I imagined you noticed recently that the retailer, No Fear, proposed a merger to the board of directors of Orange 21 (Spy Optics). Orange announced November 5th that they were not considering it. We'll see what, if anything happens next. But in the meantime, I think it's instructive to review a little of the history and relationships that exist between Orange 21 and No Fear. And there may be a lesson for companies battling to manage through the recession.

If you haven't seen the letter yourself, it's HERE. It's an interesting read.

‘By way of background, Orange 21's last 10Q was for the quarter ended June 30, 2008. We should see the new one any time now. For that quarter their sales grew 17% to $14 million compared to the same quarter the previous year. But their gross profit fell 1.9% to $6.9 million. The gross profit margin fell from 61% to 50%.

I note from the balance sheet that their inventory of $13.87 million is up 10.6% from their inventory at June 30, 2007. You can typically expect some rise in inventory when sales go up, but you'd like to see the gross margin not drop. If you're carrying more inventory, but earning a lower margin on it, that's not good for your cash flow.

On the other hand, I see that receivables were down 3.8% even with increased sales and they've cut their operating expenses for the quarter by 20.3% compared to the same quarter in 2007. They lost $273,000 for the quarter, but that's a big improvement over the loss of $1.6 million in the same quarter the previous year.

I wrote about Orange 21 maybe a year ago and said that they had some problems but seemed to be dealing with them with appropriate management and operational changes and were making progress. I'd say that's still a valid perspective, but their issues, along with a lot of other companies, are exacerbated by the recession. No Fear CEO Mark Simo alluded to this in his November 3rd letter to the Orange 21 Board of Directors when he said interested in a combination of the two brands "to maximize stockholder value while preserving the Spy Optic brand and simultaneously addressing the unprecedented economic challenges facing Orange 21. "

No Fear is a privately held retailer with 50 stores in seven states. It also had a distribution business that, according to the No Fear web site," distributes products to approximately 2,500 wholesale accounts. These accounts are exclusively young men’s specialty accounts and include motorcycle, fight and surf shops."

It was founded by Mark and Brian Simo in 1989 as an action sports retailer. According to Orange 21's proxy dated April 29, 2008, Mark Simo owns or controls through No Fear 14.25% of Orange 21's stock. Three funds control an additional 27.2%. Mr. Simo was most recently CEO of Orange 21 from October, 2006 until he resigned on September 29, 2008 and was replaced by A. Stone Douglass.

No Fear, in the years ended December 31, 2007 and 2006, bought $1.305 and $0.795 million from Orange 21 according to the company's 10K dated December 31, 2007. The same document reports that other shareholders of Orange 21 own retail stores and distribution companies that, in the same two years, bought $1.5 and $1.0 million respectively from Orange 21.

That 10K also indicates that Orange 21 had 70 shareholders of record as of March 7, 2008. That isn't many for a public company. It's a hassle to be a public company and it costs a bunch of money. The most recent proxy statement indicates they spent $396,000 on audit fees in the year ended December 31, 2007. And those are not all the costs of being public. Somebody has to prepare, review and file all these forms I'm reading. Mr. Simo refers to this in his November 3 letter to the Orange 21 board of directors when he talks about the fact that a merger "Spreads the cost of running a public entity across a larger revenue base." And of course if you aren't public, then you don't have some guy like me writing about it.

One of the things I found interesting about the letter was that Mr. Simo's list of seven reasons for a business combination were all tactical in nature. I don't mean to say they aren't valid, but having read the letter I have no idea why the combination would help either brand be a more effective competitor except they might be more financially efficient. These days, maybe that's more than enough reason.

The letter also notes that No Fear Retail is "roughly equivalent in sales to Orange 21 while generating positive EBITDA for the last three fiscal years." EBITDA stands for "earnings before interest, taxes, depreciation and amortization." The letter goes on, "combining the two businesses would create a Company with over $80 million in revenues and, as a result of the synergies discussed above, well more than $2 million in EBITDA." It does not indicate if the consolidated companies would earn a net profit.

The letter notes that the Orange 21 board would have to be prepared to do a stock for stock transaction. It doesn't talk about what the relative valuations would be and that would be part of the negotiations. It then says, "As I recognize the need to fund the combined businesses, we are in discussions with numerous parties to obtain such financing. We expect the financing to consist of a combination of debt and equity, appropriately leveraging the assets of the combined businesses while creating a capital structure to allow the combined entity to weather the current economic conditions."

Theoretically, if you do a stock for stock merger and realize the synergies of several millions of dollars that No Fear suggests exist, you might not need any financing. I guess that's not the case here.

I called Orange 21 to try and get clarification on some of these issues, but didn't get a return call. As a public company, they probably can't answer the questions I want to ask anyway. I also tried to call an analyst at an investment bank listed on the Orange 21 Web site as somebody who covered the stock, but that person had moved on and the firm doesn't cover it any more.

Conversations between Orange 21 and No Fear aren't new. A September 21, 2007 press release from Orange 21 said Orange 21 and No Fear "had mutually agreed to terminate discussions involving the acquisition of No Fear Retail Stores, Inc., a subsidiary of No Fear."

There are two reasons I decided to go to lay out these details. First, the November 3rd letter isn't really self explanatory. It's the details from the other filings that provide perspective on what's going on. The relationships between the companies and individuals are probably the only reason why a deal was even on the table. The lesson is that you can't always read an individual document in isolation and know what's happening.

More importantly, there's a lesson for all of us trying to manage through hard times. In my judgment, Orange 21 had been doing, even before the economy went south, all the financial and operational things it needed to do to clean up its old issues. I can see it in the financials. I also have the impression that the Spy brand is better positioned and the product has improved from what it used to be.

This request to negotiate a deal, which didn't have a clearly identified strategic rationale and requires financing that apparently isn't in place had potential to be very distracting at a time when Orange 21 is busy just running its business in a difficult economy. Making the letter public didn't help, and you have to wonder what Spy Optics' customers think about it.

Sometimes you got to have a deal. But if you don't, or until you find the right one, stick to your knitting.

Jeff Harbaugh is a consultant for the action sports industry and works with companies to identify and focus on critical business issues and opportunities fundamental to the bottom line. For more information, visit www.jeffharbaugh.com.