpoint. As a result of COVID-19, we were required to temporarily close our manufacturing facilities in both the Dominican Republic and Puerto Rico for several weeks spanning through both the first and second quarters of 2020. In response to COVID-19, we have incurred incremental costs associated with protecting the health and safety of our global workforce, enhanced sanitization of our global operating facilities, and information technology capabilities for employees operating remotely. Beginning in March 2020, restrictions imposed by various governmental authorities on both domestic and international shipping and travel have caused a disruption to the timing of delivery of raw materials and finished goods resulting in negative impacts to our financial position, results of operations and cash flows. The duration and severity of the outbreak and its long-term impact on our business are uncertain at this time. We are unable to predict the impact that COVID-19 will have on our future financial position, results of operations and cash flows.   Net sales. Net sales and related cost of goods sold are recognized at the time products are shipped to the customer and title transfers. Net sales are recorded net of estimated sales discounts and returns based upon specific customer agreements and historical trends. Net sales include royalty income from licensing our brands.   Cost of goods sold. Our cost of goods sold represents our costs to manufacture products in our own facilities, including raw materials costs and all overhead expenses related to production, as well as the cost to purchase finished products from our third-party manufacturers. Cost of goods sold also includes the cost to transport these products to our distribution center.   20 Table of Contents   Operating expenses. Our operating expenses consist primarily of selling, marketing, wages and related payroll and employee benefit costs, travel and insurance expenses, depreciation, amortization, professional fees, software licensing fees, facility expenses, bank charges, warehouse and outbound freight expenses.   Percentage of Net Sales   The following table sets forth consolidated statements of operations data as percentages of total net sales:       Twelve Months Ended       December 31,       2020     2019   Net sales     100.0 %     100.0 % Cost of goods sold     62.2       63.9   Gross margin     37.8       36.1   Operating expenses     28.0       28.0   Income from operations     9.8 %     8.1 %   Results of Operations   December 31, 2020 Compared to Year Ended December 31, 2019       Twelve Months Ended       December 31,   ($ in thousands)   2020     2019     Inc./ (Dec.)     Inc./ (Dec.)   NET SALES:                                 Wholesale   $ 185,554     $ 179,519     $ 6,035       3.4 % Retail     72,877       64,824       8,053       12.4   Military     18,878       26,065       (7,187 )     (27.6 ) Total Net Sales   $ 277,309     $ 270,408     $ 6,901       2.6 %   Wholesale sales increased due to a strong demand for our products as consumers continued to respond favorably to our recent product introductions. We were also able to capitalize on a strong inventory position as the economy reopened and consumers returned to shopping at brick and mortar retail.    Retail sales increased primarily due to strong growth in our direct to consumer e-Commerce and marketplace businesses. We have increased our targeted marketing efforts and brand awareness, which has led to increased traffic on our branded websites. We have also continued to expand our direct to consumer efforts on marketplaces, such as Amazon and eBay. Fiscal year 2020 was our first full year of having Seller Fulfilled Prime status, which made our entire catalog “Prime Eligible”.     21 Table of Contents   Military sales decreased slightly, as expected, due to the recent expiration of some multi-year contracts.       Twelve Months Ended       December 31,   ($ in thousands)   2020     2019     Inc./ (Dec.)   GROSS MARGIN:                         Wholesale Margin $'s   $ 66,336     $ 61,133     $ 5,203   Margin %     35.8 %     34.1 %     1.7 % Retail Margin $'s   $ 34,283     $ 28,941     $ 5,342   Margin %     47.0 %     44.6 %     2.4 % Military Margin $'s   $ 4,116     $ 7,611     $ (3,495 ) Margin %     21.8 %     29.2 %     -7.4 % Total Margin $'s   $ 104,735     $ 97,685     $ 7,050   Margin %     37.8 %     36.1 %     1.6 %       Wholesale gross margin increased primarily due to our dedicated focus to increasing full price selling by offering less discounts while maintaining stronger initial margins on some of our newer products and increased efficiencies at our manufacturing facilities.   Retail gross margins increased primarily due to an increase in direct to consumer sales which carry a higher margin and a decrease in certain Lehigh sales which carry lower margins.   Military gross margin decreased year-over-year due to adjustments related to the overhead, payroll expenses and supplies incurred during the temporary closure of our manufacturing facilities due to the COVID-19 pandemic. These expenses were partially offset by the employee retention credit tied to the CARES Act of 2020. The net effect of these closure related expenses and employee retention credits was approximately $654,000. Adjusting for the previously mentioned expenses and credits, our 2020 military margins would have been 25.3%. In 2019, margins included a $581,000 one-time expense reimbursement to our Puerto Rico facility associated with the temporary closure as a result of Hurricane Maria in 2017. Excluding the one-time reimbursement, gross margins would have been 27.0%.         Twelve Months Ended       December 31,   ($ in thousands)   2020     2019     Inc./ (Dec.)     Inc./ (Dec.)   OPERATING EXPENSES:                                 Operating Expenses   $ 77,565     $ 75,600     $ 1,965       2.6 % % of Net Sales     28.0 %     28.0 %     0.0 %           Operating expenses increased year-over-year as we continued to invest in our core brands to help initiate growth and expand within our respective markets and invest in personnel to continue to drive operational excellence throughout our organization. We also experienced an increase in variable expenses such as commissions, freight and third party platform fees associated with an increase in Wholesale and Retail sales. These increases were partially offset with a decrease in certain expenses due to the COVID-19 pandemic, such as travel and tradeshows.       Twelve Months Ended       December 31,   ($ in thousands)   2020     2019     Inc./ (Dec.)     Inc./ (Dec.)   OTHER EXPENSES:                                 Other (Expense) Income   $ (205 )   $ 146     $ (351 )     -240.4 %   Other expenses increased due to higher interest expense from borrowing against our credit facility in the second quarter of 2020 and unfavorable currency exchange rates from our Canadian business. Interest rates on our cash and cash equivalents have also declined in 2020.   22 Table of Contents       Twelve Months Ended       December 31,   ($ in thousands)   2020     2019     Inc./ (Dec.)     Inc./ (Dec.)   INCOME TAXES:                                 Income Tax Expense   $ 6,001     $ 4,769     $ 1,232       25.8 % Effective Tax Rate     22.3 %     21.5 %     0.8 %           The effective tax rate for 2020 increased due to additional state taxing authorities requiring unitary filings and additional share-based compensation not deductible for tax purposes.      LIQUIDITY AND CAPITAL RESOURCES   Overview   Our principal sources of liquidity have been our income from operations and borrowings under our credit facility and other indebtedness.   Over the last several years our principal uses of cash have been for working capital and capital expenditures to support our growth as well as dividend payments and share repurchases. Our working capital consists primarily of trade receivables and inventory, offset by accounts payable and accrued expenses. Our working capital fluctuates throughout the year as a result of our seasonal business cycle and business expansion and is generally lowest in the months of January through March of each year and highest during the months of May through October of each year. We historically utilize our revolving credit facility to fund our seasonal working capital requirements. As a result, balances on our revolving credit facility could fluctuate significantly throughout the year. Our working capital increased to $123.2 million at December 31, 2020, compared to $114.6 million at the end of the prior year.   Our capital expenditures relate primarily to projects relating to our corporate offices, property, merchandising fixtures, molds and equipment associated with our manufacturing and distribution operations and for information technology. Capital expenditures were $11.6 million for 2020 and $9.5 million in 2019. Capital expenditures for 2021 are anticipated to be approximately $9.5 million.   We lease certain machinery, equipment, and manufacturing facilities under operating leases that generally provide for renewal options. Future minimum lease payments under non-cancelable operating leases are outlined in further detail in Note 8 .   In connection with our recent acquisition of the performance and lifestyle footwear business of Honeywell International, Inc. (Honeywell), we incurred approximately $705,000 of transaction related expenses for the year ended December 31, 2020, which are included in operating expenses in the consolidated statement of operations. From the period January 1, 2021 to March 15, 2021, we incurred approximately $4.5 million of transaction related costs. We expect to incur additional integration and post-close related expenses after the date of these financial statements that cannot be quantified at this time.   We believe that our credit facility coupled with cash generated from operations will provide sufficient liquidity to fund our operations for at least the next twelve months. Our continued liquidity, however, is contingent upon future operating performance, cash flows and our ability to meet financial covenants under our credit facility. For more information regarding our credit facility please see Note 7 . Refer to Note 19   for additional information regarding our recent acquisition.   Cash Flows       Twelve Months Ended       December 31,   ($ in millions)   2020     2019   Operating activities   $ 31.4     $ 18.0   Investing activities     (11.7 )     (7.7 ) Financing activities     (6.9 )     (5.0 ) Net change in cash and cash equivalents   $ 12.8     $ 5.3     Operating Activities. The principal sources of net cash in 2020 and 2019 included increases to accounts payable and accrued liabilities. These sources of net cash were partially offset by an increase in trade receivables and inventories.   Investing Activities. The principal uses of cash in 2020 and 2019 were related to investments in molds and equipment associated with our manufacturing operations, investments in information technology and improvements made to our distribution facility. 23 Table of Contents   Financing Activities. Our financing activities during 2020 and 2019 principally were payments of dividends, proceeds from stock option issuances and repurchases of our common stock.   On March 8, 2021, we announced a new $7,500,000 share repurchase program that will replace the 2020 plan and will expire on March 4, 2022. Management could decide to repurchase additional shares under the current program up through the date of expiration of the program. For additional information regarding this share repurchase program see Note 11 .   Contractual Obligations and Commercial Commitments   The following table summarizes our contractual obligations at December 31, 2020 resulting from financial contracts and commitments. We have not included information on our recurring purchases of materials for use in our manufacturing operations. These amounts are generally consistent from year to year, closely reflect our levels of production, and are not long-term in nature (less than three months).   Contractual Obligations at December 31, 2020:   ($ in millions)   Total     Less than 1 Year     1-3 Years     3-5 Years     Over 5 Years   Long-term debt (Note 7)     -       -       -       -       -   Long-Term Taxes payable   $ 0.2       -       -       -     $ 0.2   Minimum operating lease commitments (Note 8)     1.7     $ 0.7     $ 1.0     $ 0.0       -   Expected cash requirements for credit facility (1)     0.4       0.1       0.3       -       -   Contract Liabilities (Note 14)     5.6       5.6       -       -       -   Consulting commitments     1.3       1.3       -       -       -   Total contractual obligations   $ 9.1     $ 6.8     $ 2.0     $ 0.4     $ 0.2             (1) Expected payments are approximately $0.1 million per year for the foreseeable future and are a fee on the unused portion of our credit facility.         From time to time, we enter into purchase commitments with our suppliers under customary purchase order terms. Any significant losses implicit in these contracts would be recognized in accordance with generally accepted accounting principles. At December 31, 2020, no such losses existed.   In connection with our recent acquisition of the performance and lifestyle footwear business of  Honeywell, Honeywell will provide certain services to us under the Transition Service Agreement (TSA). The costs associated with the TSA are both fixed and variable. We expect these costs to decline over time as we integrate the businesses.   Our ongoing business activities continue to be subject to compliance with various laws, rules and regulations as may be issued and enforced by various federal, state and local agencies. With respect to environmental matters, costs are incurred pertaining to regulatory compliance. Such costs have not been, and are not anticipated to become, material.   We are contingently liable with respect to lawsuits, taxes and various other matters that routinely arise in the normal course of business. We do not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities, also known as “Variable Interest Entities.” Additionally, we do not have any related party transactions that materially affect the results of operations, cash flow or financial condition.   OFF-BALANCE SHEET ARRANGEMENTS   We have no off-balance sheet arrangements as of December 31, 2020.   CRITICAL ACCOUNTING POLICIES AND ESTIMATES   Our Consolidated Financial Statements are prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires us to establish accounting policies and make estimates that affect amounts reported in our Consolidated Financial Statements. Note 1 of the Notes to Consolidated Financial Statements, which is incorporated by reference into this MD&A, describes the significant accounting policies we use in our Consolidated Financial Statements.   24 Table of Contents   An accounting estimate requires assumptions and judgments about uncertain matters that could have a material effect on the Consolidated Financial Statements. Estimates are made under facts and circumstances at a point in time, and changes in those facts and circumstances could produce results substantially different from those estimates. The most significant accounting policies and estimates and their related application are discussed below.   Revenue recognition   Revenue principally consists of sales to customers, and, to a lesser extent, license fees. See Note 14 for additional information regarding revenues.   Accounts receivable allowances   Management maintains allowances for uncollectible accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The allowance for uncollectible accounts is calculated based on the relative age and status of trade receivable balances.   Sales returns and allowances   We record a reduction to gross sales based on estimated customer returns and allowances. These reductions are influenced by historical experience, based on customer returns and allowances. The actual amount of sales returns and allowances realized may differ from our estimates. If we determine that sales returns or allowances should be either increased or decreased, then the adjustment would be made to net sales in the period in which such a determination is made.   Sales returns and allowances as a percentage of sales for the years below were as follows:       2020     2019   Sales, returns, and allowances     4.8 %     4.1 %   Inventories   Management identifies slow moving inventories and estimates appropriate loss provisions related to these inventories. Historically, these loss provisions have not been significant as the vast majority of our inventories are considered saleable and we have been able to liquidate slow moving or obsolete inventories at amounts above cost through our factory outlet stores or through various discounts to customers and e-commerce channels. Should management encounter difficulties liquidating slow moving or obsolete inventories, additional provisions may be necessary. Management regularly reviews the adequacy of our inventory reserves and makes adjustments as required. See Note 3 for additional information regarding inventories.   Intangible assets   Intangible assets, including trademarks and patents, are reviewed for impairment annually, and more frequently, if necessary. We perform such testing of indefinite-lived intangible assets in the fourth quarter of each year or as events occur or circumstances change that would more likely than not reduce the fair value of the asset below its carrying amount. See Note 5 for additional information regarding intangible assets and the annual impairment analysis.   Income taxes   Management has recorded a valuation allowance to reduce its deferred tax assets for a portion of state and local income tax net operating losses that it believes may not be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance, however, in the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. For additional information see Note 10 .   RECENT FINANCIAL ACCOUNTING PRONOUNCEMENTS   Note 2 to Consolidated Financial Statements discusses new accounting pronouncements adopted during 2020 and the expected impact of accounting pronouncements recently issued but not yet required to be adopted. To the extent the adoption of new accounting standards materially affect financial condition, results of operations, or liquidity, the impacts are discussed in the applicable section of this MD&A and the Notes to Consolidated Financial Statements.   25 Table of Contents   SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995   This report, including Management’s Discussion and Analysis of Financial Conditions and Results of Operations, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, which are intended to be covered by the safe harbors created thereby. Those statements include, but may not be limited to, all statements regarding our and management’s intent, belief, expectations, such as statements concerning our future profitability and our operating and growth strategy. Words such as “believe,” “anticipate,” “expect,” “will,” “may,” “should,” “intend,” “plan,” “estimate,” “predict,” “potential,” “continue,” “likely,” “would,” “could” and similar expressions are intended to identify forward-looking statements. Investors are cautioned that all forward-looking statements involve risk and uncertainties including, without limitations, dependence on sales forecasts, changes in consumer demand, seasonality, impact of weather, competition, reliance on suppliers, risks inherent to international trade, changing retail trends, the loss or disruption of our manufacturing and distribution operations, cyber security breaches or disruption of our digital systems, fluctuations in foreign currency exchange rates, economic changes, as well as other factors set forth under the caption “Item 1A, Risk Factors” in this Annual Report on Form 10-K and other factors detailed from time to time in our filings with the Securities and Exchange Commission. Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate. Therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. We assume no obligation to update any forward-looking statements.