S-1/A 1 d293340ds1a.htm AMENDMENT NO. 5 TO THE FORM S-1 Amendment No. 5 to the Form S-1
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As filed with the Securities and Exchange Commission on July 9, 2012.

Registration No. 333-179978

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Amendment No. 5 to

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

FENDER MUSICAL INSTRUMENTS CORPORATION

(Exact Name of Registrant as Specified in its Charter)

 

Delaware   3931   33-0081996
(State or Other Jurisdiction of
Incorporation or Organization)
  (Primary Standard Industrial
Classification Code Number)
  (I.R.S. Employer
Identification Number)

17600 North Perimeter Drive, Suite 100

Scottsdale, Arizona 85255

(480) 596-9690

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

Mark D. Van Vleet

Chief Legal Officer

Fender Musical Instruments Corporation

17600 North Perimeter Drive, Suite 100

Scottsdale, Arizona 85255

(480) 596-9690

(Name, address including zip code, and telephone number, including area code, of agent for service)

 

Copies to:

 

Alison S. Ressler

John L. Savva

Sullivan & Cromwell LLP

1870 Embarcadero Road

Palo Alto, California 94303

(650) 461-5600

 

Kevin P. Kennedy

Simpson Thacher & Bartlett LLP

2550 Hanover Street

Palo Alto, California 94304

(650) 251-5000

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, as amended, check the following box.  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨             

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨             

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

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   x  (do not check if a smaller reporting company)    Smaller reporting company   ¨

 

 

The registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this prospectus is not complete and may be changed. Neither we nor the selling stockholder may sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities, and neither we nor the selling stockholder are soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

Subject to completion, dated July 9, 2012

Prospectus

10,714,286 shares

 

LOGO

Fender Musical Instruments Corporation

Common stock

This is an initial public offering of common stock by Fender Musical Instruments Corporation. We are selling 7,142,857 shares of common stock. The selling stockholder identified in this prospectus is selling 3,571,429 shares of common stock. We will not receive any of the proceeds from the sale of the shares by the selling stockholder.

Prior to this offering, there has been no public market for our common stock. The estimated initial public offering price is between $13.00 and $15.00 per share.

We have applied to have our shares of common stock listed on the Nasdaq Global Select Market, subject to notice of issuance, under the symbol “FNDR.” We are an “emerging growth company” as that term is used in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, and, as such, will be subject to reduced public company reporting requirements.

 

        Per share        Total  

Initial public offering price

     $                      $                        

Underwriting discounts and commissions

     $           $     

Proceeds to us, before expenses

     $           $     

Proceeds to selling stockholder, before expenses

     $           $     

Delivery of the shares of common stock is expected to be made on or about                     , 2012. The selling stockholder identified in this prospectus has granted the underwriters an option for a period of 30 days to purchase, on the same terms and conditions as set forth above, up to an additional 1,607,143 shares of our common stock. We will not receive any of the proceeds from the sale of shares by this selling stockholder if the underwriters exercise their option to purchase additional shares of common stock.

Investing in our common stock involves substantial risk. Please read “Risk factors” beginning on page 17.

Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

J.P. Morgan   William Blair

 

Baird   Stifel Nicolaus Weisel     Wells Fargo Securities   

                    , 2012


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Table of contents

 

     Page  

Prospectus summary

     1   

Risk factors

     17   

Special note regarding forward-looking statements

     41   

Use of proceeds

     42   

Dividend policy

     42   

Capitalization

     43   

Dilution

     46   

Selected consolidated financial data

     48   

Management’s discussion and analysis of financial condition and results of operations

     51   

Business

     86   

Management

     112   

Transactions with related persons

     142   

Principal and selling stockholders

     145   

Description of capital stock

     148   

Shares eligible for future sale

     152   

Material U.S. tax consequences to non-U.S. holders of common stock

     155   

Underwriting

     159   

Conflicts of interest

     166   

Validity of common stock

     167   

Experts

     167   

Where you can find more information

     167   

Index to consolidated financial statements

     F-1   

 

 

No dealer, salesperson or other person is authorized to give any information or to represent anything not contained in this prospectus. You must not rely on any unauthorized information or representations. This prospectus is an offer to sell only the shares offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information contained in this prospectus is current only as of its date.

 


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Prospectus summary

This summary highlights information contained elsewhere in this prospectus. This summary does not contain all the information you should consider before investing in our common stock. You should read this entire prospectus carefully, including our consolidated financial statements and related notes, and our risk factors beginning on page 17, before deciding whether to purchase shares of our common stock. Unless the context otherwise requires, we use the terms “FMIC,” the “company,” “we,” “us” and “our” in this prospectus to refer to Fender Musical Instruments Corporation and its subsidiaries on a consolidated basis.

Our company

We are a leading, global musical instruments company whose portfolio of music lifestyle brands brings the passion of music to life. Since the founding of our predecessor company by Leo Fender in 1946, we have built a comprehensive portfolio of brands led by the iconic Fender brand and other brands such as Squier, Jackson, Guild, Ovation and Latin Percussion, which we own, and Gretsch, EVH (Eddie Van Halen) and Takamine, for which we are the licensee. We believe that the Fender brand in particular is closely associated with the birth of rock ‘n roll and has a strong legacy in music and in popular culture. We believe our brands benefit from the fact that numerous current and historical musicians and groups use or have used our products. While a number of our brands, including Fender, have broad appeal, other brands in our portfolio offer products with distinct sounds or styles targeted at musicians in particular genres, including rock ‘n roll, country, jazz, heavy metal, blues and world music.

Our broad product portfolio includes fretted instruments (comprised of electric, acoustic and bass guitars, banjos, ukuleles, mandolins and resonator guitars), guitar amplifiers, percussion instruments and accessories. We believe our guitars and guitar amplifiers revolutionized the way music is written, played and heard. We design and market our products to a variety of musicians from beginners to professionals across a broad range of prices.

In 2011, we had the #1 market share by revenue in the United States in electric, acoustic and bass guitars and electric and bass guitar amplifiers, according to data provided by MI Sales Trak as of December 2011. In addition, since the acquisition of Kaman Music Corporation (now known as KMC Musicorp), or KMC, in 2007, we believe we have been one of the largest independent distributors of musical instrument accessories in the United States. To support our brands and product leadership, we continue to bring new and innovative products to market that inspire our consumers and enhance brand loyalty.

We distribute our products globally in over 85 countries through what we believe to be one of the largest direct-to-retail sales forces in the musical instruments industry in the United States, Canada, Europe and Mexico, as well as through a network of distributors in selected international markets. We sell our products through independent and national music retailers, mass merchants, online and catalog retailers and third-party distributors. In fiscal 2011, we generated 58.7% of our gross sales before discounts and allowances from the independent channel (representing over 13,000 independently-owned music stores), 23.5% collectively from the national channel, mass merchants and online and catalog retailers, and 17.8% from third-party distributors. Gross sales before discounts and allowances is comprised of our product sales

 

 

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but, unlike net sales, does not include licensing income and dealer freight collection, and is not net of cash discounts, sales return allowances and rebates.

Our strategically managed global supply chain is comprised of a network of our own manufacturing facilities in the United States and Mexico, distribution and warehouse facilities in North America (the United States and Canada) and Europe, and established sourcing relationships with original equipment manufacturers, or OEMs, and suppliers in Asia, Europe, North America and Mexico. We primarily manufacture our products that are sold at higher price points in the United States.

Our brand portfolio, broad selection of products, longstanding culture of ongoing innovation and new product introductions, global supply chain and distribution network and strong consumer loyalty have been key drivers of our financial performance. Our net sales were $612.5 million in fiscal 2009, $617.8 million in fiscal 2010 and $700.6 million in fiscal 2011; our net income was $10.8 million in fiscal 2009, a net loss of $1.7 million in fiscal 2010 and net income of $19.0 million in fiscal 2011; and our adjusted EBITDA was $43.8 million in fiscal 2009, $23.6 million in fiscal 2010 and $52.9 million in fiscal 2011. For the first quarter of fiscal 2012, our net sales were $173.8 million, our net income was $1.9 million and our adjusted EBITDA was $10.7 million, compared to net sales of $170.1 million, net income of $6.9 million and adjusted EBITDA of $11.6 million for the first quarter of fiscal 2011. See “—Recent developments” for a discussion of available information on our second quarter of fiscal 2012. See “Summary consolidated financial data—Non-GAAP financial measures” for the definition of adjusted EBITDA and a reconciliation from net income (loss) to adjusted EBITDA.

Market opportunity

We operate in the global musical instruments and accessories industry, which generated approximately $15.8 billion in global retail sales and $6.4 billion in U.S. retail sales in 2010, according to the December 2011 edition of Music Trades magazine. The musical instruments and accessories industry generated approximately $6.6 billion in U.S. retail sales in 2011, according to the April 2012 edition of Music Trades magazine. The categories of retail musical products that we address, including fretted instruments, instrument amplifiers, percussion products and general accessories, generated an estimated $5.0 billion in U.S retail sales in 2011, according to the April 2012 edition of Music Trades magazine.

We believe our opportunities for sales growth are supported by several long-term trends that we think will increase consumer demand for our products, including the continued popularity of guitar-based music and bands and visibility of guitars in popular culture; increasing accessibility as improvements in manufacturing techniques are resulting in high-quality instruments at relatively low retail prices; technological advancements that continue to enhance a consumer’s ability to access, learn, create, personalize and distribute music; increasing popularity and gradual incorporation of guitar-based music in some large, emerging markets like China and India; and increasing availability of guitar-based music and alternative music education programs. We cannot, however, be certain whether or when these market and industry trends will increase the demand for, or sales of, our products.

The musical instruments industry is highly fragmented and is served by a variety of companies, including independent instrument makers, large multinational corporations, technology-based

 

 

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electronics manufacturers and print publishers. To the extent that there is future industry consolidation, we believe that our previous experience with acquisitions and partnerships and our global scale will enhance our ability to make strategic acquisitions or enter into strategic partnerships as opportunities arise.

Our competitive strengths

Portfolio of lifestyle brands and associations with leading musicians

We have a portfolio of some of the most recognized global music lifestyle brands and products. Our brands are used by many of the world’s best known musicians and groups, both current and historical. We believe that the use of our products by these professional musicians, whose popularity and actions often influence consumers, results in consumers aspiring to own our products and inspires them to create their own music using our products. We collaborate with many of these famous musicians through our Signature Artist Program, in which these musicians provide specifications for instruments bearing their signatures and endorse their signature instruments, which are then marketed and sold to our customers. We also have a dedicated Artist Relations group that works closely with professional musicians to meet their musical instrument needs, including through custom made products.

Industry leader with broad product portfolio

In 2011, we had the #1 market share by revenue in electric, acoustic and bass guitars and electric and bass guitar amplifiers according to data provided by MI Sales Trak as of December 2011, and were the leading U.S.-based supplier by revenue to the overall musical instruments industry, according to the April 2012 edition of Music Trades magazine. In fiscal 2011, fretted instruments, guitar amplifiers, percussion products, and accessories and other products represented 59.9%, 12.1%, 9.1% and 18.9%, respectively, of our gross sales before discounts and allowances. We believe the broad and diversified range of products in our portfolio helps to mitigate the impact of economic cycles, as sales of some product categories are less affected than others by economic downturns. We have expanded our product portfolio through a combination of innovation, strategic acquisitions, joint ventures and licensing arrangements. We believe that our range of brands and products positions us to be a strategic and reliable supplier to our retail partners and consumers.

Heritage of innovation and new product introductions

With the creation of the Telecaster guitar and Stratocaster guitar over 50 years ago, we began a tradition of innovation that continues today. We believe that we have had a profound influence on the evolution of the music industry – for example, we produced the Precision Bass, which we believe was the first commercially successful electric bass guitar and a key enabler of rock ‘n roll music. We have demonstrated an ability to continuously develop and introduce innovative products and features that are designed to grow the market for our products and enhance our brands. An example is our Fender Mustang amplifier, which we introduced in fiscal 2010. This product includes the FUSE software platform, which lets musicians connect to an online community where they can play, edit and share their own music. In addition, we often collaborate with leading artists through our Signature Artist Program and incorporate their ideas

 

 

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into our designs. Our Custom Shop, where we design and build custom and limited edition electric and bass guitars, also serves as a laboratory for the generation of ideas that can be more widely incorporated in our products.

Leading global footprint

We have developed global design, production and distribution capabilities and longstanding customer relationships that we believe would be difficult to replicate. We believe the scale and quality of our direct-to-retail sales force and distributor network enhance the loyalty of our retail partners and position us to become an increasingly important manufacturer and supplier in the industry. By facilitating a positive in-store experience at our retail partners and providing customer service programs, we believe we further enhance our brands and build consumer loyalty. Our manufacturing platform provides scalability and volume flexibility as we have a balanced mix of products manufactured internally and sourced externally. This infrastructure allows us to rapidly respond to the changing needs of consumers in our key markets, while maintaining the quality of our products.

Experienced senior management team and skilled workforce

We have assembled an experienced senior management team led by Larry Thomas, our Chief Executive Officer. Our senior management team brings together a deep knowledge of our industry, products, mission and culture, and an execution-oriented operating philosophy that are critical to our success. This extensive experience goes beyond senior management and deep into the organization. We believe that our company culture and the strength of our brands enable us to attract and retain highly-talented employees who share our passion for music and interact with our retail partners and consumers in an authentic and credible way.

Our strategy

Increase awareness and consumer loyalty as lifestyle brands

We intend to continue to develop our brands as lifestyle brands through a variety of activities. An important component of this strategy is to increase our brands’ presence outside of our normal retail channels, such as at global music festivals, where consumers can directly interact with our products. We intend to continue to increase our social media presence through tools such as Facebook and Twitter, and to engage directly with consumers through online lifestyle communities focused on artist-driven music content. In addition, we intend to tailor our marketing communications to cultivate our aspirational lifestyle brands’ images and also to develop products to meet specific consumer preferences. We believe that applying the marketing and branding strategies that have been successful with our Fender brand can increase consumer awareness of, and loyalty to, other brands in our portfolio that we believe have potential to generate additional revenue and increase market share. We cannot be certain, however, whether or when our marketing and branding strategies will generate additional revenue or increase market share.

 

 

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Expand our product offering through continued innovation

We intend to continue our tradition of innovation to bring new products and features to consumers, while maintaining the quality of our products. Over the last two years, we have increased the pace at which we bring new products to market through more robust innovation processes and expanded the breadth of new products introduced. A recent example is our Fender Select line of hand-crafted production guitars, which we introduced in January 2012 and which utilize premium materials and are priced at a higher price point than our standard line of Fender guitars. Our new product releases have the potential to produce additional revenue streams, as well as provide us with an opportunity to update and refresh our existing product lines. We believe that new product releases also create an aspirational desire for consumers to upgrade and purchase new products. We cannot be certain, however, whether or when our new product releases will produce additional revenue streams.

Accelerate our international growth

We intend to extend our reach to a broader global consumer base that might not otherwise be exposed to our products. Over the past 10 years, we have experienced international sales growth as we have entered new markets and introduced additional products into established international markets. Our gross sales before discounts and allowances in markets outside of the United States grew from $81.5 million in fiscal 2001 to $329.7 million in fiscal 2011. We believe that international markets will provide growth opportunities in the near to intermediate term, and we intend to expand our reach in countries where we have not historically focused our sales efforts; increase sales of our KMC products outside the United States; and grow our direct-to-retail sales internationally in markets that we believe present opportunities for additional growth. We cannot be certain, however, whether or when these market and industry trends will increase the demand for, or sales of, our products.

Expand our licensing and co-branding activities

We believe licensing our trademarks such as Fender and others builds awareness of our brands and furthers our strategy of reaching new consumers, while developing additional relationships with existing consumers through new products. We believe that these licensing agreements typically offer low investment costs and attractive margin opportunities without the risk of cannibalizing existing product sales. We intend to expand our licensing activities to additional products in new and existing categories and further expand our licensing activities outside the United States. In addition, we intend to continue to pursue non-revenue generating co-branding initiatives, which we believe further increase our exposure and position our products as lifestyle brands by leveraging our partners’ resources and consumer reach beyond the musical instruments industry.

Continue to be a partner of choice for strategic relationships

We believe that our experience in acquisitions and partnerships and our global scale enhance our ability to complete acquisitions and form strategic relationships within the musical instruments industry. We intend to build on our experience in acquisitions and strategic relationships by continuing to evaluate potential acquisition opportunities, license agreements, distribution

 

 

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arrangements and other strategic relationships. We evaluate these opportunities based on the potential to leverage our marketing, sales, distribution, sourcing and manufacturing capabilities to add value and contribute to growth with new brands and products. Over the last 15 years, we have executed a variety of acquisitions of companies and assets and entered into licensing and distribution arrangements that have expanded our brand portfolio.

Promote operational efficiencies

We intend to continue to drive operational efficiencies to improve our operating margin while maintaining or enhancing the quality of our products. In addition, we intend to continue investing in manufacturing technologies, such as robotic painting, to improve product quality, increase capacity and lower cost. We also plan to improve our wood storage, climate control and wood grading practices and expand our capability to manufacture the raw pieces of wood used in the manufacture of guitars. We continually evaluate shifting additional production to manufacturing facilities with lower or more stable costs. For example, our Ensenada, Mexico manufacturing facility provides us with products at stable, relatively low costs, and we intend to explore opportunities to move additional production to that facility.

Risks related to our business

Our business is subject to numerous risks and uncertainties, including those highlighted in the section titled “Risk factors.” Some of these risks are:

 

 

Recent difficult economic conditions have adversely affected consumer purchases of discretionary items, such as our products, and may continue to harm our business and results of operations.

 

 

We derived approximately 27.3% of our net sales in fiscal 2011, and approximately 25.5% of our net sales in the first quarter of fiscal 2012, from Europe, and the financial uncertainty in Europe could significantly harm our business and results of operations.

 

 

Our ability to increase our net sales will depend in large part on growth in the markets for our products.

 

 

If we are not able to accurately forecast demand for our products, our business and results of operations would be harmed.

 

 

If we are unable to anticipate and respond to changes in consumer demand and trends, our net sales, business and results of operations would suffer.

 

 

Any delay in the delivery of our products to customers could harm our business and results of operations.

 

 

We depend on OEMs for production of a significant portion of our products. If we are unable to maintain these manufacturing relationships or enter into additional or different arrangements as needed, our net sales would suffer.

 

 

Any disruption we experience at our manufacturing facilities or our distribution system or any disruption at our OEMs could hurt our ability to deliver our products to customers.

 

 

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Our OEMs may not continue to produce products that are consistent with our standards, which could damage the value of our brands and harm our business and results of operations.

 

 

Any disruption in the supply of raw materials and components we and third parties need to manufacture our products could harm our net sales.

 

 

We may be subject to the enforcement of regulations and laws relating to the importation and use of certain raw material, which could adversely affect our ability to use certain raw materials and harm our business.

 

 

We depend on our relationships with dealers and their ability to sell our products, and one dealer is responsible for a significant percentage of our net sales. Any disruption in these relationships could harm our net sales.

 

 

For sales in some countries outside the United States, we rely in part on third party distributors and are subject to the risk that these distributors may not effectively sell our products.

 

 

We are subject to credit risk associated with our largest customer, whose corporate family rating and probability of default rating was downgraded by Moody’s Investors Service in November 2010 to Caa2 (which Moody’s defines as “poor standing and subject to very high credit risk”) from Caa1, and affirmed by Moody’s Investors Service at Caa2 in February 2012. This customer and its affiliates accounted for approximately 15.8% and 17.2% of our net sales in fiscal 2011 and the first quarter of fiscal 2012, respectively, and approximately 16.6% of our accounts receivable as of April 1, 2012.

 

 

Weston Presidio and our directors and officers and insiders will continue to have substantial control over us after this offering and will be able to influence corporate matters. Upon completion of this offering, funds and a director affiliated with Weston Presidio will beneficially own 17.8% of our outstanding common stock, and our other directors and executive officers and their affiliates will beneficially own, in the aggregate, approximately 10.1% of our outstanding common stock.

Recent developments

Our unaudited consolidated financial data for the fiscal quarter ended July 1, 2012, or the second quarter of fiscal 2012, presented below are preliminary, based upon our estimates and subject to completion of our financial closing procedures. These data have been prepared by and are the responsibility of management. Our independent registered public accounting firm, KPMG LLP, has not audited, reviewed, compiled or performed any procedures, and does not express an opinion or any other form of assurance with respect to these data. Although we believe that the estimates set forth below are reasonable, this summary is not a comprehensive statement of our financial results for this period, and our actual results may differ materially from these estimates due to the completion of our financial closing procedures, final adjustments and other developments that may arise between now and the time the financial results for this period are finalized.

The following are preliminary estimates of the financial metrics listed below for the second quarter of fiscal 2012:

Net sales in the second quarter of fiscal 2012 is expected to be between $166 million and $168 million, a decrease of 0.4% at the midpoint of the range as compared to $167.7 million in the

 

 

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second quarter of fiscal 2011. Our net sales in the second quarter of fiscal 2011 was favorably impacted by filling the cancellable backlog created by a paint supply issue at our Corona, California manufacturing facility in fiscal 2010. See “Management’s discussion and analysis of financial condition and results of operations—Opportunities, challenges and risks.” As of January 2, 2011, we had approximately $26.2 million of cancellable backlog. We believe a substantial majority of this backlog related to this production problem and contributed to higher sales in the first and second quarters of fiscal 2011 as we filled the backlog. We estimate that approximately 2.5% of our net sales in the second quarter of fiscal 2011 resulted from filling the backlog from fiscal 2010, as described above.

Income from operations in the second quarter of fiscal 2012 is expected to be between $8.5 million and $8.9 million, a decrease of 13.9% at the midpoint of the range as compared to $10.1 million in the second quarter of fiscal 2011. The estimated decline in income from operations was mainly driven by our increased investment in labor related expenses due to increased headcount and salary increases and expenses incurred in connection with the establishment of an office in China, partially offset by an increase in overall effective prices for our products and improved factory operating efficiency in the second quarter of fiscal 2012.

Net income in the second quarter of fiscal 2012 is expected to be between $3.0 million and $3.4 million, a decrease of 5.9% at the midpoint of the range as compared to $3.4 million in the second quarter of fiscal 2011. The estimated decline in net income compared to the second quarter of fiscal 2011 was primarily due to investments in labor related expenses due to increased headcount and salary increases and expenses incurred in connection with the establishment of an office in China, as well as a higher effective tax rate. These reductions in net income were partially offset by lower interest expense, an increase in overall effective prices for our products and improved factory operating efficiency in the second quarter of fiscal 2012.

We have provided a range for the preliminary results described above primarily because our financial closing procedures for the second quarter of fiscal 2012 are not yet complete and, as a result, we expect that our final results upon completion of our closing procedures will vary from our preliminary estimates within the ranges as described above. We expect to complete our closing procedures with respect to the second quarter of fiscal 2012 in August 2012.

Corporate information

We were incorporated in Delaware in January 1985. Our principal executive offices are located at 17600 North Perimeter Drive, Suite 100, Scottsdale, Arizona 85255. Our telephone number is (480) 596-9690. Our website address is www.fender.com. Information contained on our website is not incorporated by reference into this prospectus, and you should not consider information contained on our website to be part of this prospectus or in deciding whether to purchase shares of our common stock.

We have a number of registered marks, including Fender®, Stratocaster®, Telecaster®, Precision Bass®, Jazz Bass®, Squier® and others, in several jurisdictions, including the United States, and we have also applied to register a number of other marks in various jurisdictions. This prospectus also contains trademarks and trade names of other companies. All trademarks and trade names appearing in this prospectus are the property of their respective holders. We do not intend our use or display of other companies’ trade names or trademarks to imply a relationship with, or endorsement or sponsorship of us by, these other companies.

 

 

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Emerging growth company status

We are an “emerging growth company,” as defined in the JOBS Act. For as long as we are an “emerging growth company,” we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies,” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding advisory “say-on-pay” votes on executive compensation and shareholder advisory votes on golden parachute compensation.

Under the JOBS Act, we will remain an “emerging growth company” until the earliest of:

 

 

the last day of the fiscal year during which we have total annual gross revenues of $1 billion or more;

 

 

the last day of the fiscal year following the fifth anniversary of the completion of this offering;

 

 

the date on which we have, during the previous three-year period, issued more than $1 billion in non-convertible debt; and

 

 

the date on which we are deemed to be a “large accelerated filer” under the Securities Exchange Act of 1934, or the Exchange Act. We will qualify as a large accelerated filer as of the first day of the first fiscal year after we have (i) more than $700 million in outstanding common equity held by our non-affiliates and (ii) been public for at least 12 months. The value of our outstanding common equity will be measured each year on the last day of our second fiscal quarter.

The JOBS Act also provides that an “emerging growth company” can utilize the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, or the Securities Act, for complying with new or revised accounting standards. However, we are choosing to “opt out” of such extended transition period, and, as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for companies that are not “emerging growth companies.” Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

 

 

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The offering

 

Common stock offered by us

7,142,857 shares

 

Common stock offered by the selling stockholder

3,571,429 shares

 

Underwriters’ option to purchase additional shares

The selling stockholder has granted the underwriters a 30-day option to purchase up to an additional 1,607,143 shares.

 

Common stock to be outstanding after this offering

26,361,833 shares

 

Use of proceeds

We estimate that the net proceeds to us from this offering will be approximately $88.2 million, after deducting assumed underwriting discounts and commissions and estimated offering expenses payable by us, assuming an initial public offering price of $14.00 per share, which is the midpoint of the range of the initial public offering price listed on the cover page of this prospectus. We intend to use the net proceeds to us to repay a portion of the amount outstanding under the term loan portion of our senior secured credit facility. We will not receive any proceeds from the sale of the shares sold by the selling stockholder. See “Use of proceeds.”

 

Directed share program

The underwriters have reserved for sale, at the initial public offering price, up to approximately 535,714 shares of our common stock being offered for sale to certain of our suppliers, business partners, customers, distributors, holders of more than 5% of our capital stock and artists with whom we have relationships, as well as some of our officers, directors and employees and certain of their family members. We will offer these shares to the extent permitted under applicable regulations in the United States and in various countries. The number of shares available for sale to the general public in this offering will be reduced to the extent these persons purchase reserved shares. Any reserved shares not purchased will be offered by the underwriters to the general public on the same terms as the other shares.

 

 

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Conflicts of interest

We expect to use more than 5% of the net proceeds from the sale of our common stock to repay indebtedness under the term loan portion of our senior secured credit facility owed by us to affiliates of J.P. Morgan Securities LLC who are lenders under the term loan portion of our senior secured credit facility. See “Use of proceeds.” Accordingly, this offering is being made in compliance with the requirements of Rule 5121 of the Financial Industry Regulatory Authority’s conduct rules. This rule provides generally that if at least 5% of the net proceeds from the sale of securities, not including underwriting compensation, is used to reduce or retire the balance of a loan or credit facility extended by the underwriters or their affiliates, a “qualified independent underwriter” meeting certain standards must participate in the preparation of this prospectus and exercise the usual standards of diligence with respect thereto. William Blair & Company, L.L.C. is assuming the responsibilities of acting as the qualified independent underwriter in conducting due diligence. See “Conflicts of interest” for a more detailed discussion of potential conflicts of interest.

 

Dividend policy

Currently, we do not anticipate paying cash dividends.

 

Proposed Nasdaq Global Select Market symbol

FNDR

The number of shares of our common stock to be outstanding following this offering is based on 19,218,976 shares of our common stock outstanding as of April 1, 2012, and excludes:

 

 

6,609,708 shares of common stock issuable upon exercise of options outstanding as of April 1, 2012 at a weighted average exercise price of $9.72 per share;

 

 

2,114,448 shares of common stock reserved for issuance under our 2012 Equity Compensation Plan (which includes 769,104 shares reserved for issuance under our predecessor equity compensation plans), which will become effective upon completion of this offering;

 

 

restricted stock units, representing the right, at the option of the company, to deliver 29,400 shares of common stock or an equivalent cash amount, of which 5,880 restricted stock units have vested as of April 1, 2012; and

 

 

49,000 shares of restricted stock that were granted to James A. Druckrey following commencement of his employment as our Executive Vice President and Chief Operating Officer and an additional 49,000 shares of restricted stock or an equivalent number of restricted stock units to be granted to Mr. Druckrey after 60 days of his employment.

Unless otherwise indicated, this prospectus reflects and assumes the following:

 

 

a 98-for-1 stock split of our classes of common stock, which occurred on July 6, 2012;

 

 

the effectiveness of amendments to our certificate of incorporation as of March 5, 2012, which redesignated our class A common stock as common stock on a share-for-share basis;

 

 

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the automatic conversion of our class B common stock and class C common stock into an aggregate of 8,468,964 shares of common stock upon the closing of this offering; and

 

 

no exercise by the underwriters of their option to purchase up to an additional 1,607,143 shares of common stock from the selling stockholder in the offering.

 

 

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Summary consolidated financial data

The following table sets forth our summary consolidated financial data as of the dates and for the periods indicated. Our summary consolidated statement of operations for each of the years ended January 3, 2010, January 2, 2011, and January 1, 2012, have been derived from our audited consolidated financial statements, which are included elsewhere in this prospectus. We have derived the consolidated statements of operations data for the 13 weeks ended April 3, 2011, and April 1, 2012, and the balance sheet data as of April 1, 2012,from our unaudited interim financial statements appearing elsewhere in this prospectus. The unaudited consolidated financial statements were prepared on a basis consistent with our audited consolidated financial statements and include, in the opinion of management, all adjustments necessary for the fair presentation of the financial information contained in those statements.

We operate and report financial information on a 52 or 53 week fiscal year ending on the Sunday closest to the end of December. The reporting periods contained in our audited consolidated financial statements included in this prospectus contain 53 weeks of operations in fiscal 2009, 52 weeks of operations in fiscal 2010 and 52 weeks of operations in fiscal 2011. The quarterly reporting periods contained in the unaudited consolidated financial statements included in this prospectus consist of 13 weeks ended on April 3, 2011, and April 1, 2012.

The historical results presented below are not necessarily indicative of the results to be expected for any future period, and the results for any interim period may not necessarily be indicative of the results that may be expected for a full year. The following summaries of our consolidated financial data for the periods presented should be read in conjunction with “Risk factors”, “Selected consolidated financial data”, “Capitalization”, “Management’s discussion and analysis of financial condition and results of operations” and our consolidated financial statements and the related notes, which are included elsewhere in this prospectus.

 

 

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     Fiscal year ended     13 weeks ended  
 

January 3,
2010

    January 2,
2011
    January 1,
2012
   

April 3,
2011

   

April 1,
2012

 

 

 
                      (unaudited)  
    (in thousands, except share and per share data)  

Consolidated statement of operations data:

         

Net sales

  $ 612,521      $ 617,830      $ 700,554      $ 170,106      $ 173,769   

Cost of goods sold

    420,919        447,250        483,020        117,848        119,459   
 

 

 

   

 

 

 

Gross profit

    191,602        170,580        217,534        52,258        54,310   
 

 

 

   

 

 

 

Operating expenses:

         

Selling, general and administrative

    125,711        121,651        137,128        33,917        39,294   

Warehouse

    25,878        27,713        28,426        7,044        7,045   

Research and development

    9,004        9,299        10,157        2,397        2,679   

Impairment charges

    1,200        777                        
 

 

 

   

 

 

 

Total operating expenses

    161,793        159,440        175,711        43,358        49,018   
 

 

 

   

 

 

 

Income from operations

    29,809        11,140        41,823        8,900        5,292   
 

 

 

   

 

 

 

Other income (expense):

         

Net foreign currency exchange (loss) gain

    (3,602     (1,175     (3,807     (269     1,042   

Interest expense

    (15,636     (12,688     (14,927     (2,815     (3,388

Other, net

    1,723        386        1,130        371        (96
 

 

 

   

 

 

 

Total other income (expense)

    (17,515     (13,477     (17,604     (2,713     (2,442
 

 

 

   

 

 

 

Income (loss) before income taxes

    12,294        (2,337     24,219        6,187        2,850   

Income tax expense (benefit)

    1,507        (652     5,208        (756     990   
 

 

 

   

 

 

 

Net income (loss)

    10,787        (1,685     19,011        6,943        1,860   

Net income available to redeemable common stockholders

    4,724        15,584        15,785        394        13,696   
 

 

 

   

 

 

 

Net income (loss) available (attributable) to common stockholders

  $ 6,063      $ (17,269   $ 3,226      $ 6,549      $ (11,836
 

 

 

   

 

 

 

Net income (loss) per common share available (attributable) to common stockholders:

         

Basic

  $ 0.53      $ (1.51   $ 0.29      $ 0.59      $ (1.06

Diluted

  $ 0.45      $ (1.51   $ 0.25      $ 0.58      $ (1.06

Weighted average common shares outstanding:

         

Basic

    11,451,594        11,453,946        11,141,718        11,118,786        11,173,568   

Diluted

    13,596,912        11,453,946        12,789,784        11,206,790        11,173,568   

Pro forma net income per common share (unaudited):

         

Basic

      $ 0.99        $ 0.10   

Diluted

      $ 0.91        $ 0.09   

Weighted average common shares used in computing pro forma net income per common share (unaudited) (1):

         

Basic

        19,151,356          19,071,976   

Diluted

        20,799,422          20,317,948   

 

 

 

(1)   Weighted average common shares used in computing pro forma net income per common share (unaudited) gives effect as of January 3, 2011 to the automatic conversion of our class B common stock and class C common stock into an aggregate of 8,468,964 shares of common stock, which will occur upon the closing of this offering.

 

 

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Our consolidated balance sheet data as of April 1, 2012, is presented:

 

 

on an actual basis;

 

 

on a pro forma basis to reflect the automatic conversion of our class B common stock and class C common stock into an aggregate of 8,468,964 shares of common stock upon the closing of the offering; and

 

 

on a pro forma as adjusted basis, reflecting the pro forma adjustments and the sale of                  shares of common stock by us in this offering at an assumed initial public offering price of $14.00 per share, which is the midpoint of the range of the initial public offering price listed on the cover page of this prospectus, after deducting assumed underwriting discounts and commissions and estimated offering expenses payable by us, and the application of such proceeds to repay approximately $88.2 million of the amount outstanding under the term loan portion of our senior secured credit facilities.

 

As of April 1, 2012

(in thousands)

  

Actual

(unaudited)

   

Pro

forma

(unaudited)

    

Pro forma

as adjusted

(unaudited)

 

 

 

Consolidated balance sheet data (1):

       

Cash and cash equivalents

   $ 13,789      $ 13,789         13,789   

Inventories

     178,369        178,369         178,369   

Working capital

     205,453        205,453         205,453   

Property and equipment—net

     35,427        35,427         35,427   

Total assets

     369,769        369,769         369,769   

Total debt and capital lease obligations, including current maturities

     257,182        257,182         168,982   

Redeemable common stock

     113,485                  

Total stockholders’ (deficit) equity

   $ (79,953   $ 33,532         121,732   

 

 

 

(1)   A $1.00 increase in the assumed initial public offering price of $14.00 per share would decrease total debt and capital lease obligations, including current maturities, and would increase total stockholders’ (deficit) equity by $6.6 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting assumed underwriting discounts and commissions. A $1.00 decrease in the assumed initial offering price of $14.00 per share would increase total debt and capital lease obligations, including current maturities, and would decrease total stockholders’ (deficit) equity by $6.6 million. An increase of 100,000 shares in the number of shares sold in this offering by us would decrease total debt and capital lease obligations, including current maturities, and would increase total stockholders’ (deficit) equity from this offering by $1.3 million, assuming an initial public offering price of $14.00 per share and after deducting assumed underwriting discounts and commissions. A decrease of 100,000 shares in the number of shares sold in the offering by us would increase total debt and capital lease obligations, including current maturities, and would decrease total stockholders’ (deficit) equity from this offering by $1.3 million, assuming an initial public offering price of $14.00 per share and after deducting assumed underwriting discounts and commissions.

 

 

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Non-GAAP financial measures

To provide investors with additional information about our financial results, we disclose within this prospectus adjusted EBITDA, a non-GAAP financial measure. We have provided below a reconciliation between adjusted EBITDA and net income or loss, the most directly comparable GAAP financial measure.

We have included adjusted EBITDA in this prospectus because we believe it allows investors to understand and evaluate our core operating performance and trends. In particular, the exclusion of certain expenses in calculating adjusted EBITDA can provide a useful measure for period-to-period comparisons of our core business.

Some limitations of adjusted EBITDA are:

 

 

adjusted EBITDA does not include the impact of equity-based compensation;

 

 

adjusted EBITDA does not include the impact of impairment charges;

 

 

adjusted EBITDA does not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debts;

 

 

adjusted EBITDA does not reflect income tax payments that may represent a reduction in cash available to us;

 

 

although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future; and

 

 

other companies may calculate adjusted EBITDA differently or not at all, which reduces its usefulness as a comparative measure.

Because of these limitations, you should consider adjusted EBITDA alongside other financial performance measures, including net income (loss) and our financial results presented in accordance with GAAP. The following table presents a reconciliation of net income (loss) to adjusted EBITDA for each of the periods indicated:

 

      Fiscal year ended      13 weeks ended  

(in thousands)

   January 3,
2010
     January 2,
2011
    January 1,
2012
     April 3,
2011
    April 1,
2012
 

 

 
                         (unaudited)  
Reconciliation of net income (loss) to adjusted EBITDA             

Net income (loss)

   $ 10,787       $ (1,685   $ 19,011       $ 6,943      $ 1,860   

Interest expense

     15,636         12,688        14,927         2,815        3,388   

Income tax expense (benefit)

     1,507         (652     5,208         (756     990   

Depreciation and amortization

     12,052         10,776        8,732         2,248        2,352   

Impairment charges

     1,200         777                         

Stock based compensation

     2,592         1,741        5,049         351        2,068   
  

 

 

 

Adjusted EBITDA

   $ 43,774       $ 23,645      $ 52,927       $ 11,601      $ 10,658   
  

 

 

 

 

 

 

 

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Risk factors

Investing in our common stock involves a high degree of risk. You should consider carefully the risks and uncertainties described below, together with all of the other information in this prospectus, before deciding whether to purchase shares of our common stock. Although we have discussed all known material risks, the risks described below are not the only ones that we face. Additional risks that are not yet known to us or that we currently believe to be immaterial also could impair our business or results of operations. If any of the following risks is realized, our business, results of operations and prospects could be harmed. In that event, the price of our common stock could decline and you could lose part or all of your investment.

Risks related to our business and industry

Recent difficult economic conditions have adversely affected consumer purchases of discretionary items, such as our products, and may continue to harm our business and results of operations.

Sales of musical instruments depend in significant part on discretionary consumer spending, which tends to decline during difficult economic conditions. Discretionary consumer spending also is affected by other factors, including changes in tax rates and tax credits, interest rates and the availability and terms of consumer credit. The recent recession in the United States and other countries in which we sell our products has adversely impacted consumers’ ability and willingness to spend discretionary income, and we believe it has adversely affected our net sales in recent years. A continuation or worsening of the current weakness in the economy would negatively affect consumer purchases of our products and would continue to harm our business and results of operations.

We derive a substantial portion of our net sales from Europe, and the financial uncertainty in Europe could significantly harm our business and results of operations.

Europe accounted for approximately 27.3% of our net sales in fiscal 2011 and approximately 25.5% of our net sales in the first quarter of fiscal 2012. The financial uncertainty in Europe (including concerns that certain European countries may default in payments due on their national debt) in recent months has adversely affected, and may continue to adversely affect, sales of our products in Europe. To the extent that these adverse economic conditions in Europe continue or worsen, demand for our products by both consumers and retailers may decline, which could significantly harm our business and results of operations.

Our ability to increase our net sales will depend in large part on growth in the markets for our products.

Our ability to grow our net sales depends on growth in the markets for our products. In particular, growth in our core markets is primarily driven by individuals deciding to play fretted or percussion instruments, as well as by existing musicians purchasing additional instruments and accessories. We believe that the rate at which new fretted instrument or percussion players are created, as well as the extent to which musicians continue to play these instruments and purchase new products, depends on a number of factors, including:

 

 

the popularity of genres of music that feature our primary product categories (namely fretted instruments, guitar amplifiers and percussion);

 

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the popularity of music in general;

 

 

other factors, such as music and song sales, that affect individuals’ exposure to music;

 

 

the ability to entice consumers to play musical instruments initially and to continue playing; and

 

 

the ability of music programs to foster a lasting interest in music and musical instruments at an early age.

Any changes in trends or preferences that negatively affect these or other factors may lead to a decline in the size of the market for our products. In addition, our ability to grow our business internationally may be limited to the extent that popular music genres in a particular country or region do not incorporate the types of products that we sell.

If we are not able to accurately forecast demand for our products, our business and results of operations would be harmed.

Our products typically have a lead time of 90 days and, in some cases, longer, to obtain sufficient inventory and to replenish supply. Accordingly, we make decisions that determine our inventory levels based on our expectations regarding demand for our products. Actual demand may differ significantly from demand levels that we project, and is particularly uncertain with respect to new products. If we underestimate demand for a new or existing product, we will not have sufficient inventory to meet this demand, which could result in delayed shipments to customers and lost sales. On the other hand, if we overestimate demand, we will have excess inventory of finished products as well as raw materials and work-in-progress. This excess inventory could become obsolete, could result in us incurring costs to manufacture those products earlier than we would otherwise have been required to do so or could result in us shifting production to other products for which we may not have materials in stock, all of which would harm our business and results of operations.

The current difficult, volatile economic conditions in the Unites States, Europe and other countries has made, and may continue to make, accurate forecasting particularly challenging. Any failure on our part to accurately forecast demand for our products could adversely affect our net sales, business and results of operations.

If we are unable to anticipate and respond to changes in consumer demand and trends, our net sales, business and results of operations would suffer.

Consumer preferences and demand, both within the markets for our various products and with respect to the musical instruments market as a whole, are subject to rapid change and are difficult to predict. Consumer preferences may shift away from fretted instruments or musical instruments in general, and towards other areas based on new products and trends or for other reasons. In addition, shifts of preferences as to style of music may impact demand for our products and can change our product mix. For example, shifts towards electronic music or music created using sampling or other digital technology, synthesizers or keyboards could reduce the demand for many of our products, as we do not sell significant quantities of synthesizers, keyboards or software-based musical instruments. Because our brand names are most closely associated with electric, acoustic and bass guitars, percussion instruments and guitar amplifiers, shifts in consumer preferences towards genres that typically do not incorporate these products,

 

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such as rap or electronic music, also could reduce the demand for many of our products. In fiscal 2011, fretted instruments and guitar amplifiers represented 72.0% of our gross sales before discounts and allowances.

If we are not able to anticipate, identify and respond to changes in consumer preferences in a timely manner, or at all, our net sales could decline and our business and results of operations would be harmed.

Any delay in the delivery of our products to customers could harm our business and results of operations.

A critical component of our ability to complete sales to our customers is our ability to meet our customers’ demand in a timely manner. Any delay in the shipment of our products could result in lost sales. It is especially important that we meet our customers’ demand in a timely manner during the holiday selling season. In some instances, delays in filling our retail customers’ product orders has led to increased backlog as we work to fulfill these orders. Events that could result in shipment delays include:

 

 

disruption at our manufacturing facilities or those of our OEMs, as a result of a variety of factors, including labor disruptions, natural disasters, and technological or mechanical failures in the machines used to manufacture our products or in our enterprise resource planning, or ERP, systems;

 

 

delays in receiving raw materials or component parts required to manufacture our products;

 

 

delays in the transportation of our products either to our warehouse facilities or to our customers; and

 

 

inaccurate forecasting.

Any of these or other events that disrupt the supply of our products to our customers could cause our net sales to decline and harm our business and results of operations.

We depend on OEMs for production of a significant portion of our products. If we are unable to maintain these manufacturing relationships or enter into additional or different arrangements as needed, our net sales would suffer.

We depend on OEMs primarily located in Asia to manufacture a significant portion of our products. In fiscal 2011 and the first quarter of 2012, products manufactured by OEMs accounted for approximately 64% and 62%, respectively, of our gross sales before discounts and allowances, including distributed brands, and approximately 53% and 52%, respectively, of our gross sales before discounts and allowances of our owned brands. In certain of our product lines, we are dependent on a single manufacturer to produce those products. Due to lack of financial resources, disruptions at their facilities, labor shortages or disputes, difficulty or delay in obtaining raw materials, parts and components or otherwise, these manufacturers may not be able to provide us with manufacturing capacity to meet our needs. From time to time, some of our OEMs, including OEMs that are the sole manufacturer of specific product lines, have encountered financial difficulties or other problems, which have caused delays in the production and delivery of our products. If we were unable to obtain sufficient quantities of our products from these manufacturers in a timely manner, our business and results of operations would suffer.

 

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We do not have long-term contracts with any of these OEMs, and there can be no assurance that we will be able to renew these contracts on favorable terms or at all. In addition, there can be no assurance that these OEMs will continue to devote sufficient time, attention and resources to our products or that these OEMs will not manufacture products for our competitors. It is also possible that financial difficulties could cause one or more our OEMs to discontinue their business. For example, in the fourth-quarter of fiscal 2011, Chushin Musical Instruments Mfg., Inc., which manufactured certain electric guitars for us, discontinued its business, and, as a result, we were required to source those guitars from other OEMs.

Manufacturing our products, especially our fretted instruments, requires a skilled and trained workforce, and we have invested significant resources in training our OEMs in the production of our products. If we were to have to obtain an additional OEM due to the loss of one of our existing OEMs, because we are not satisfied with one of our existing OEM’s performance, one of our existing OEMs discontinued its business, or otherwise, we would need to spend significant resources in locating and training a new OEM and there can be no assurance that we could locate such a manufacturer in a timely manner or at all. Any failure to locate a new OEM in a timely manner or at all could adversely affect our business and results of operations.

In addition, we have in the past replaced, and may in the future replace, OEMs for a variety of reasons, including cost, quality and capacity. The replacement of any OEM could lead to disruptions in our supply chain and lost sales.

Any disruption we experience at our manufacturing facilities or our distribution system or any disruption at our OEMs could hurt our ability to deliver our products to customers.

We rely on our manufacturing facilities in Arizona, California, Connecticut, South Carolina and Mexico, and OEMs in China, India, Indonesia, Japan, South Korea, Taiwan, Thailand and Vietnam to produce our products, and we rely on our distribution facilities in California, Kentucky, Tennessee, the Netherlands and Canada to manage our inventory and ship our products. Our manufacturing and distribution facilities include computer controlled equipment, and are subject to a number of risks related to security, computer viruses, software and hardware malfunctions, power interruptions, mechanical failures or other system failures. Our operations also could be interrupted by earthquakes, fires, floods, tornadoes or other natural disasters near our manufacturing facilities or distribution centers. One of our primary manufacturing facilities and our primary distribution facility are located in Southern California, an area that has experienced earthquakes and fires. A natural disaster or other catastrophic event could cause interruptions in the manufacture or distribution of our products and loss of inventory and could impair our ability to fulfill customer orders in a timely manner. Our manufacturing facility in Corona, California is also located in an area where many workers are represented by labor unions. If the employees in our Corona facility were to become unionized, we could be subject to labor disruptions and increased labor costs. We also operate a manufacturing facility in Ensenada, Mexico. Recently, Mexico has experienced a period of increasing criminal violence, primarily due to the activities of drug cartels and related organized crime. These activities and the possible escalation of violence associated with them could disrupt our manufacturing activities in Mexico and impair our ability to fulfill customer orders in a timely manner.

Our OEMs’ operations could similarly be disrupted, either temporarily or completely, by any of the events described above, as well as by other events, including poor financial condition, labor disputes, social unrest, quarantines or closures due to disease outbreak, or terrorism. Any

 

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disruptions at our OEMs’ operations could delay the shipment of our products and could result in lost sales or price increases we must either absorb or pass on to our customers, which could adversely affect the demand for our products. For example, in fiscal 2011 one of our OEMs experienced severe flooding at one of its factories. This OEM requested price increases from us that we were not willing to fully absorb or seek to pass on to our customers. As a result, we are currently exploring alternative sources for the products manufactured by that OEM.

We are currently expanding our Mexican plant capability to operate as a cost-effective alternative to some of our OEM capacity in Asia. Although we have switched some production to Mexico on a limited basis, switching production to Mexico on a larger scale in the event of disruptions in Asia would take from several months to a year and could result in significant lost sales. Any disruption to an OEM that is the sole manufacturer of a particular product would have a significant impact on our net sales of that product. To the extent disruptions at an OEM occur for an extended time period, we may be required to obtain new manufacturers. This process would increase the complexity of our supply chain management and be time consuming and expensive, and would likely result in delays in deliveries of our products to our customers. Furthermore, there is no assurance that we could find new manufacturers who are satisfactory to us on commercially acceptable terms or at all. We maintain only a limited amount of business interruption insurance that would not be sufficient to cover us in the event of significant disruption at our facilities or at any of our OEMs.

Our operations depend on the timely performance of services by third parties, including the shipment of our products to and from our distribution facilities, as well as the shipment of supplies to our manufacturing operations. If we encounter problems with our manufacturing or distribution operations, our net sales and our business and results of operations could be harmed.

Our OEMs may not continue to produce products that are consistent with our standards, which could damage the value of our brands and harm our business and results of operations.

We rely on our OEMs to maintain production quality that meets our standards. Our OEMs may not continue to produce products that are consistent with our standards as a result of the use of lower-quality raw materials, changes in production methods, a shortage of qualified employees or poor financial condition. For example, as of December 31, 2011, more than 11,000 guitars manufactured by one of our OEMs had failed our quality control inspections because the OEM began using a lower-quality component without our permission, and several thousand additional guitars manufactured by that OEM may fail our inspections as well. Our quality control measures largely consist of inspecting samples of products shipped to us and visiting our OEMs. We do not, however, base any of our employees at these manufacturing sites. Our inspection methods may prove inadequate to detect defects in our products before they reach consumers. If OEMs do not maintain adequate quality control measures, or if the quality control inspection measures that we employ fail to detect quality control issues, our reputation and the value of our brands could be harmed, and we could incur increased returns and warranty expense, which would harm our business and operating results.

Any disruption in the supply of raw materials and components we and third parties need to manufacture our products could harm our net sales.

At our owned factories, the primary raw material used in our products is hardwood, principally poplar, ash, alder and hardwood maple. We also use rosewood in portions of approximately 45.0%

 

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of our finished goods from these factories. In addition, we use a limited amount of other exotic and rare woods in our products. We depend on third party suppliers to supply these raw materials to us and our OEMs. In addition to raw materials, we also use third party suppliers for certain components needed for our fretted and percussion instruments and guitar amplifiers. These components include fretted instrument cases, tubes for our guitar amplifiers, strings for our fretted instruments, drum heads, printed circuit boards, guitar amplifier speakers, selected pick-ups, paint, machine heads, grill-cloths and plastic and metal components such as control knobs.

We do not have long-term contracts with our suppliers and, in some cases, rely on a single supplier for all of our requirements for a particular raw material or component. We are subject to the risk that these third party suppliers will not be able or willing to continue to provide us and our OEMs with raw materials and components that meet our specifications, quality standards and delivery schedules. Factors that could impact our suppliers’ willingness and ability to continue to provide us with the required materials and components include disruption at or affecting our suppliers’ facilities, such as work stoppages or natural disasters, adverse weather or other conditions that affect wood supply, the financial condition of our suppliers and deterioration in our and our OEMs’ relationships with these suppliers. In addition, we cannot be sure that we or our OEMs will be able to obtain these materials and components on satisfactory terms. For example, the supply of exotic woods, such as mahogany and rosewood, used in some of our guitars and bass guitars is becoming less available, which, over time, may increase cost or cause us to seek alternative materials that may not be consistent with current quality standards. Any increase in raw material and component costs could reduce our sales and harm our gross margins. In addition, any loss of a specific wood may permanently cause a change in one or more of our products that may not be accepted by end users or cause us to eliminate that product altogether.

Similarly, in the past, we relied on a single supplier of paint for the guitars manufactured at our Corona, California manufacturing facility. That supplier discontinued business in fiscal 2010. For a variety of reasons, including the specialized nature of the paint we require, replacing that supplier was costly and time consuming. As a result, we were unable to produce guitars at our Corona facility for a period of approximately four months in fiscal 2010, and full production did not resume for a further three months. This disruption significantly reduced our net sales and income from operations in fiscal 2010, and the associated delays created a backlog of orders. The disruption also led to increases in scrap and rework rates and costs associated with testing new paints and training personnel to use new paints during this period. Although we have since developed secondary sources for our primary paint coatings, the unavailability of paints or other key raw materials could adversely affect our business in the future.

We depend on a limited number of suppliers for tubes used in our guitar amplifiers and certain exotic woods that we use in a selection of our guitars. For example, we believe there are only three primary manufacturers for the tubes used in certain of our guitar amplifiers, located in China, Russia, and the Czech Republic. In some cases, these manufacturers are the sole source of certain types of tubes. If we are unable to find acceptable substitutes for these suppliers, we may be required to produce these tubes internally or change our designs. Similarly, through-hole componentry used in certain of our guitar amplifiers is becoming scarcer worldwide as most electronics manufacturers shift to surface-mount components. We do not have long-term agreements with these suppliers and we cannot be sure that they will continue to supply us or our OEMs with the materials needed to manufacture our products, on acceptable terms or at all.

 

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If we are unable to sustain historical technologies, such as vacuum tubes, traditional tone woods and through-hole componentry, our business and results of operations could suffer.

Disruption in the supply of materials would impair our ability to sell our products and meet customer demand, and also could delay the launch of new products, any of which could harm our business and results of operations. If we were to have to change suppliers, the new supplier may not be able to provide us materials or components in a timely manner and in adequate quantities that are consistent with our quality standards and on satisfactory pricing terms. In addition, alternative sources of supply may not be available for raw materials that are scarce or components for which there are a limited number of suppliers.

We may be subject to the enforcement of regulations and laws relating to the importation and use of certain raw materials, which could adversely affect our ability to use certain raw materials and harm our business.

We are subject to a variety of customs and import regulations that, if not properly followed could delay or impact our importation of raw materials, which could adversely affect our business. For example, in June 2011, German officials began a criminal investigation pertaining to less than 500 Fender guitars containing Brazilian rosewood fingerboards to determine if they were improperly imported into Germany between approximately March 2010 and January 2011. We are investigating whether the necks of the subject products may be replaced with materials that are not subject to the import restriction at issue.

One of our competitors, Gibson Guitar Corp., is in litigation with the U.S. Fish & Wildlife Service, or Fish & Wildlife, for alleged violations of the Lacey Act, which regulates trade in wood and other plant products. Most recently in August 2011, Fish & Wildlife raided Gibson’s headquarters and seized rosewood from India, alleging that it was exported under an incorrect tariff code and that Gibson was not identified in importation paperwork. Although we believe our sourcing and importation practices are in compliance with the Lacey Act and other applicable regulations, Fish & Wildlife or other applicable regulators could take a different view, which could restrict or prevent our use of specific types of woods from specific countries/regions of the world, and/or subject us to fines and other penalties.

In the case of certain raw materials that we use in our products, including certain types of woods, we may be subject to pressure from environmental groups to use alternative types of materials. These alternative materials could reduce the quality of our products or could be more expensive, either of which could harm our business and results of operations. In addition, negative publicity regarding environmental matters also could harm our brands.

We may also be subject to the enforcement of other new or existing regulations and laws relating to the sourcing, transportation, distribution and use of raw materials and components, including wood, electrical components and adhesives, which could impact our ability to use certain raw materials or components and harm our business.

We depend on our relationships with dealers and their ability to sell our products, and one dealer is responsible for a significant percentage of our net sales. Any disruption in these relationships could harm our net sales.

We sell our products at wholesale to dealers and, accordingly, depend on the willingness and ability of our dealers to market and sell our products to consumers. For fiscal 2009, fiscal 2010,

 

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fiscal 2011 and the first quarter of fiscal 2012, Guitar Center Inc., or Guitar Center, and its affiliates accounted for approximately 15.2%, 15.8%, 15.8% and 17.2% of our net sales, respectively. Sales of our products depend in part on dealers and distributors implementing effective retail sales initiatives that create and sustain demand for the products they purchase from us. If these initiatives are not successfully implemented or if any of our significant customers were to reduce the quantity of our products it sells, stop selling our products, focus selling efforts on our competitors’ products or generally reduce its operations due to financial difficulties or otherwise, our business and results of operations would suffer. For example, during fiscal 2009, Guitar Center and its affiliates reduced their purchases of our products, which in turn negatively affected our net sales. We do not have long-term contracts with dealers, including Guitar Center and its affiliates. Our dealers are generally not obligated to purchase specified amounts of our products, and they generally purchase products from us on a purchase order basis.

In addition, we rely on our dealers, especially specialty music dealers that provide individual sales assistance, to be knowledgeable about our products and their features. If we are not able to educate our dealers so that they may effectively sell our products, or if our dealers do not provide positive buying experiences for our consumers, our brands and business would be harmed.

For sales in some countries outside the United States, we rely in part on third party distributors and are subject to the risk that these distributors may not effectively sell our products.

For sales in some countries outside the United States, including markets in Asia and Latin America, we rely on independent distributors to sell our products to dealers. We do not control our independent distributors, and many of our contracts allow our distributors to offer our competitors’ products. Our competitors may incentivize distributors to favor their products. We generally do not have long-term contracts with these distributors and the substantial majority of our contracts do not contain meaningful minimum purchase commitments. Consequently, with little or no notice, many of these distributors may terminate their relationships with us or materially reduce the level of their purchases of our products. If we were to lose one or more of our distributors, we would need to obtain a new distributor to cover the particular location or product line, which may not be possible on favorable terms or at all. In the alternative, we would need to use our own sales force to replace the distributor. Expanding our sales force into new locations takes a significant amount of time and resources, and there is no assurance that we would be successful in such an expansion. In addition, we are party to two exclusive distribution agreements for the Japanese market with two of our significant stockholders that contain restrictions limiting our ability to terminate the agreements. Should we desire to replace these distributors with our own sales force, as we have done in Europe, or if we were to seek to retain a new distributor for the Japanese market, these agreements may prevent us from doing so.

We are subject to credit risk associated with our largest customer.

Historically, a significant portion of our domestic net sales has been generated by our largest customer. As a result, we experience some concentration of credit risk in our accounts receivable, with Guitar Center and its affiliates representing an aggregate of $11.6 million, or approximately 16.6%, of our accounts receivable as of April 1, 2012. In November 2010, Moody’s Investors Service downgraded Guitar Center’s corporate family rating and probability of default rating to Caa2 (which Moody’s defines as “poor standing and subject to very high credit risk”) from Caa1, citing Guitar Center’s highly leveraged capital structure and heavy interest burden. Moody’s

 

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affirmed Guitar Center’s Caa2 rating on February 29, 2012. These factors make Guitar Center more vulnerable to any deterioration in its financial performance, whether as a result of adverse economic conditions or otherwise. A substantial majority of our accounts receivable, including all of our accounts receivable from Guitar Center and its subsidiaries, are not covered by collateral or credit insurance.

If one or more of our significant customers were to experience serious financial difficulty, as a result of weak economic conditions or otherwise, and were to reduce its inventory in one or more of our products or limit or cease operations, our business and results of operations would be significantly harmed. Consolidation of our customers in the future or additional concentration of market share among our customers may also increase the concentration of our credit risk.

We participate in floor plan financing arrangements for many of our independent dealers under which a third party finances, or “floors,” the purchase of products from us. Under these arrangements, we are subject to credit risk in the event that the independent dealers do not repay amounts owed under these arrangements. In particular, under those floor plan arrangements that are recourse, we would be obligated to reimburse the third party financing sources either in full or in part in the event the independent dealers default on their obligations. Although recourse arrangements are not currently material to our net sales, if we were to increase our use of these arrangements in the future, a failure of these independent dealers to satisfy their obligations, either as a result of deterioration in their financial condition or otherwise, could cause our bad debt expense to increase significantly. In addition, one of the primary third party financing sources that finances floor plan arrangements ceased providing these arrangements in the United Kingdom in 2009, and any further reduction in the availability of floor plan financing may prevent dealers from carrying an adequate inventory of our products, which could reduce demand and reduce our net sales.

We operate in highly competitive markets, and, if we do not compete effectively, our business and results of operations will be harmed.

The markets in which we operate are highly competitive and are served by a variety of established companies with recognized brand names, as well as new market entrants. Companies in these markets compete based on a variety of factors, including price, style of instrument, sound and sound quality, features and brand recognition. Our ability to increase our net sales depends, in part, on our ability to compete effectively and maintain or increase our market share. We compete with different types of companies and based on different factors in each market. For example, in the market for beginner instruments competition is largely based on price as well as brand recognition. In the markets for higher-priced and professional instruments, competition tends to be based more on sound, sound quality and style of instrument. In certain areas of the markets in which we compete, some of our competitors may be more established, benefit from greater name recognition or have greater manufacturing and distribution channels and other resources than we do. If we are not able to compete effectively, we may lose market share, our net sales could decline or grow at a slower rate and our business and results of operations would be harmed.

If we fail to maintain the value of our brands, our business will be harmed.

Our success depends on the value of our brands. Fender and our other brand names are central to our business as well as to the implementation of our strategies for expanding our business.

 

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Maintaining, promoting and positioning our brands will depend largely on our ability to provide quality products that respond to consumer preferences in a timely manner, as well as on the success of our marketing efforts. Our brands could be adversely affected if we fail to achieve these objectives or if we or others with whom we are associated take actions that harm our public image or reputation. In addition, our brands could be harmed if our products are not viewed as distinctive. If the value of our brands were to decline, our net sales would decline and our business and results of operations would be harmed.

If we are unable to protect our intellectual property rights, the value of our brands could decline and our business could suffer.

Our intellectual property is critical to the success of our business. We particularly rely on our trademarks for our brand recognition, and rely on trade dress, patents and other intellectual property rights to protect and maintain the distinctiveness of our products and their sound quality and style. Despite our efforts, the steps we have taken to protect our intellectual property may not be adequate to prevent infringement of our intellectual property. For example, we have been unable to obtain registered trademark protection in the United States for the specific category of musical instruments for the two dimensional guitar body designs commonly used on our iconic Stratocaster, Telecaster and Precision Bass guitars. In addition, the regulations of certain foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States. From time to time, we have discovered unauthorized products in the marketplace that are counterfeit reproductions of our products. Although we expend efforts to pursue counterfeiters, it is not practicable to pursue all counterfeiters. If we are unsuccessful in challenging a third party’s products on the basis of trademark infringement or if we are unable to dedicate sufficient resources to detecting and pursuing counterfeit products or otherwise do not aggressively pursue producers or sellers of counterfeit products, continued sales of these products could adversely impact our brands and our business and results of operations.

We have registered many of our brand names and some of our product designs as trademarks in the United States and in certain foreign countries. We may not, however, be successful in asserting trademark, trade name or trade dress protection with respect to our brand names and our product designs and third parties may seek to oppose or challenge our trademark registrations. For instance, as described further under “Business—Legal proceedings,” in connection with trademark registration opposition proceedings that we initiated against one of our competitors, Peavey Electronics Corporation, or Peavey, filed counterclaims against us, petitioning for cancellation of two of our registered headstock designs that are used in many of our electric guitars and bass guitars. If we are not successful in this cancellation proceeding, our ability to prevent other companies from copying the subject headstock designs may suffer. In addition, our pending patent applications may not result in the issuance of patents, and even issued patents may be contested, circumvented or invalidated and may not provide us with proprietary protection or competitive advantages.

Further, while we enter into non-disclosure agreements with employees, OEMs, distributors and others to protect our confidential information and trade secrets, we may be unable to prevent such parties from breaching these agreements with us and using our intellectual property in an unauthorized manner. If our efforts to protect our intellectual property are inadequate, or if a third party misappropriates our rights, the value of our brands could be harmed, which would adversely affect our business. Defending our intellectual property rights, including through litigation, can be very expensive and time consuming, and there is no assurance that we will be successful.

 

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We have licensed in the past, and expect to license in the future, certain of our proprietary rights, such as our trademarks, to third parties. Despite our efforts to protect our trademarks, these licensees may take actions that diminish the value of our proprietary rights and harm our brands and reputation.

Claims by others that we infringe their intellectual property rights could harm our business.

From time to time, third parties claim that one or more of our products or the products that we distribute infringe their proprietary rights. Any claims of infringement by a third party, even those without merit, could cause us to incur substantial costs defending against the claim, and could distract our management from our business. Furthermore, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages or that prevents us from offering one or more of our products. In addition, we might be required to seek a license for the use of such intellectual property, which may not be available on acceptable terms or at all. Alternatively, we may be required to alter our products to make them non-infringing, which could require significant effort and expense and ultimately may not be successful. Any of these events could harm our business and results of operations.

If we do not develop new or innovative products that meet evolving market needs, or if our new products do not achieve market acceptance, our business and results of operations will suffer.

We believe our long-term success will depend in part on our ability to continue to introduce new products that appeal to consumers and on our ability to develop new and innovative products that employ developing technologies and address evolving market needs. A significant portion of our sales in any year is from new or modified products that we have introduced in that year. For example, in fiscal 2011, 10.8% of our gross sales before discounts and allowances were attributable to products introduced in that year. In addition, modern technologies, such as digital signal processing technologies, are offering opportunities to develop instruments and guitar amplifiers that can address the needs of musicians in a wide variety of musical styles, and developments in technology offer opportunities to develop instruments and guitar amplifiers that provide higher sound quality at a lower cost. We have devoted, and continue to devote, significant resources to research and development. Our research and development expenses totaled $10.2 million in fiscal 2011 and $2.7 million in the first quarter of fiscal 2012. Our business and results of operations will, however, suffer if we are unable to develop innovative new products that achieve market acceptance.

Our operating results are subject to quarterly variations in our net sales, which could make our operating results difficult to predict and could adversely affect the price of our common stock.

We have experienced, and expect to continue to experience, substantial quarterly variations in our net sales and net income. Our quarterly results of operations fluctuate, in some cases significantly, as a result of a variety of other factors, including, among other things:

 

 

the timing of new product releases or other significant announcements by us or our competitors;

 

 

new advertising initiatives;

 

 

fluctuations in raw materials and component costs;

 

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changes in school budgets for musical instrument purchases; and

 

 

changes in our practices with respect to building inventory.

As a result of these quarterly fluctuations, comparisons of our operating results between different quarters within a single year are not necessarily meaningful and may not be accurate indicators of our future performance. Any quarterly fluctuations that we report in the future may differ from the expectations of market analysts and investors, which could cause the price of our common stock to fluctuate significantly.

The loss of one or more members of our senior management team would adversely affect our business and our ability to execute our business strategy.

Our future success depends in large part on our ability to retain members of our senior management team, including our Chief Executive Officer, Larry Thomas, and to attract and retain other qualified managerial personnel. Mr. Thomas’ current employment agreement with us expires on March 31, 2015. Our management and other employees can terminate their employment with us at any time, and we do not maintain key person life insurance on employees other than Mr. Thomas. The proceeds of that policy would likely be inadequate to compensate us for the loss of Mr. Thomas’ services. While we have begun developing a management succession plan, it remains in the early stages of development and there can be no assurance that we will implement a successful management succession plan. The unexpected loss of one or more members of our senior management team could harm our business and our ability to execute our business strategy.

We depend on skilled craftspeople and engineers to develop and create our products, and an educated sales force to sell our products, and the failure to attract and retain such individuals could adversely affect our business.

Although portions of our manufacturing processes are automated, certain of our products, particularly our high-end guitars, continue to require a significant amount of skilled labor and handiwork. We rely on skilled and well-trained engineers and craftspeople both for the design and production of our products, as well as in our research and development functions. Our inability to attract or retain qualified employees in our design, production or research and development functions or elsewhere in our company could result in diminished quality of our product and delinquent production schedules, impede our ability to develop new products and harm our business and results of operations. In addition, we rely on a skilled sales force that is knowledgeable about our products. If we are not able to retain or attract qualified individuals to our sales force, or if we are not able to grow our sales force when needed, our ability to maintain or increase our net sales would suffer.

Many of the skills we require are not widely taught in traditional universities or schools. For example, vacuum tube and transistor based electronics design is no longer widely taught. Similarly, the skills required to construct and repair fretted instruments are only taught in highly-specialized trade schools. For these reasons, many of the skills required to manufacture our products are taught to new employees by more experienced staff. If we are unable to retain and promote talent within these areas of expertise who can teach their skills to new employees, we may be unable to sustain our historical technologies, and the long-term success of our business could be adversely affected.

 

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The artists who play our instruments are an important aspect of our brands’ images. The loss of the support of artists for our products or the inability to attract new artists may harm our business.

If our products are not used by current or future artists and famous musicians, our brands could lose value and our net sales could decline. Similarly, our Signature Artist program is a significant component of our marketing program. Through this program, famous musicians provide specifications for instruments bearing their signature, endorse their signature instrument and permit us to use their images in selected advertisements or on our websites, typically in exchange for royalties based on sales of their signature instruments. We do not have long-term contracts with any of these musicians, and these musicians are not restricted from endorsing our competitors’ products or required to use our products exclusively. If we are unable to maintain our current relationships with these artists, if these artists are no longer popular or if we are unable to continue to attract the endorsement of new artists in the future, the value of our brands and our net sales could decline.

If we are not able to maintain our relationships with third parties for whom we act as distributor or sales representative, our business and results of operations would be harmed.

We derive a portion of our net sales from product lines for which we act as distributor or sales representative. These arrangements include products such as Gretsch guitars and drums, Sabian cymbals, EVH guitars and guitar amplifiers and Takamine guitars. Some of the agreements governing these arrangements are for a fixed term and are renewable only upon the agreement of both parties. In other cases, the agreements have fixed terms and automatically renew unless notice is given a specified period of time in advance of the expiration of the current term. In addition, some of these agreements may be terminated in the event we do not satisfy certain performance conditions, including minimum purchase, sale and royalty requirements, and in the event of a change in control of FMIC.

If we are unable to renew these agreements on acceptable terms or at all or if we take actions that permit these agreements to be terminated, we may lose access to those product lines, which could adversely affect our business and results of operations. In some instances, including with respect to the distribution of Takamine guitars, we do not have agreements, other than purchase orders, that govern the distributor relationship. In such instances, this lack of an agreement means that should a dispute develop between us and the licensor, we could quickly lose the business associated with that product line.

We rely on information technology systems in all aspects of our business, and any failure or interruption in our information technology systems could disrupt and harm our business.

We rely on information technology systems in all aspects of our business, including for order processing, inventory and supply chain management, control of our distribution channels, communications and customer billing. If any aspect of these information technology systems were to suffer security breaches, hardware or software malfunctions or other disruptions or failures, our ability to meet customers’ expectations, retain critical data and otherwise operate our business could suffer. If a breach of security were to occur, sensitive customer transactional data could be misappropriated, and we could be exposed to liability and our reputation could be harmed.

 

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In addition, maintenance and upgrades of our systems could result in significant capital expenditures. Some of these systems are legacy systems that are no longer supported by the original vendor of the product. Accordingly, we are required to perform maintenance and upgrades of these systems ourselves, which can be time consuming and expensive, and, depending on the required maintenance or upgrade, we may not be able to perform these functions effectively or at all.

We currently utilize three separate enterprise resource planning systems. One of these systems is no longer supported externally. In addition, there is no assurance that these systems will continue to work together to enable us to operate our business in an efficient manner. We are planning to integrate these systems and anticipate that this integration will take at least three years. Although we do not expect the costs associated with the integration to be material, integration of the systems will be time consuming and our costs to integrate these systems could exceed our expectation and may disrupt our business. If we attempt to integrate these systems, or implement new enterprise resource planning systems, but are unable to do so effectively or at all, our ability to meet customer expectations and to manage our business operations could suffer.

We use third party data centers to co-locate or host some of our systems and to provide key data processing and hosting functions. We do not control the operation of these facilities. These facilities, as well as our own facilities over which we retain control, could suffer damage or interruption from earthquakes, floods, fires, terrorist attacks, power losses, telecommunications failures and similar events, and could also be subject to break-ins, computer viruses, sabotage, intentional acts of vandalism and other misconduct. The occurrence of any of these events, a decision by a third party to close facilities without adequate notice or other unanticipated problems could result in significant disruption to our business operations.

We do not control our suppliers, OEMs or licensees, or require them to comply with a formal code of conduct, and actions that they might take could harm our reputation and net sales.

We do not control our suppliers, OEMs or licensees of our trademarks or their labor, environmental or other practices. A violation of labor, environmental or other laws by our suppliers, OEMs or licensees, or a failure of these parties to follow generally accepted ethical business practices, could create negative publicity and harm our reputation. In addition, we may be required to seek alternative suppliers, OEMs or licensees if these violations or failures were to occur. We do not inspect or audit compliance by our suppliers, OEMs or licensees with these laws or practices, and we do not require our suppliers, OEMs or licensees to comply with a formal code of conduct. We ask our OEMs to represent to us that they are fully in compliance with applicable laws, including local labor, environmental and safety laws, in connection with their performance of their contracts with us; however, other than seeking these representations, we do not generally monitor this compliance. In certain instances, our channel distribution partners have inspected our OEMs and have found violations of these channel partners’ internal codes of conduct relating to certain labor and environmental matters that have needed to be remedied. Other consumer products companies have faced significant criticism for the actions of their OEMs, and we could face such problems ourselves. Any of these events could reduce demand for our products, harm our ability to meet demand if we need to locate alternative suppliers or OEMs and harm our reputation, business and results of operations.

 

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Currency exchange rate fluctuations could result in lower net sales and decreased gross margins.

Foreign currency fluctuations have had and could in the future have an adverse effect on our business and results of operations. A significant portion of our products are sold outside of the United States in foreign currencies. Our expenses are chiefly denominated in U.S. dollars, while a significant percentage of our net sales from sales in euros and the British pound. This exposes us to the risk that a strengthening U.S. dollar could cause our net sales to decline relative to our costs, thereby decreasing our gross margins.

We engage in hedging activities to mitigate the impact of the translation of foreign currencies on our financial results. Our hedging activities are designed to reduce, but do not eliminate, the effects of foreign currency fluctuations. Factors that could affect the effectiveness of our hedging activities include accuracy of sales forecasts, volatility of currency markets and the availability of hedging instruments. In particular, the current economic volatility in Europe makes it more difficult to forecast sales in Europe and put in place effective hedging activities in relation to our exposure to the euro. In recent months there have been concerns over the future of the euro single currency. Any breakup of the eurozone would adversely affect our foreign currency exposure and the effectiveness of our hedging activities. Since our hedging activities are designed to reduce volatility, they not only reduce the negative impact of a stronger U.S. dollar, but they also reduce the positive impact of a weaker U.S. dollar.

Our international operations and the operations of our OEMs are subject to additional risks that are beyond our control and that could harm our business.

We have international operations and also use OEMs located in Asia to manufacture some of our products. Accordingly, we are subject to a number of risks related to conducting business internationally, any of which could harm our business, including:

 

 

differing cultural, social and economic customs;

 

 

increased transportation costs;

 

 

delays and other logistical problems relating to the transportation of goods shipped by ocean or air freight;

 

 

tariffs, import and export controls and other barriers;

 

 

longer payment cycles and greater problems in collecting accounts receivable;

 

 

restrictions on the transfer of funds;

 

 

changing economic conditions;

 

 

increased labor costs and/or shortages;

 

 

fluctuations in exchange rates;

 

 

changes in governmental policies and regulations;

 

 

limitations on the level of intellectual property protection;

 

 

poor or unstable infrastructure of certain foreign countries;

 

 

differing and potentially adverse tax laws;

 

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trade sanctions, political unrest, terrorism, war and epidemics or the threats of any of these events;

 

 

difficulties in ensuring compliance by our employees, agents and contractors with our business practices, as well as with applicable U.S. or foreign laws, including anti-bribery laws, labor laws and laws regulating the manufacture of our products; and

 

 

difficulties in understanding and complying with local laws and regulations in foreign jurisdictions.

Changes in our effective tax rates could affect future results.

We are subject to taxation in the United States and various other foreign jurisdictions in which we do business. Some of these foreign jurisdictions have higher statutory tax rates than those in the United States, and certain of our international earnings are also taxable in the United States. Accordingly, our effective tax rates will vary depending on the relative proportion of foreign to U.S. income and absorption of foreign tax credits, changes in the valuation of our deferred tax assets and liabilities and changes in tax laws. In addition, we are subject to examination of our income tax returns by the U.S. Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our income tax reserves and expense. Should actual events or results differ from our current expectations, charges or credits to our income tax expense reserves and income tax expense may become necessary. Any such adjustments could have a significant impact on our results of operations.

In the past, we have expanded our operations in part through acquisitions, license agreements and distribution arrangements, and may continue to do so in the future. These transactions subject us to risks that, if not properly managed, could harm our business and results of operations.

We have in the past grown our business in part through strategic acquisitions, license agreements and distribution arrangements and expect to continue to do so in the future as part of our strategy to grow our business and expand our product lines. In December 2007 we acquired KMC, which was our largest acquisition to date. Our recent acquisitions, as well as any future acquisitions, entail a number of risks that may prevent us from achieving the expected benefits from the acquisitions, including:

 

 

diversion of management time from operating the business to focus on integration issues;

 

 

difficulties in integrating operations, personnel and information technology systems across different corporate cultures and systems;

 

 

declining employee retention and morale issues resulting from changes in reporting arrangements, job functions or compensation arrangements;

 

 

difficulties in integrating different production facilities and methodologies;

 

 

difficulties in integrating new products into our marketing functions;

 

 

potential exposure to unanticipated liabilities;

 

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increased borrowings under our current credit facility or a new facility in the event we borrow funds in connection with an acquisition; and

 

 

dilution to our existing stockholders if we issue equity in connection with future acquisitions.

Since the acquisition of KMC, we have consolidated some of our existing manufacturing and other operations with those of KMC. We have migrated sales and distribution of KMC products in Europe to our existing European sales and distribution platforms. KMC is, however, still responsible for its international sales and distribution operations outside of Europe. We also are evaluating our current warehouse facilities in an effort to streamline our inventory and distribution functions and shorten the time it takes to deliver our products to customers. These and other activities designed to integrate KMC operations with our existing operations are disruptive and require significant management time and attention, and a number of these activities have only recently been completed or are continuing. To the extent we cannot complete these integration activities effectively and on a timely basis, we will not achieve the benefits we intend to realize from the KMC acquisition and our business and results of operations would be harmed.

The pursuit of future acquisitions also may divert management’s time and attention from our operations. In addition, to the extent that we are not able to identify or complete additional acquisitions on satisfactory terms or at all, our ability to grow our business and expand our product lines may be adversely affected. If we are not able to effectively manage these or any other risks relating to past or future acquisitions, our business and results of operations could be harmed.

From time to time, we make investments in certain joint ventures or other entities in which we have a minority or non-controlling interest. These investments may involve risks, including that our interests are not aligned with those of our partners. These joint ventures or other entities may take actions that could harm the value of our investment or our reputation, or otherwise harm our business and results of operations.

Defects in our products could harm our brands and our business.

Our products may expose us to liability from claims by consumers for damages, including bodily injury or property damage. These claims, whether meritorious or not, could harm our reputation and net sales, be costly to defend and could harm our business and results of operations. In addition, even if no bodily injury or property damage occurs from a defect, if our products do not function properly, we may be obligated to replace these products at no additional charge, which also could harm our business and results of operations. Although we maintain general product liability insurance, there can be no assurance that we will be adequately covered against claims or that we will not have to obtain additional coverage in the future, which may not be available on acceptable terms or at all.

Our operations may subject us to liabilities for environmental or other regulatory matters, the costs of which could be material.

Our manufacturing operations in the United States and Mexico involve the use, handling, storage and disposal of hazardous substances, including, for example, the paint used for our guitars, and we are subject to numerous environmental, health and safety laws and regulations, including those regulating the handling, storage and disposal of hazardous substances and discharges to

 

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the air, soil and water, as well as the investigation and remediation of contaminated sites. Many of these laws impose strict, retroactive, joint and several liability upon owners and operators of properties, including with respect to environmental matters that occurred prior to the time the party became an owner or operator. In addition, we may have liability with respect to third party sites to which we sent waste for disposal in the past. From time to time, we have been required to make payments or modify our operations and facilities as a result of environmental matters. For example, in fiscal 2009, we reached a settlement with the Environmental Protection Agency pursuant to which we agreed to pay approximately $79,000 in penalties due to improper waste storage and inadequate personnel training at our Corona, California facility. If we were to become liable in the future with respect to the release of any hazardous substance or contamination of any site, we may be subject to significant fines and cleanup costs. In addition, these or other events, including changes in environmental, health and safety laws, may require us to modify our operations or facilities, which could be costly.

In addition to risks relating to traditional environmental law and regulations, we also face increasing complexity in the design and manufacture of our products as we must adjust to new and upcoming requirements relating to the materials composition of many of our products, including worker safety laws. We have incurred costs to comply with these regulations in the past and will incur additional costs in the future. In addition, compliance with these regulations could disrupt our operations and logistics. We will need to ensure that we can design and manufacture compliant products and that we can be assured a supply of compliant components from our suppliers. These and other environmental regulations may require us to redesign our products to utilize new components that are compatible with these regulations, which may result in additional costs to us or cause us to eliminate the products from our portfolio.

Many of our products are also subject to regulations, including with respect to certifications and safety testing. In the second quarter of fiscal 2010, we received a letter of inquiry from the Federal Communications Commission, or FCC, asking for information about Fender electronic digital device products subject to part 15 of the FCC’s rules governing radio frequency devices. As regulations of our products and operations increase, there is a risk that we are not aware of, and not in full compliance with, all regulations to which we may be subject globally.

Our secured credit facilities contain restrictive and financial covenants, and if we are unable to comply with these covenants, we will be in default, which could result in acceleration of our outstanding indebtedness.

As of April 1, 2012, on an as adjusted basis after giving effect to the application of a portion of the net proceeds to us of this offering, we would have approximately $167.6 million outstanding under our secured credit facilities. Our secured credit facilities contain covenants that require us to maintain certain specified financial ratios and restrict our ability to pay dividends with respect to our capital stock, encumber our assets, incur additional indebtedness, engage in certain business combinations or undertake various other corporate activities. In addition, we have pledged substantially all of our assets and properties under these facilities. These restrictive and financial covenants, as well as the pledge, reduce our operating flexibility and may prevent us from engaging in certain transactions that may be beneficial to us. In addition, our ability to comply with these covenants could be affected by events beyond our control.

Although we are currently in compliance with these covenants, in the future if we are unable to comply with any of these covenants, we will be in default, which could result in the acceleration

 

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of our outstanding indebtedness. In such event, we would most likely need to raise funds from alternative sources, which funds may not be available to us on acceptable terms or at all. Alternatively, such an event could require us to sell our assets and otherwise curtail our operations in order to pay our lenders, which could harm our business and results of operations.

If we are required to refinance our credit facilities, due to an acceleration of indebtedness as a result of an event of default, a change of control of our company, an acceleration of the revolver portion of our credit facilities as a result of the term loan portion not being refinanced, extended or repaid by March 9, 2014, or otherwise, we do not believe that we would be able to receive terms that are as favorable to us as those under our current facilities, either with respect to interest rate or operating and financial covenants.

In addition, our indebtedness and our need to allocate a portion of our cash flows to repayments under our credit facilities could have important consequences, including:

 

 

reducing the availability of our cash flow for other purposes, including working capital, capital expenditures, product development, acquisitions or other corporate requirements;

 

 

increasing our vulnerability to general adverse economic and industry conditions; and

 

 

limiting our flexibility in planning for, or reacting to, changes in our business and our industry.

Our debt obligations under our secured credit facilities have variable interest rates, which makes us more vulnerable to increases in interest rates and could cause our interest expense to increase and decrease cash available for operations and other purposes.

We had $246.2 million of debt, bearing interest at a variable rate, outstanding under our credit facilities as of January 1, 2012 and $255.8 million of debt, bearing interest at a variable rate, outstanding under our credit facilities as of April 1, 2012. Recent interest rates in the United States have been at historically low levels, and any increase in these rates would increase our interest expense and reduce our funds available for operations and other purposes. Although from time to time we enter into agreements to hedge a portion of our interest rate exposure, these agreements may be costly and may not protect against all interest rate fluctuations. Accordingly, we may experience material increases in our interest expense as a result of increases in interest rate levels generally. Based on the $246.2 million of variable interest rate indebtedness that was outstanding as of January 1, 2012, a hypothetical 100 basis point increase or decrease in the interest rate on our long-term debt would have resulted in an approximately $1.0 million change to our interest expense for fiscal 2011.

We will incur significant increased costs as a result of being a public company, and our management will be required to devote substantial time to compliance efforts.

As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. The Sarbanes-Oxley Act, as well as rules subsequently implemented by the Securities and Exchange Commission, or SEC, and the Nasdaq Stock Market’s Global Select Market, or Nasdaq, impose additional requirements on public companies, including enhanced corporate governance practices and reporting requirements. We also will be required to establish and maintain internal control over financial reporting and disclosure controls and procedures. In particular, under the current rules of the SEC, beginning with fiscal 2013, we must

perform system and process evaluation and testing of our internal control over financial

 

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reporting to allow management to report on the effectiveness of our internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. Beginning with fiscal 2018, or such earlier time as we are no longer an “emerging growth company” as defined in the JOBS Act, our independent registered public accounting firm also will be required to report on our internal control over financing reporting. See “Prospectus summary—Emerging growth company status” for a description of circumstances where we could lose our “emerging growth company” status. We expect to incur substantial accounting and auditing expenses and expend significant management time in complying with the requirements of Section 404. In addition, we could be required to expend significant management time and financial resources to correct any material weaknesses in our internal control over financial reporting that may be identified. If our management is unable to certify the effectiveness of our internal control over financial reporting, our independent registered public accounting firm cannot render an opinion on the effectiveness of our internal control over financial reporting when that requirement becomes applicable to us or material weaknesses in our internal control over financial reporting were identified, we could be subject to regulatory scrutiny and a loss of public confidence, which could seriously harm our business and reduce our stock price. In addition, if we do not maintain adequate financial and management personnel, processes and controls, we may not be able to accurately report our financial performance on a timely basis, which could cause a decline in our stock price and harm our ability to raise capital. Failure to accurately report our financial performance on a timely basis could also jeopardize our continued listing on Nasdaq or any other stock exchange on which our common stock may be listed. Delisting of our common stock on any exchange would reduce the liquidity of the market for our common stock, which would reduce the price of our stock and increase the volatility of our stock price.

Our management and other personnel will need to devote a substantial amount of time to these public company requirements, and there is no assurance that we will be able to comply with these requirements in a timely manner or at all. Moreover, these rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly. These rules and regulations also could make it more difficult for us to attract and retain qualified persons to serve on our board of directors and board committees or as executive officers. Some members of our management team have limited or no experience in managing a public company, which may require those members to devote additional time to familiarize themselves with public company requirements and may increase the risk that we will not be able to comply with those requirements in a timely manner or at all.

Risks related to this offering and ownership of our common stock

The trading price of our common stock may be volatile, and you might not be able to sell your shares at or above the initial public offering price.

Our common stock has no prior trading history. The trading price of our common stock could be volatile, and you could lose all or part of your investment in our common stock. Factors affecting the trading price of our common stock could include:

 

 

variations in our operating results or those of our competitors;

 

 

new product or other significant announcements by us or our competitors;

 

 

changes in our product mix;

 

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changes in consumer preferences;

 

 

fluctuations in currency exchange rates;

 

 

the gain or loss of significant customers;

 

 

recruitment or departure of key personnel;

 

 

changes in the estimates of our operating results or changes in recommendations by any securities analysts that elect to follow our common stock;

 

 

changes in general economic conditions as well as conditions affecting our industry in particular;

 

 

sales of our common stock by us, our significant stockholders or our directors or executive officers; and

 

 

the expiration of contractual lock-up agreements.

In addition, in recent years, the stock market has experienced significant price fluctuations. Fluctuations in the stock market generally or with respect to companies in our industry could cause the trading price of our common stock to fluctuate for reasons unrelated to our business, operating results or financial condition. Some companies that have had volatile market prices for their securities have had securities class actions filed against them. A suit filed against us, regardless of its merits or outcome, could cause us to incur substantial costs and could divert management’s attention.

A market for our securities may not develop or be maintained and our stock price may decline after the offering.

Prior to this offering, there has been no public market for shares of our common stock. An active public trading market for our common stock may not develop or, if it develops, may not be maintained, after this offering. Our company, the selling stockholder and the representatives of the underwriters will negotiate to determine the initial public offering price, and the initial public offering price does not necessarily reflect the price at which investors will be willing to buy and sell our shares following this offering. The initial public offering price may be higher than the trading price of our common stock following this offering. As a result, you could lose all or part of your investment.

Future sales of our shares, or the perception that such sales may occur, could cause our stock price to decline.

If our existing stockholders sell substantial amounts of our common stock in the public market, or are perceived by the public market as intending to sell, the trading price of our common stock could decline below the initial public offering price. Based on shares outstanding as of April 1, 2012, upon completion of this offering, we will have 26,361,833 shares of common stock outstanding after this offering. Of these shares, 11,028,572 shares of common stock will be freely tradable, without restriction, in the public market. Our executive officers, directors and the holders of substantially all of our shares of common stock have entered into contractual lock-up agreements with the underwriters pursuant to which they have agreed, subject to certain exceptions, not to sell or otherwise transfer any of their common stock or securities convertible

 

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into or exchangeable for shares of common stock for a period through the date 180 days after the date of the final prospectus for this offering, subject to extension under some circumstances. J.P. Morgan Securities LLC and William Blair & Company, L.L.C. may, however, permit these holders to sell shares prior to the expiration of the lock-up agreements. For additional information, see “Shares eligible for future sale” and “Underwriting.”

Upon the expiration of the contractual lock-up agreements pertaining to this offering, up to an additional 15,333,261 shares will be eligible for sale in the public market, 6,053,739 of which are held by directors, executive officers and other affiliates and will be subject to volume and manner of sale limitations under Rule 144 under the Securities Act. Certain of our existing stockholders have demand and piggyback rights to require us to register with the SEC up to 6,053,739 shares of our common stock, subject to contractual lock-up agreements. See “Description of capital stock—Registration rights” for more information. If we register any of these shares of common stock, those stockholders would be able to sell those shares freely in the public market.

In addition, the shares that are either subject to outstanding options or that may be granted in the future under our equity incentive plans will become eligible for sale in the public market to the extent permitted by the provisions of various vesting agreements, the contractual lock-up agreements and Rules 144 and 701 under the Securities Act.

The following table shows when the 26,361,833 shares of our common stock that will be outstanding when this offering is complete, will be eligible for sale in the public market:

 

      Shares eligible for sale  
Date    Number of
shares
    

Percentage of

outstanding

shares

 

 

 

On the date of this prospectus

     11,028,572         41.8   

At various times beginning 181 days or more after the date of this prospectus

     15,333,261         58.2   

 

 

After this offering, we intend to register the shares of our common stock that we have issued or may issue under our equity plans. Once we register these shares, they can be freely sold in the public market upon issuance, subject to any vesting or contractual lock-up agreements.

In addition, our amended and restated certificate of incorporation to be effective immediately prior to the completion of this offering authorizes us to issue 133,000,000 shares of common stock, of which 26,361,833 shares will be outstanding after this offering.

If any of these additional shares described are sold, or if it is perceived that they will be sold, in the public market, the trading price of our common stock could decline. For additional information, see “Shares eligible for future sale.”

We are an “emerging growth company,” and the reduced disclosure requirements applicable to “emerging growth companies” could make our common stock less attractive to investors.

We are an “emerging growth company,” as defined in the JOBS Act. For as long as we are an “emerging growth company,” we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies,” including, but not limited to, not being required to comply with the auditor

 

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attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding advisory “say-on-pay” votes on executive compensation and shareholder advisory votes on golden parachute compensation. We will remain an “emerging growth company” until the earliest of (i) the last day of the fiscal year during which we have total annual gross revenues of $1 billion or more; (ii) the last day of the fiscal year following the fifth anniversary of the completion of this offering; (iii) the date on which we have, during the previous three-year period, issued more than $1 billion in non-convertible debt; and (iv) the date on which we are deemed to be a “large accelerated filer” under the Exchange Act.

We cannot predict if investors will find our common stock less attractive to the extent we rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile.

If securities or industry analysts do not publish research or publish unfavorable research about our business, our stock price and trading volume could decline.

The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business. We do not currently have and may never obtain research coverage by securities and industry analysts. If securities and industry analysts do not commence and continue coverage of our company, the trading price for our stock would suffer. In the event we obtain securities or industry analyst coverage, if one or more of the analysts who covers us downgrades our stock or publishes unfavorable research about our business or our industry, our stock price would likely decline. If one or more of these analysts ceases coverage of our company or fails to publish reports on us regularly, demand for our stock could decrease, which could cause our stock price and trading volume to decline.

Weston Presidio and our directors and officers and insiders will continue to have substantial control over us after this offering and will be able to influence corporate matters.

Upon completion of this offering, funds and a director affiliated with the growth capital firm Weston Presidio will beneficially own 17.8% of our outstanding common stock, and our other directors and executive officers and their affiliates will beneficially own, in the aggregate, approximately 10.1% of our outstanding common stock. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit your ability to influence corporate matters and may have the effect of delaying or preventing a third party from acquiring control over us. For information regarding the ownership of our outstanding stock by Weston Presidio and our executive officers and directors and their affiliates, see “Principal and selling stockholders.”

 

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Anti-takeover provisions in our charter documents and Delaware law could discourage, delay or prevent a change in control of our company.

Our certificate of incorporation and bylaws, as well as Delaware law, contain provisions that may discourage, delay or prevent a change in our management or control over us that stockholders may consider favorable. Among other things, these provisions:

 

 

authorize the issuance of “blank check” preferred stock that could be issued by our board of directors to discourage a takeover attempt;

 

 

establish a classified board of directors, as a result of which the successors to the directors whose terms have expired will be elected to serve from the time of election and qualification until the third annual meeting following their election;

 

 

require that directors only be removed from office for cause;

 

 

provide that vacancies on the board of directors, including newly created directorships, may be filled only by a majority vote of directors then in office;

 

 

limit who may call special meetings of stockholders;

 

 

prohibit stockholder action by written consent, requiring all actions to be taken at a meeting of the stockholders;

 

 

require supermajority stockholder voting to effect certain amendments to our bylaws;

 

 

establish advance notice requirements for nominations for elections to our board of directors or for proposing other matters that can be acted upon by stockholders at stockholder meetings; and

 

 

impose restrictions on mergers and other combinations between us and certain interested stockholders.

For more information regarding these and other provisions, see “Description of capital stock—Anti-takeover effects of our certificate of incorporation and bylaws and Delaware law.”

 

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Special note regarding forward-looking statements

This prospectus contains forward-looking statements that relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. In some cases, you can identify these statements by forward-looking words such as “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “targets,” “likely,” “will,” “would,” “could,” “may,” “might,” the negative of these terms and other comparable terminology. Forward-looking statements include, but are not limited to, statements about:

 

 

anticipated trends and challenges in our business and the markets in which we operate;

 

 

our expectations regarding consumer preferences and our ability to respond to changes in consumer preferences;

 

 

our ability to maintain the popularity of our brands or continue developing our brands as lifestyle brands;

 

 

our ability to expand our product offerings;

 

 

our ability to expand our brands beyond the traditional musical instruments category or to expand our licensing and co-branding activities;

 

 

our ability to maintain or broaden our relationships with signature artists, dealers, manufacturers, distributors and others;

 

 

our ability to expand in international markets;

 

 

our ability to successfully identify and manage any potential acquisitions or distribution relationships and to benefit from our recent acquisitions or distribution relationships;

 

 

our ability to maintain or enhance operational efficiencies; and

 

 

our expectations regarding the use of proceeds from this offering.

Actual events or results may differ materially from expected events or results. All forward-looking statements involve risks, assumptions and uncertainties. See “Risk factors” and elsewhere in this prospectus for additional discussion of these risks, assumptions and uncertainties and for other risks and uncertainties. These risks, assumptions and uncertainties are not necessarily all of the important factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements. There may also be risks of which we are currently unaware, or that we currently regard as immaterial based on the information available to us, that later prove to be material. In addition, new risks may emerge from time to time, and it is not possible for management to predict or identify all risk factors, nor can we assess the impact of all factors on our business or the extent to which any factor or combination of factors may cause actual events or results to differ materially from those contained in any forward-looking statements. In light of these risks, assumptions and uncertainties the forward-looking events discussed in this prospectus might not occur. Except as required by law, we undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

 

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Use of proceeds

We estimate that our net proceeds from the sale of the common stock that we are offering will be approximately $88.2 million, assuming an initial public offering price of $14.00 per share, which is the midpoint of the range of the initial public offering price listed on the cover page of this prospectus, and after deducting assumed underwriting discounts and commissions and estimated offering expenses payable by us. A $1.00 increase or decrease in the assumed initial public offering price of $14.00 per share would increase or decrease the net proceeds to us from this offering (after deducting assumed underwriting discounts and commissions) by $6.6 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same. An increase or decrease of 100,000 shares in the number of shares sold in this offering by us would increase or decrease the net proceeds to us from this offering (after deducting assumed underwriting discounts and commissions) by $1.3 million, assuming an initial public offering price of $14.00 per share. We will not receive any proceeds from the sale of shares of common stock by the selling stockholder.

We intend to use the net proceeds to us from this offering to repay a portion of the amount outstanding under the term loan portion of our senior secured credit facility. As of April 1, 2012, the interest rate on the term loan portion of our senior secured credit facility, which is scheduled to mature in June 2014, was 2.50%. See “Management’s discussion and analysis of financial condition and results of operations—Liquidity and capital resources—Long-term debt” for more information. We have used borrowings under our credit facility for working capital purposes, capital expenditures and to fund acquisitions of businesses and assets, including the acquisition of KMC.

Dividend policy

We have not declared or paid cash dividends on our common stock within the past two fiscal years. We currently intend to retain all available funds and any future earnings for use in the operation of our business and do not anticipate paying any cash dividends in the foreseeable future. Any future determination to declare cash dividends will be made at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements, general business conditions and other factors that our board of directors may deem relevant. In addition, our senior secured credit facility limits our ability to pay dividends to our stockholders. See “Management’s discussion and analysis of financial condition and results of operations—Liquidity and capital resources” for additional information.

 

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Capitalization

The following table sets forth our cash and cash equivalents, short-term debt and capitalization as of April 1, 2012:

 

 

on an actual basis;

 

 

on a pro forma basis to reflect (i) the filing of our amended and restated certificate of incorporation immediately prior to the completion of this offering, and (ii) the automatic conversion of our class B common stock and class C common stock into an aggregate of 8,468,964 shares of common stock upon the closing of the offering; and

 

 

on a pro forma as adjusted basis, reflecting the pro forma adjustments and the sale of                  shares of common stock by us in this offering at an assumed initial public offering price of $14.00 per share, which is the midpoint of the range of the initial public offering price listed on the cover page of this prospectus, after deducting assumed underwriting discounts and commissions and estimated offering expenses payable by us, and the application of such proceeds to repay approximately $88.2 million of the amount outstanding under the term loan portion of our senior secured credit facility.

You should read this table in conjunction with the sections of this prospectus titled “Selected consolidated financial data” and “Management’s discussion and analysis of financial condition and results of operations” and with our consolidated financial statements and related notes included elsewhere in this prospectus.

 

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As of April 1, 2012

(in thousands, except share and per share data)

  

Actual

(unaudited)

   

Pro forma

(unaudited)

   

Pro forma as
adjusted (1)

(unaudited)

 

 

 

Cash and cash equivalents

   $ 13,789      $ 13,789      $ 13,789   
  

 

 

 

Short-term debt

   $ 3,000      $ 3,000      $ 3,000   

Long-term debt:

      

Revolver

     14,000        14,000        14,000   

Term loan

     238,848        238,848        150,648   

Redeemable common stock:

      

Common Stock and Class B common stock, par value $0.01 per share; 35,417,984 shares authorized, 482,160 shares (consisting of 335,160 shares of Common stock and 147,000 shares of Class B common stock) issued and outstanding, actual; no shares authorized, issued and outstanding, pro forma and pro forma as adjusted

     6,801                 

Class C common stock, par value $0.01 per share; 7,563,248 shares authorized, issued and outstanding, actual; no shares authorized, issued and outstanding, pro forma and pro forma as adjusted

     106,684                 

Stockholders’ (deficit) equity:

      

Preferred stock, par value $0.01 per share; no shares, authorized, issued and outstanding, actual; 7,000,000 shares authorized, no shares issued and outstanding, pro forma and pro forma as adjusted

                     

Common stock, par value $0.01 per share; 27,104,056 shares authorized, 10,414,852 shares, issued and outstanding, actual; 133,000,000 shares authorized, 19,218,976 shares issued and outstanding, pro forma; 133,000,000 shares authorized, 26,361,833 shares issued and outstanding, pro forma as adjusted

     104        192        264   

Class B common stock, par value $0.01 per share; 8,313,928 shares authorized, 758,716 shares issued and outstanding, actual; no shares authorized, issued and outstanding, pro forma and pro forma as adjusted

     8                 

Additional paid-in capital

            113,405        201,533   

Accumulated other comprehensive income

     2,401        2,401        2,401   

Accumulated deficit

     (82,466     (82,466     (82,466
  

 

 

 

Total stockholders’ (deficit) equity

     (79,953     33,532        121,732   
  

 

 

 

Total capitalization

   $ 289,380      $ 289,380      $ 289,380   
  

 

 

 

 

 
(1)   A $1.00 increase in the assumed initial public offering price of $14.00 per share would decrease long-term debt: term loan, and would increase additional paid-in capital and total stockholders’ (deficit) equity by $6.6 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting assumed underwriting discounts and commissions. A $1.00 decrease in the assumed initial public offering price of $14.00 per share would increase long-term debt: term loan, and would decrease additional paid-in capital and total stockholders’ (deficit) equity by $6.6 million. An increase of 100,000 shares in the number of shares sold in this offering by us would decrease long-term debt: term loan, and would increase additional paid-in capital and total stockholders’ (deficit) equity from this offering by $1.3 million, assuming an initial public offering price of $14.00 per share and after deducting assumed underwriting discounts and commissions. A decrease of 100,000 shares in the number of shares sold in the offering by us would increase long-term debt: term loan, and would decrease additional paid-in capital and total stockholders’ (deficit) equity from this offering by $1.3 million, assuming an initial public offering price of $14.00 per share and after deducting assumed underwriting discounts and commissions.

 

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The number of shares of our common stock to be outstanding following this offering is based on 19,218,976 shares of our common stock outstanding as of April 1, 2012, and excludes:

 

 

6,609,708 shares of common stock issuable upon exercise of options outstanding as of April 1, 2012, at a weighted average exercise price of $9.72 per share;

 

 

2,114,448 shares of common stock reserved for issuance under our 2012 Equity Compensation Plan (which includes 769,104 shares reserved for issuance under our predecessor equity compensation plans), which will become effective upon completion of this offering;

 

 

restricted stock units, representing the right at the option of the company to deliver 29,400 shares of common stock or an equivalent cash amount, of which 5,880 restricted stock units have vested as of April 1, 2012; and

 

 

49,000 shares of restricted stock that were granted to James A. Druckrey following commencement of his employment as our Executive Vice President and Chief Operating Officer and an additional 49,000 shares of restricted stock or an equivalent number of restricted stock units to be granted to Mr. Druckrey after 60 days of his employment.

See “Management—Equity benefit plans” for a description of our equity plans.

 

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Dilution

Our pro forma net tangible book value as of April 1, 2012, was negative $5.0 million, or approximately negative $0.26 per share. Our pro forma net tangible book value per share represents the amount of our total tangible assets reduced by the amount of our total liabilities and divided by the total number of shares of our common stock outstanding after giving effect to the automatic conversion of all outstanding shares of class B common stock and class C common stock into shares of common stock upon the closing of this offering.

Net tangible book value dilution per share to new investors represents the difference between the amount per share paid by new investors in this offering and the net tangible book value per share of common stock immediately after completion of this offering. After giving effect to the pro forma adjustments described above and receipt of the net proceeds from our sale of                  shares of common stock in this offering at an assumed initial public offering price of $14.00 per share, which is the midpoint of the range of the initial public offering price listed on the cover page of this prospectus, and after deducting assumed underwriting discounts and commissions and estimated offering expenses payable by us and reflecting the application of a portion of the net proceeds to us from the offering to repay approximately $88.2 million of the amount outstanding under the term loan portion of our senior secured credit facility, our pro forma as adjusted net tangible book value as of April 1, 2012, would have been $83.2 million, or $3.16 per share. This represents an immediate increase in pro forma as adjusted net tangible book value of $3.42 per share to existing stockholders and an immediate dilution in pro forma net tangible book value of $10.84 per share to new investors in this offering, as illustrated in the following table:

 

Assumed initial public offering price per share           $14.00  

Pro forma net tangible book value per share as of April 1, 2012

   $ (0.26 )  

Increase in pro forma as adjusted net tangible book value per share attributable to new investors in this offering

     3.42     
  

 

 

   

Pro forma as adjusted net tangible book value per share after giving effect to this offering

       3.16   
    

 

 

 

Dilution per share to new investors in this offering

     $ 10.84   
    

 

 

 

 

 

A $1.00 increase or decrease in the assumed initial public offering price of $14.00 per share would increase or decrease our pro forma as adjusted net tangible book value per share after giving effect to this offering by $0.25 and increase or decrease dilution per share to new investors in this offering by $0.75, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, and after deducting assumed underwriting discounts and commissions payable by us.

An increase or decrease of 100,000 shares in the number of shares sold in this offering by us would increase or decrease our pro forma as adjusted net tangible book value per share after giving effect to this offering by $0.05, and increase or decrease dilution per share to new investors in this offering by $0.05, assuming an initial public offering price of $14.00 per share and after deducting assumed underwriting discounts and commissions payable by us.

 

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The following table presents on a pro forma as adjusted basis as of April 1, 2012, after giving effect to the differences between the existing stockholders and the new investors in this offering with respect to the number of shares purchased from us, the total consideration paid and the average price paid per share:

 

 

 
     Shares purchased           Total consideration      Average
price per
share
 
     Number      Percent           Amount      Percent     

 

       

 

 

 

Existing stockholders

     19,218,976         72.9%          $ 69,040,000         40.8%       $ 3.59   

New investors in this offering

     7,142,857         27.1                99,999,998         59.2             14.00   

 

 

Totals

     26,361,833         100.0%          $ 169,039,998         100.0%       $ 6.41   

 

 

A $1.00 increase or decrease in the assumed initial public offering price of $14.00 per share would increase or decrease the total consideration paid by new investors in this offering and the total consideration paid by all stockholders by $7,142,857, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same. An increase or decrease of 100,000 shares in the number of shares sold in this offering by us would increase or decrease the total consideration paid by new investors in this offering and the total consideration paid by all stockholders by $1,400,000, assuming an initial public offering price of $14.00 per share.

Sales of shares of common stock by the selling stockholder in our initial public offering will reduce the number of shares of common stock held by existing stockholders to 15,647,547, or approximately 59.4% of the total shares of common stock outstanding after our initial public offering, and will increase the number of shares held by new investors to 10,714,286, or approximately 40.6% of the total shares of common stock outstanding after our initial public offering.

If the underwriters’ option to purchase additional shares is exercised in full, our existing stockholders would own 53.3% and new investors in this offering would own 46.7% of the total number of shares of our common stock outstanding after this offering.

As of April 1, 2012, there were options outstanding to purchase 6,609,708 shares of our common stock and restricted stock units outstanding representing the right, at our option, to deliver 29,400 shares of common stock to the holders of such units. To the extent outstanding options are exercised or we deliver shares of common stock to holders of outstanding stock units, there will be further dilution to new investors. For a description of our equity plans, see “Management—Equity benefit plans.”

 

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Selected consolidated financial data

The following selected consolidated statement of operations data for each of the years ended January 3, 2010, January 2, 2011, and January 1, 2012, and the selected consolidated balance sheet data as of January 2, 2011, and January 1, 2012, have been derived from our audited consolidated financial statements which are included elsewhere in this prospectus. The selected statement of operations data for each of the years ended December 30, 2007, and December 28, 2008, and the balance sheet data as of December 30, 2007, December 28, 2008, and January 3, 2010, have been derived from our audited consolidated financial statements, which are not included in this prospectus. The selected consolidated statement of operations data for each of the 13 weeks ended April 3, 2011, and April 1, 2012, and the selected consolidated balance sheet data as of April 1, 2012, have been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. The unaudited consolidated financial statements were prepared on a basis consistent with our audited consolidated financial statements and include, in the opinion of management, all adjustments necessary for the fair presentation of the financial information contained in those statements.

We operate and report financial information on a 52 or 53 week year with the fiscal year ending on the Sunday closest to the end of December. Fiscal 2007 contained 52 weeks of operations, fiscal 2008 contained 52 weeks of operations, fiscal 2009 contained 53 weeks of operations, fiscal 2010 contained 52 weeks of operations and fiscal 2011 contained 52 weeks of operations. The quarterly reporting periods contained in the unaudited consolidated financial statements included in this prospectus consist of 13 weeks ended on April 3, 2011, and April 1, 2012.

The historical results presented below are not necessarily indicative of the results to be expected for any future period and the results for any interim period may not necessarily be indicative of the results that may be expected for a full year. You should read the selected consolidated financial and operating data for the periods presented in conjunction with “Risk factors,” “Capitalization,” “Management’s discussion and analysis of financial condition and results of operations” and our consolidated financial statements and the related notes, which are included elsewhere in this prospectus.

 

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    Fiscal year ended     13 weeks ended  
    December 30,
2007 (1)
    December 28,
2008
    January 3,
2010
    January 2,
2011
    January 1,
2012
   

April 3,
2011

    April 1,
2012
 

 

 
                                  (unaudited)  
    (in thousands, except share and per share data)  

Consolidated statement of operations data:

             

Net sales

  $ 457,156      $ 712,907      $ 612,521      $ 617,830      $ 700,554      $ 170,106      $ 173,769   

Cost of goods sold

    299,121        485,072        420,919        447,250        483,020        117,848        119,459   
 

 

 

 

Gross profit

    158,035        227,835        191,602        170,580        217,534        52,258        54,310   
 

 

 

 

Operating expenses:

             

Selling, general and administrative

    88,234        150,349        125,711        121,651        137,128        33,917        39,294   

Warehouse

    14,699        26,536        25,878        27,713        28,426        7,044        7,045   

Research and development

    7,011        8,557        9,004        9,299        10,157        2,397        2,679   

Impairment charges

           32,570        1,200        777                        
 

 

 

 

Total operating
expenses

    109,944        218,012        161,793        159,440        175,711        43,358        49,018   
 

 

 

 

Income from operations

    48,091        9,823        29,809        11,140        41,823        8,900        5,292   
 

 

 

 

Other income (expense):

             

Net foreign currency exchange gain (loss)

    (832     1,781        (3,602     (1,175     (3,807     (269     1,042   

Interest expense

    (24,521     (25,766     (15,636     (12,688     (14,927     (2,815     (3,388

Other, net

    (1,977     533        1,723        386        1,130        371        (96
 

 

 

 

Total other income (expense)

    (27,330     (23,452     (17,515     (13,477     (17,604     (2,713     (2,442
 

 

 

 

Income (loss) before income taxes

    20,761        (13,629     12,294        (2,337     24,219        6,187        2,850   

Income tax expense (benefit)

    6,151        (5,435     1,507        (652     5,208        (756     990   
 

 

 

 

Net income (loss)

    14,610        (8,194     10,787        (1,685     19,011        6,943        1,860   

Net income available to redeemable common stockholders

    69,844               4,724        15,584        15,785        394        13,696   
 

 

 

 

Net income (loss) available (attributable) to common stockholders

  $ (55,234   $ (8,194   $ 6,063      $ (17,269   $ 3,226      $ 6,549      $ (11,836
 

 

 

 

Net income (loss) per common share available (attributable) to common stockholders:

             

Basic

  $ (5.04   $ (0.72   $ 0.53      $ (1.51   $ 0.29      $ 0.59      $ (1.06

Diluted

  $ (5.04   $ (0.72   $ 0.45      $ (1.51   $ 0.25      $ 0.58      $
(1.06

Weighted average common shares outstanding:

             

Basic

    10,957,576        11,430,720        11,451,594        11,453,946        11,141,718        11,118,786        11,173,568   

Diluted

    10,957,576        11,430,720        13,596,912        11,453,946        12,789,784        11,206,790        11,173,568   

 

 

 

 

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     Fiscal year ended      13 weeks ended      
     December 30,
2007 (1)
   December 28,
2008
   January 3,
2010
   January 2,
2011
   January 1,
2012
    

April 3,

2011

  

April 1,

2012

 

 

 
                               

(unaudited)

 
     (in thousands, except share and per share data)  

Pro forma net income per common share (unaudited)

                    

Basic

               $ 0.99          $ 0.10   

Diluted

               $ 0.91          $ 0.09   

Weighted average common shares used in computing pro forma net income per common share (unaudited) (2):

                    

Basic

                 19,151,356            19,071,976   

Diluted

                 20,799,422            20,317,948   

 

 

 

(1)   Excludes the impact of our acquisition of KMC, which was completed on December 31, 2007.

 

(2)   Weighted average common shares used in computing pro forma net income per common share (unaudited) gives effect as of January 3, 2011, to the automatic conversion of our class B common stock and class C common stock into an aggregate of 8,468,964 shares of common stock, which will occur upon the closing of this offering.

 

As of

(in thousands)

   December 30,
2007 (1)
    December 28,
2008
    January 3,
2010
    January 2,
2011
    January 1,
2012
    April 1,
2012
 

 

 

Consolidated balance sheet data:

            

Cash and cash equivalents

   $ 28,784      $ 19,369      $ 44,961      $ 15,990      $ 12,971      $ 13,789   

Inventories

     119,093        202,615        145,648        163,876        181,333        178,369   

Working capital

     145,242        183,080        169,912        184,489        191,052        205,453   

Property and equipment—net

     31,310        37,498        32,906        28,504        31,389        35,427   

Total assets

     272,476        422,161        356,772        346,897        366,580        369,769   

Total debt and capital lease obligations, including current maturities

     201,062        344,229        249,971        268,287        247,520        257,182   

Total stockholders’ (deficit)

     (133,348     (79,420     (68,308     (84,272     (67,811     (79,953

 

 

 

(1)   Excludes the impact of our acquisition of KMC, which was completed on December 31, 2007.

 

 

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Management’s discussion and analysis of

financial condition and results of operations

You should read the following discussion and analysis of our financial condition and results of operations together with “Selected consolidated financial data” and our consolidated financial statements and the related notes and other financial information, which are included elsewhere in this prospectus. Some of the information contained in this discussion and analysis includes forward-looking statements that involve risks and uncertainties. You should review the “Risk factors” and “Special note regarding forward-looking statements” sections of this prospectus for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.

We operate and report financial information on a 52 or 53 week fiscal year ending on the Sunday closest to the end of December. The reporting periods contained in our audited consolidated financial statements included in this prospectus contain 52 weeks of operations in fiscal 2011, 52 weeks of operations in fiscal 2010 and 53 weeks of operations in fiscal 2009. The quarterly reporting periods contained in the unaudited consolidated financial statements included in this prospectus consist of 13 weeks ended on April 3, 2011, and April 1, 2012. Historical results are not necessarily indicative of the results to be expected for any future period, and results for any interim period may not necessarily be indicative of the results that may be expected for a full year.

Overview

We are one of the world’s leading marketers, manufacturers and distributors of musical instruments and accessories. We design, develop, manufacture and purchase musical instruments, accessories and related products for sale and distribution to wholesale and retail outlets throughout the world. We have built a comprehensive portfolio of brands led by the iconic Fender brand and other brands such as Squier, Jackson, Guild, Ovation and Latin Percussion, which we own, and Gretsch, EVH (Eddie Van Halen) and Takamine, for which we are the licensee. We act as an exclusive manufacturer and/or distributor for brands such as Gretsch, EVH and Takamine. For some of the brands we distribute, we pay the licensors a royalty payment based on sales we generate on those brands. For the remaining brands that we distribute, we purchase products from manufacturers or OEMs, and resell those products to our customers. Through these brands, we reach a broad range of musicians, from beginners to professionals, across many genres of music.

Our revenues are derived primarily from the sale of fretted instruments, guitar amplifiers, percussion and accessories. For fiscal 2011, approximately 59.9% of our gross sales before discounts and allowances were generated from the sale of fretted instruments, 12.1% from guitar amplifiers, 9.1% from percussion and 18.9% from accessories. Gross sales before discounts and allowances is comprised of product sales but, unlike net sales, does not include licensing income and dealer freight collection, and is not net of cash discounts, sales return allowances and rebates. We distribute our products through the following five sales channels:

 

 

Independent channel—comprised of over 13,000 independently owned music stores that typically offer personalized customer service. Some of our independent retailers are also authorized to sell our products on their websites. This channel represented a majority of our gross sales before discounts and allowances for fiscal 2011 and the first quarter of fiscal 2012.

 

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National channel—comprised of large, multi-unit musical instrument retailers such as Guitar Center and Sam Ash who have nationwide store networks through which they then resell these products to consumers.

 

 

Mass merchant channel—comprised of large-format, multi-unit stores that purchase our products from us and then resell these products to consumers. Costco was our most significant mass merchant customer in fiscal 2011.

 

 

Online and catalog channel—we also sell some of our products to certain online, mail order, catalog and telesales companies, including Musician’s Friend, American Music Supply and Amazon.

 

 

Distributor channel—within Asia, Latin America and certain other markets, we sell our products primarily through distributors who, in turn, sell to retailers within their authorized distribution areas.

We are organized into two reporting segments: Fender Musical Instruments, or FMI, and KMC Musicorp, or KMC. While both FMI and KMC include the sale and distribution of fretted instruments, guitar amplifiers, percussion and accessories, FMI markets to both domestic and international customers and KMC primarily focuses on distribution of accessories and certain musical instruments in North America. For fiscal 2011, FMI represented 73.1% and KMC represented 26.9% of our net sales, respectively. For the first quarter of fiscal 2012, FMI represented 72.8% and KMC represented 27.2% of our net sales, respectively.

Our products are manufactured by us at our owned or leased manufacturing facilities or by OEMs. We believe this combination of facilities provides us with increased manufacturing capacity and the flexibility and scale to more efficiently and quickly respond to consumer demand. We have manufacturing operations in Corona, California; New Hartford, Connecticut; Ensenada, Mexico; Scottsdale, Arizona; and Ridgeland, South Carolina. We primarily manufacture our products that are sold at higher price points in the United States. Products manufactured by our OEMs are typically sold at lower price points.

Our products are sold in the United States and approximately 85 countries around the world, with net sales outside of the United States representing approximately 46.7% and 43.4% of our net sales in fiscal 2011 and the first quarter of fiscal 2012, respectively. Geographically, we segregate our business into the following three regions:

 

 

North America (United States and Canada)

 

 

Europe (including the Middle East and Africa)

 

 

International (Asia, Australia and Latin America)

Our predecessor company was founded in 1946 by Leo Fender. In 1965, Leo Fender sold Fender Electric Instrument Company to Columbia Records Distribution Corp., a division of Columbia Broadcasting System, Inc., or CBS. The business reemerged as a stand-alone company when the late William Schultz and current Board member, William (Bill) Mendello, formed Fender Musical Instruments Corporation to purchase the business from CBS in 1985. On December 31, 2007, we acquired Kaman Music Corporation, now known as KMC Musicorp, a distributor of musical instruments and accessories.

 

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Opportunities, challenges and risks

We intend to focus on generating sales through our existing sales channels. As we grow and expand our business, we anticipate an increasing percentage of our new sales will come from our international dealers and distributors.

Europe represented approximately 27.3% and 25.5% of our net sales in fiscal 2011 and the first quarter of fiscal 2012, respectively, and has been the geographic area where we have historically realized higher gross margins. Europe has been a critical part of our growth, and we intend to continue to increase our presence in the European market through expansion of our accessories business and by increasing the portion of net sales we generate by selling product directly to European retailers. However, in the near term, we expect the percentage of our net sales generated from Europe to decline due to current difficult European economic and market conditions.

During fiscal 2012, we intend to create a specialty sales force in North America to focus on selling our non-Fender branded instruments and accessories. We intend to apply the sales, marketing and branding strategies that have been successful with our Fender brand to these other brands to enhance their future earnings contribution.

We generated less than 1% of our net sales through licensing fees and royalties in fiscal 2011 and the first quarter of fiscal 2012. As this is an area where we see a significant growth opportunity, we plan to increase our licensing fee and royalty revenue as a percentage of our net sales through expansion into new product categories and geographies.

We have a global manufacturing footprint through our owned facilities and OEM partners that is focused on delivering quality products at a competitive price. Our products manufactured in our Corona, California factory are priced at a premium and we believe offer us a distinct competitive advantage. In fiscal 2011, we began increasing our level of capital investment in both our Corona, California and Ensenada, Mexico facilities to improve productivity. We intend to continue these capital investments as we believe these investments will ultimately allow us to achieve higher overall gross margins, although in the near term the benefits of these investments may not be reflected in our financial results.

In fiscal 2011 and the first quarter of fiscal 2012, products manufactured by OEMs accounted for approximately 64% and 62%, respectively, of our gross sales before discounts and allowances. Accordingly, our operating results are affected by conditions in the geographic regions in which these OEMs are located, including, in many cases, rising labor rates, commodity price fluctuations and currency fluctuations. We continually evaluate shifting additional production to manufacturing facilities with lower or more stable costs. For example, our Ensenada, Mexico manufacturing facility provides us with products at stable, relatively low costs, and we intend to explore opportunities to move additional production to that facility.

We intend to increase our investment in research and development in absolute dollars to develop new products, including our specialty products. We also plan to invest in our marketing efforts by increasing our focus on direct to consumer marketing initiatives.

During the second quarter of fiscal 2010, we experienced a supply issue with our main paint supplier, who ceased operation due to financial difficulty. This paint supply issue caused us to temporarily stop the production of a number of our electric and bass guitars manufactured in Corona, California in April 2010. We resumed full production at this facility by the end of fiscal

 

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2010. As of January 2, 2011, we had approximately $26.2 million of cancellable backlog. We believe that a substantial majority of this backlog related to this production problem and contributed to higher sales in the first and second quarters of fiscal 2011 as we filled the backlog. Following this disruption, we increased our focus on evaluating our sources of supply across our manufacturing operations to develop second sources of supplies where feasible. Nevertheless, we could face other manufacturing difficulties that could similarly harm our results in the future.

Basis of presentation

Net sales is comprised of:

Revenue from:

 

 

Product sales:    consists of sales of fretted instruments, guitar amplifiers, percussion and accessories, sold through our independent channel, national channel, distributor channel, mass merchant channel and online/catalog channel. We recognize revenue when products are delivered, collection of the receivable is probable, persuasive evidence of an arrangement exists, and the sales price to our customers is fixed or determinable;

 

 

Royalty income:    consists of licensing fees and royalties earned by us from contractual relationships we have with third parties that allow them to use our intellectual property in return for a fixed fee or percentage of their sales; and

 

 

Dealer freight collection:    consists of the net freight billed to customers less freight allowances;

Net of:

 

 

Cash discounts:    consists of discounts given to customers for early payment of their receivable balances;

 

 

Sales returns allowances:    consists of adjustments to our sales returns reserve. This reserve is based upon estimates of the projected returns in future periods based on our experience with returns recorded in previous periods; and

 

 

Rebates:    consists of incentives we provide to customers who achieve predetermined growth targets, which we accrue based on our expectation of whether these targets will be achieved.

Cost of goods sold consists of:

 

 

The cost of manufactured products (raw materials consumed, the cost to procure materials, labor costs, including wages, stock based compensation expense and employee benefits, and factory overhead to produce finished good products).

 

 

The cost of products purchased for resale;

 

 

The cost to inspect and repair products;

 

 

Shipping costs associated with inbound freight. These costs are capitalized as part of inventory and included in cost of goods sold as the inventory is sold;

 

 

Promotional expense associated with products or samples provided to our dealers, distributors and customers, in addition to certain advertising arrangements, such as purchasing catalog pages;

 

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Royalty expenses, including payments to certain artists for our use of their names, likeness and/or images in connection with the sales of products we jointly develop with them. Royalty expenses also includes amounts paid for Gretsch and EVH products and other products incorporating third party intellectual property;

 

 

Dealer freight expense incurred for shipments to customers, excluding customers who pay for their own freight;

 

 

Warranty costs associated with the repair of products under warranty agreements; and

 

 

Charges to write-down the carrying value of our inventory when it exceeds the net realizable value, to adjust for obsolete inventory and to adjust for periodic physical inventory counts.

Gross profit/gross margin

Our gross profit equals our net sales minus cost of goods sold. Our gross margin measures our gross profit as a percentage of net sales.

Our gross margins fluctuate based on product and geographic mix as certain of our products are sold at higher gross margins than others. Generally, we earn higher gross margins on our Fender brand electric guitars. We typically earn lower gross margins on products we purchase from others and distribute. Gross margins have typically been higher in North America and Europe than in other international markets where the majority of our net sales are through distributors.

In the near term, we anticipate our gross margins to be in line with our historical results. We believe our gross margins in the intermediate to long term will benefit from our strategies of increasing our direct sales to retailers in international markets and earning additional royalty income by expanding our licensing business. Furthermore, we are also increasing our investment in our manufacturing facilities to improve our operating efficiencies and gross margins.

Operating expenses

Our operating expenses consist of the following:

 

 

Selling, general and administrative;

 

 

Warehouse;

 

 

Research and development; and

 

 

Impairment charges.

Our selling, general and administrative expenses consist primarily of personnel and facility costs related to our executive, sales, marketing, finance, customer service, information technology, human resources and administrative personnel, including wages, stock based compensation and employee benefits. Other significant selling, general and administrative expenses include advertising and promotions related to in-store advertising, trade shows, travel and entertainment and promotional products. We also record professional and contract service expenses, rent and lease expenses associated with corporate locations and equipment, and legal expenses in selling, general and administrative expenses. In the long term, we expect selling, general and administrative expenses to stay relatively flat as a percentage of sales. However in the near term, we expect selling, general and administrative expenses to increase as a percentage of sales as we

 

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expand into new international markets, invest in additional marketing initiatives and incur expenses associated with becoming a public company.

Our warehouse expenses consist primarily of personnel costs, including wages and employee benefits, and facility costs. These warehouse costs represent our handling costs to store, move and prepare products for shipment from our warehouse facilities. Additionally, we incur outside service expenses related to the use of a third party warehouse distribution management service for our European distribution of products. We expect our warehouse expenses to stay relatively flat as a percentage of sales in both the near and long term.

Our research and development expenses consist primarily of personnel costs, including wages, stock based compensation and employee benefits, for our research and development teams. We also incur costs associated with professional services when we require external expertise on various projects such as advanced electronics for our guitar amplifiers. We expense research and development costs as incurred. We expect our research and development expenses to increase slightly as a percentage of sales in the near and long term as a result of investment in product innovation.

Impairment charges consist of charges we record when we have determined that the carrying value of our goodwill, long-lived assets, or indefinite-lived intangible assets exceeds the fair value. We conduct an annual impairment test of goodwill and other intangibles at the end of each fiscal year or more frequently if there are any impairment indicators identified during the year. We also continually evaluate whether events and circumstances have occurred that indicate the remaining useful life of amortizable intangible assets may warrant revision.

Income from operations

We define income from operations as gross profit less our operating expenses. We use operating income as an indicator of the profitability of our business and our ability to manage costs.

Net foreign currency exchange gain (loss)

Net foreign currency exchange gain (loss) consists of gains and losses resulting from foreign exchange hedging activity, the foreign currency effect of the remeasurement of certain assets and liabilities of our foreign subsidiaries that are denominated in currencies other than the functional currency of the subsidiary and foreign exchange transaction gains and losses.

We use derivatives, including foreign currency forward contracts and options, to hedge against certain of the foreign exchange risks to which we are exposed. Certain derivatives are designated and qualify as cash flow hedges. Cash flow hedges are generally hedges against the foreign currency risk arising from changes in cash flows from forecasted foreign currency transactions, forecasted cash flows arising from an asset or liability that is carried on our consolidated balance sheets, or foreign currency firm commitments that are not recognized on our consolidated balance sheets. In order to qualify for accounting as a cash flow hedge, a derivative must satisfy a

number of criteria, including the requirement that the derivative is deemed to be highly effective in hedging the related foreign currency risk. Changes in the fair value of cash flow hedges are divided into an effective and an ineffective portion. The effective portion of a change in value of a cash flow hedge is generally the change in value of the derivative to the extent that it offsets, but does not exceed, the change in value of the item being hedged. Any excess in the change in fair value of the derivative over the change in fair value of the item being hedged is deemed to

 

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be the ineffective portion. The effective portion of changes in the fair value of cash flow hedges is recorded in accumulated other comprehensive income (loss) and subsequently reclassified into earnings in the same period that the hedged item affects earnings. Any ineffective portion of the change in fair value of the cash flow hedge is recorded directly in net foreign currency gain (loss) in the consolidated statement of operations and comprehensive income (loss). Certain of our derivatives used to manage the foreign currency exposures are not designated as cash flows hedges because they do not satisfy the requirements of cash flow hedges or because we have not elected to apply hedge accounting to them. Changes in the fair value of the derivatives not designated as cash flow hedges are recorded directly in net foreign currency gain (loss) in earnings. The fair value of our derivative instruments is determined either using market quotes or valuation models that are based upon the net present value of estimated future cash flows that incorporate current market data inputs. We hold derivative instruments for hedging purposes only, not for speculative or trading purposes.

We operate outside the United States primarily through wholly-owned subsidiaries in Europe, Canada and Mexico. We have determined that the functional currency of each of our foreign subsidiaries, with the exception of our Mexican and Dutch subsidiaries, is the local currency of each such subsidiary, and that the functional currency of our Mexican and Dutch subsidiaries is the U.S. dollar. For each of our subsidiaries, monetary assets and liabilities (such as cash, marketable securities, accounts receivable and accounts payable) that are denominated in a currency that is not the functional currency of that subsidiary are remeasured and translated into the subsidiary’s functional currency using current exchange rates. Gains and losses resulting from this remeasurement process are included in net foreign currency exchange gain (loss).

Interest expense

Interest expense consists of interest on our term loan and revolver, amortization of deferred loan costs and net settlements on interest rate swap agreements. We use interest rate swap agreements to manage our exposure to interest rate fluctuations by effectively fixing the interest rate on a portion of our floating-rate debt. We expect our interest expense to decrease following this offering both in absolute terms and as a percentage of net sales as we repay a portion of the amount outstanding under the term loan portion of our senior secured credit facility with a portion of the net proceeds to us from this offering.

Other, net

Other, net consists of miscellaneous income and expenses and interest income from financing charges to customers.

Income tax expense (benefit)

We are subject to income taxes in the United States and various other foreign jurisdictions in which we do business. Some of these foreign jurisdictions have higher statutory tax rates than those in the United States, and certain of our international earnings are also taxable in the United States. Accordingly, our effective tax rates will vary depending on the relative proportion of foreign to U.S. income and absorption of foreign tax credits, changes in the valuation of our deferred tax assets and liabilities and changes in tax laws. In addition, we are subject to examination of our income tax returns by the U.S. Internal Revenue Service, or IRS, and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these

 

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examinations to determine the adequacy of our income tax reserves and expense. Should actual events or results differ from our current expectations, charges or credits to our income tax expense reserves and income tax expense may become necessary. Any such adjustments could have a significant impact on our results of operations.

Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. As of January 1, 2012, and April 1, 2012, we did not have any valuation allowances recorded as we expect to fully utilize all of our deferred tax assets and we did not have any net operating loss or tax credit carry-forwards. For fiscal 2009, 2010 and 2011, we had effective tax rates of 12.3%, 27.9% and 21.5%, respectively. For the first quarter of fiscal 2011 and the first quarter of fiscal 2012, we had effective tax rates of (12.2)% and 34.7%, respectively. We expect our effective tax rate to increase to approximately 36% in the long term as we do not expect the recurrence of certain tax refunds and credits that we have had in the recent past.

Results of operations

The following table sets forth selected items in our consolidated statements of operations in dollars and as a percentage of net sales for the periods presented:

 

     Fiscal year     13 weeks ended  
    2009     2010     2011     Apr. 3,
2011
(unaudited)
    Apr. 1,
2012
(unaudited)
 
(dollars in thousands)  

Actual

    Percent
of net
sales
   

Actual

   

Percent
of net
sales

   

Actual

    Percent
of net
sales
   

Actual

   

Percent

of net

sales

   

Actual

   

Percent

of net

sales

 

 

 

Net sales

  $ 612,521        100.0%      $ 617,830        100.0%      $ 700,554        100.0%      $ 170,106        100.0%      $ 173,769        100.0%   

Cost of goods sold

    420,919        68.7%        447,250        72.4%        483,020        68.9%        117,848        69.3%        119,459        68.7%   
 

 

 

 

Gross profit

    191,602        31.3%        170,580        27.6%        217,534        31.1%        52,258        30.7%        54,310        31.3%   
 

 

 

 

Operating expenses:

                   

Selling, general and administrative

    125,711        20.5%        121,651        19.7%        137,128        19.6%        33,917        19.9%        39,294        22.6%   

Warehouse

    25,878        4.2%        27,713        4.5%        28,426        4.1%        7,044        4.1%        7,045        4.1%   

Research and development

    9,004        1.5%        9,299        1.5%        10,157        1.4%        2,397        1.4%        2,679        1.5%   

Impairment charges

    1,200        0.2%        777        0.1%               0.0%               0.0%               0.0%   
 

 

 

 

Total operating expenses

    161,793        26.4%        159,440        25.8%        175,711        25.1%        43,358        25.5%        49,018        28.2%   
 

 

 

 

Income from operations

    29,809        4.9%        11,140        1.8%        41,823        6.0%        8,900        5.2%        5,292        3.0%   
 

 

 

 

Other income (expense):

                   

Net foreign currency exchange (loss)

    (3,602     -0.6%        (1,175     -0.2%        (3,807     -0.5%        (269     -0.2%        1,042        0.6%   

Interest expense

    (15,636     -2.6%        (12,688     -2.1%        (14,927     -2.1%        (2,815     -1.7%        (3,388     -1.9%   

Other, net

    1,723        0.3%        386        0.1%        1,130        0.2%        371        0.2%        (96     -0.1%   
 

 

 

 

Total other income (expense)

    (17,515     -2.9%        (13,477     -2.2%        (17,604     -2.5%        (2,713     -1.6%        (2,442     -1.4%   
 

 

 

 

Income (loss) before income taxes

    12,294        2.0%        (2,337     -0.4%        24,219        3.5%        6,187        3.6%        2,850        1.6%   
 

 

 

 

Income tax expense (benefit)

    1,507        0.2%        (652     -0.1%        5,208        0.7%        (756     -0.4%        990        0.6%   
 

 

 

 

Net income (loss)

  $ 10,787        1.8%      $ (1,685     -0.3%      $ 19,011        2.7%      $ 6,943        4.1%      $ 1,860        1.1%   
 

 

 

 

 

 

 

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The first quarter of fiscal 2012 compared to the first quarter of fiscal 2011

Net sales

Net sales increased by $3.7 million, or 2.2%, to $173.8 million in the first quarter of fiscal 2012 from $170.1 million in the first quarter of fiscal 2011. The increase was primarily driven by growth in both the North America and international markets of $4.5 million. This increase was partially offset by lower overall effective prices of $0.7 million due primarily to market conditions in Europe. Net sales in the first quarter of fiscal 2011 included the effect of filling backlog resulting from the supply issue with our main paint supplier, which impacted the production of our electric and bass guitars manufactured in Corona, California as discussed in “—Opportunities, challenges and risks” above. As of January 2, 2011, we had approximately $26.2 million of cancellable backlog. We believe a substantial majority of this backlog related to this production problem and contributed to higher sales in the first and second quarters of fiscal 2011 as we filled the backlog. We estimate that approximately 10% of our net sales in the first quarter of fiscal 2011 resulted from filling the backlog from fiscal 2010, as described above.

Net sales from FMI increased by $3.4 million, or 2.7%, to $126.5 million in the first quarter of fiscal 2012 from $123.1 million in the first quarter of fiscal 2011. The increase was primarily driven by growth in the North America market of $4.2 million. The increase was partially offset by lower overall effective prices of $0.7 million due primarily to market conditions in Europe. We estimate that approximately 14% of our FMI sales in the first quarter of fiscal 2011 resulted from filling the backlog from fiscal 2010, as described above.

Net sales from KMC increased by $0.3 million, or 0.7%, to $47.3 million in the first quarter of fiscal 2012 from $47.0 million in the first quarter of fiscal 2011. The increase was primarily driven by growth in our international distributor channel.

Cost of goods sold

Cost of goods sold increased by $1.6 million, or 1.4%, to $119.5 million in the first quarter of fiscal 2012 from $117.8 million in the first quarter of fiscal 2011. The increase in cost of goods sold was primarily driven by a volume increase of $2.5 million in the first quarter of fiscal 2012. Further contributing to this increase was an inventory adjustment of $1.2 million related to a discontinued product in the first quarter of fiscal 2012. These increases in cost of goods sold were partially offset by favorable product mix of $1.1 million, factory operating efficiency gains of $0.8 million and lower freight and duty costs of $0.6 million in the first quarter of fiscal 2012 as compared to the first quarter of fiscal 2011. We estimate that approximately 10% of our cost of goods sold in the first quarter of fiscal 2011 was due to the resolution of the previously discussed paint supply issue.

Cost of goods sold from FMI increased by $1.5 million, or 1.8%, to $85.5 million in the first quarter of fiscal 2012 from $84.0 million in the first quarter of fiscal 2011. The increase in cost of goods sold was primarily driven by a volume increase of $2.2 million in the first quarter of fiscal 2012. Further contributing to the increase in cost of goods sold was an inventory adjustment of $1.2 million related to a discontinued product in the first quarter of fiscal 2012. These increases in cost of goods sold were partially offset by favorable product mix of $1.2 million, factory operating efficiency gains of $0.4 million and lower freight and duty costs of $0.6 million in the first quarter of fiscal 2012 as compared to the first quarter of fiscal 2011. We estimate that approximately 14% of our cost of goods sold in the first quarter of fiscal 2011 was due to the resolution of the previously discussed paint supply issue.

 

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Cost of goods sold from KMC increased by $0.1 million, or 0.2%, to $34.0 million in the first quarter of fiscal 2012 from $33.9 million in the first quarter of fiscal 2011. The increase in cost of goods sold was primarily driven by a volume increase of $0.3 million and $0.2 million from changes in product mix in the first quarter of fiscal 2012. These increases were partially offset by operating efficiency gains of $0.4 million in the first quarter of fiscal 2012.

Gross profit/gross margin

Gross profit increased by $2.0 million, or 3.9%, to $54.3 million in the first quarter of fiscal 2012 from $52.3 million in the first quarter of fiscal 2011. Gross margin of 31.3% in the first quarter of fiscal 2012 increased 60 basis points from gross margin of 30.7% in the first quarter of fiscal 2011. The increase in gross profit was primarily driven by a volume increase of $1.3 million and favorable product mix of $1.1 million in the first quarter of fiscal 2012 compared to the first quarter of fiscal 2011. Further favorably impacting gross profit were operating efficiency gains of $0.8 million in the first quarter of fiscal 2012 and lower freight and duty costs of $0.6 million in the first quarter of fiscal 2012. These increases in gross profit were partially offset by an inventory adjustment of $1.2 million related to a discontinued product in the first quarter of fiscal 2012 and lower prices of $0.7 million related primarily to Europe in the first quarter of fiscal 2012. We estimate that approximately 10% of our gross profit in the first quarter of fiscal 2011 was due to the resolution of the previously discussed paint supply issue.

FMI gross profit increased by $1.8 million, or 4.6%, to $41.0 million in the first quarter of fiscal 2012 from $39.2 million in the first quarter of fiscal 2011. Gross margin of 32.4% in the first quarter of fiscal 2012 increased 60 basis points from gross margin of 31.8% in the first quarter of fiscal 2011. The increase in gross profit was primarily driven by a volume increase of $1.2 million and favorable product mix of $1.2 million in the first quarter of fiscal 2012 compared to the first quarter of fiscal 2011. Further favorably impacting gross profit were operating efficiency gains of $0.4 million in the first quarter of fiscal 2012 and lower freight and duty costs of $0.6 million in the first quarter of fiscal 2012. These increases in gross profit were partially offset by an inventory adjustment of $1.2 million related to a discontinued product in the first quarter of fiscal 2012 and lower prices of $0.6 million in the first quarter of fiscal 2012. We estimate that approximately 13% of our FMI gross profit in the first quarter of fiscal 2011 was due to the resolution of the previously discussed paint supply issue.

KMC gross profit increased by $0.2 million, or 1.8%, to $13.3 million in the first quarter of fiscal 2012 from $13.1 million in the first quarter of fiscal 2011. Gross margin of 28.2% in the first quarter of fiscal 2012 increased 30 basis points compared to the first quarter of fiscal 2011 gross margin of 27.9%. The increase in gross profit was primarily driven by operating efficiency gains of $0.4 million in the first quarter of fiscal 2012. Partially offsetting these increases in gross profit were price discounts on excess inventory of $0.1 million in the first quarter of fiscal 2012.

Selling, general and administrative expenses

Selling, general and administrative expenses increased by $5.4 million, or 15.9%, to $39.3 million in the first quarter of fiscal 2012 compared to $33.9 million in the first quarter of fiscal 2011. Approximately $3.1 million of the increase in selling, general and administrative expenses was the result of an increase in our labor related expenses. The remaining increase in the first quarter of fiscal 2012 was the result of an increase in advertising and promotional expenses, including related travel and entertainment expenses, of $1.5 million, an increase in professional services of

 

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$0.3 million due primarily to IT and other consulting projects and an increase in building rent of approximately $0.2 million as the result of the relocation of our corporate headquarters.

The increase in our labor related expenses resulted from an increase in headcount and salary increases of approximately $1.2 million. Additionally, stock options issued in the second and third quarters of fiscal 2011 resulted in an increase in our stock-based compensation expense of approximately $1.6 million compared to the first quarter of fiscal 2011. The remaining increase in labor related costs of $0.3 million was the result of higher employee benefits and insurance costs.

The increase in advertising and promotional expenses, including related travel and entertainment expense, was primarily the result of costs related to the Musikmesse tradeshow in Germany of approximately $0.7 million. The tradeshow took place in the first quarter of fiscal 2012 but had been held in the second quarter during 2011. We also incurred higher costs related to the NAMM tradeshow of approximately $0.3 million as compared to the first quarter of fiscal 2011. The remaining increase in advertising and promotional expense related to new marketing initiatives, including our planned expansion into China.

Warehouse expenses

Warehouse expenses remained flat at approximately $7.0 million for both the first quarter of fiscal 2012 and the first quarter of fiscal 2011. Warehouse expense increased by $0.2 million related to labor and professional services; however, the increase was offset by a decrease in building rent of approximately $0.2 million.

Research and development expenses

Research and development expenses increased by $0.3 million, or 11.8%, to $2.7 million in the first quarter of fiscal 2012 compared to $2.4 million in the first quarter of fiscal 2011. The increase in research and development expenses was due primarily to an increase in labor related expenses.

Income from operations

As a result of the factors discussed above, income from operations decreased by $3.6 million, or 40.5% to $5.3 million in the first quarter of fiscal 2012 from $8.9 million in the first quarter of fiscal 2011. Income from operations as a percentage of net sales decreased 2.2 percentage points to 3.0% in the first quarter of fiscal 2012 from 5.2% in the first quarter of fiscal 2011.

Net foreign currency exchange gain (loss)

Our net foreign currency exchange gain (loss) increased by $1.3 million to a gain of $1.0 million in the first quarter of fiscal 2012 compared to a loss of $0.3 million in the first quarter of fiscal 2011. The increase was primarily the result of increased gains related to our Mexican Peso denominated foreign exchange hedging activity of $1.2 million and a decrease in losses from our Euro, Canadian Dollar and British Pound denominated foreign exchange hedging activity of approximately $0.6 million. The increase was partially offset by an increase in losses related to our Japanese Yen denominated foreign hedging activity of $0.4 million.

Interest expense

Interest expense increased by $0.6 million, or 20.4%, to $3.4 million in the first quarter of fiscal 2012 compared to $2.8 million in the first quarter of fiscal 2011. The increase was the result of

 

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additional interest expense in the first quarter of fiscal 2012 of $0.3 million from our interest rate swap agreement and the result of a $0.3 million reduction in interest expense in the first quarter of fiscal 2011 resulting from a reversal of interest expense that had been previously recognized related to an uncertain tax position for certain research and development tax credits.

Other, net

Other, net decreased by $0.5 million to $0.1 million in expense in the first quarter of fiscal 2012 from $0.4 million of income in the first quarter of fiscal 2011. The first quarter of fiscal 2011 included $0.3 million of interest income received in connection with a tax refund. Other changes were the result of miscellaneous immaterial items.

Income taxes expense

Income tax expense increased by $1.8 million to $1.0 million in the first quarter of fiscal 2012 compared to an income tax benefit of $0.8 million in the first quarter of fiscal 2011. Effective tax rates were 34.7% and (12.2)% for the first quarter of fiscal 2012 and the first quarter of fiscal 2011, respectively.

The effective tax rate for the first quarter of fiscal 2011 was impacted by a favorable resolution of a tax dispute resulting in a refund of $1.8 million and the utilization of research and development tax credits of approximately $1.0 million. Excluding these items, the effective tax rate for the first quarter of fiscal 2011 would have been approximately 33.0%. The effective tax rate for the first quarter of fiscal 2012 was not affected by any significant unusual items.

Net income

As a result of the factors discussed above, net income decreased $5.0 million, or 72.5%, from $6.9 million in the first quarter of fiscal 2011 to $1.9 million in the first quarter of fiscal 2012.

Fiscal 2011 compared to fiscal 2010

Net sales

Net sales increased by $82.7 million, or 13.4%, to $700.6 million in fiscal 2011 from $617.8 million in fiscal 2010. The increase was primarily driven by an increase in overall effective prices and a reduction in discounts for our products, success in new product introductions, continued growth in international markets and overall market conditions, and the resolution of the production problem related to our paint supplier in fiscal 2010 as discussed in “—Opportunities, challenges and risks” above. As of January 2, 2011, we had approximately $26.2 million of cancellable backlog. We believe a substantial majority of this backlog related to this production problem and contributed to higher sales in the first and second quarters of fiscal 2011 as we filled the backlog.

Net sales from FMI increased by $77.8 million, or 17.9%, to $512.0 million in fiscal 2011 from $434.3 million in fiscal 2010. We experienced growth in net sales in both domestic and international markets in fiscal 2011, including 15.6% growth in North America, international growth of 31.0% and European growth of 15.7%. We estimate that less than 5.0% of our FMI fiscal 2011 sales resulted from filling the backlog from fiscal 2010, as described above. Further impacting net sales performance was an $11.9 million increase in overall effective prices and reduction in discounts for our products in fiscal 2011. The effects of foreign currency movements favorably contributed approximately $7.6 million to net sales in fiscal 2011 compared to fiscal 2010.

 

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Net sales from KMC increased by $4.9 million, or 2.7%, to $188.5 million in fiscal 2011 from $183.6 million in fiscal 2010. The increase was primarily driven by the growth in the North America mass merchant channel, which increased by $4.0 million with increased online retail sales.

Cost of goods sold

Cost of goods sold increased by $35.8 million, or 8.0%, to $483.0 million in fiscal 2011 from $447.3 million in fiscal 2010. The increase in cost of goods sold was driven primarily by a volume increase of $36.8 million. We estimate that approximately 28.5% of this volume increase was due to the resolution of the previously discussed paint supply issue. The increase in cost of goods sold was also impacted by an increase in material costs of $3.9 million in fiscal 2011 and the effects of foreign currency movements, which contributed approximately $4.2 million to the increase in cost of goods sold in fiscal 2011. These increases were partially offset by $4.5 million of manufacturing variances and idle facility charges in fiscal 2010 that did not occur in fiscal 2011, operating efficiency gains of $3.7 million in fiscal 2011, a decrease in workers’ compensation expense from fiscal 2010 of $0.8 million and a favorable adjustment of $0.5 million, a majority of which was attributable to a government refund related to customs and duties charges in fiscal 2011.

Cost of goods sold from FMI increased by $30.4 million, or 9.7%, to $345.8 million in fiscal 2011 from $315.4 million in fiscal 2010. The increase in cost of goods sold was driven by a volume increase of $31.8 million. We estimate that approximately 33.0% of this volume increase was due to the resolution of the previously discussed paint supply issue. In addition, the increase in cost of goods sold was impacted by an increase in material costs of $3.9 million in fiscal 2011 and the effects of foreign currency movements, which contributed approximately $4.0 million to the increase in cost of goods sold in fiscal 2011. These increases were partially offset by $4.5 million of manufacturing variances and idle facility charges in fiscal 2010 that did not occur in fiscal 2011, improved operating efficiency gains of $3.7 million, a decrease in workers’ compensation expense from fiscal 2010 of $0.8 million and a favorable adjustment of $0.5 million, a majority of which was attributable to a government refund related to customs and duties charges in fiscal 2011.

Cost of goods sold from KMC increased by $5.3 million, or 4.0%, to $137.2 million in fiscal 2011 from $131.9 million in fiscal 2010. The increase in cost of goods sold was driven by a volume increase of $5.1 million. The effects of foreign currency movements contributed approximately $0.2 million to the increased cost of goods sold in fiscal 2011.

Gross profit/gross margin

Gross profit increased by $47.0 million, or 27.5%, to $217.5 million in fiscal 2011 from $170.6 million in fiscal 2010. Gross margin of 31.1% in fiscal 2011 increased 350 basis points from fiscal 2010 gross margin of 27.6%. The increase in gross profit was driven by a volume increase of $24.7 million and favorable product mix of $0.7 million. We estimate that approximately 40.0% of this volume and mix increase was due to the resolution of the previously discussed paint supply issue. In addition, the increase in gross profit was due in part to an increase in overall effective prices and reduction in discounts for our products in fiscal 2011 of $11.5 million and improved factory operating efficiency gains in fiscal 2011 of $3.7 million. In addition, the fiscal 2010 paint supply issue contributed to manufacturing variances and idle facility charges of $4.5 million in fiscal 2010 that did not occur in fiscal 2011. Further favorably impacting fiscal 2011 gross profit was a decrease in workers’ compensation expense from fiscal 2010 of $0.8 million as well as a favorable adjustment of $0.5 million, a majority of which was attributable to a government refund related to customs and duties charges in fiscal 2011. The effects of foreign

 

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currency movements contributed approximately $3.7 million of the increase in gross profit in fiscal 2011 compared to fiscal 2010. These increases were partially offset by increases in our material costs of $3.9 million in fiscal 2011 compared to fiscal 2010.

FMI gross profit increased by $47.3 million, or 39.8%, to $166.2 million in fiscal 2011 from $118.9 million in fiscal 2010. Gross margin of 32.5% in fiscal 2011 increased 510 basis points from fiscal 2010 gross margin of 27.4%. The increase in gross profit was driven by a volume increase of $24.9 million and favorable product mix of $1.2 million in fiscal 2011, an increase in overall effective prices and reduction in discounts for our products of $11.8 million and improved factory operating efficiency gains of $3.7 million. We estimate that approximately 40.0% of this volume and mix increase was due to the resolution of the previously discussed paint supply issue. In addition, the paint supply issue contributed to manufacturing variances and idle facility charges of $4.5 million in fiscal 2010 that did not occur in fiscal 2011. Gross profit in fiscal 2011 was also favorably impacted by a decrease in workers’ compensation expense of $0.8 million compared to fiscal 2010 and a favorable adjustment of $0.5 million, a majority of which was attributable to a government refund related to customs and duties charges in fiscal 2011. The effects of foreign currency movements contributed approximately $3.7 million of the increase in gross profit in fiscal 2011 compared to fiscal 2010. These increases were partially offset by increases in our material costs of $3.9 million in fiscal 2011 compared to fiscal 2010.

KMC gross profit decreased by $0.4 million, or 0.7%, to $51.3 million in fiscal 2011 from $51.7 million in fiscal 2010. Gross margin of 27.2% in fiscal 2011 decreased 100 basis points compared to fiscal 2010 gross margin of 28.2%. The decrease in gross profit was primarily driven by higher freight allowance programs of $1.0 million, partially offset by the favorable effects of foreign currency movements of $0.6 million.

Selling, general and administrative expenses

Selling, general and administrative expenses increased by $15.5 million, or 12.7%, to $137.1 million in fiscal 2011 compared to $121.7 million in fiscal 2010. Approximately $11.5 million of the increase in selling, general and administrative expense was the result of an increase in our labor-related expenses. The remaining increase in selling, general and administrative expenses in fiscal 2011 was the result of travel and entertainment expenses of $2.8 million related to strategic marketing initiatives to expand and strengthen our customer base and relationships and a $1.0 million increase in our legal costs as the result of a settlement payment made to resolve a dispute with a former supplier. See “Business—Legal proceedings.”

The increase in our labor expense resulted from the reinstatement of our annual merit, 401(k) employer matching contribution and management bonus programs during fiscal 2011 which resulted in an increase of approximately $7.3 million in labor expenses as compared to fiscal 2010. Additionally, stock options issued during fiscal 2011 resulted in an increase in our stock based compensation expense by approximately $3.1 million compared to fiscal 2010. The remaining increase in labor-related costs was the result of increased employee benefits and insurance rates, commissions and the use of temporary labor services.

Warehouse expenses

Warehouse expenses increased by $0.7 million, or 2.6%, to $28.4 million in fiscal 2011 compared to $27.7 million in fiscal 2010. The increase was primarily due to an increase in labor-related expenses of approximately $0.9 million as a result of temporary labor and overtime worked by

 

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warehouse personnel and additional outside services costs of $0.6 million related to our third party distribution center in Europe. The increase was partially offset by decreases in our rent expense of $0.6 million and depreciation of $0.6 million in fiscal 2011 compared to fiscal 2010.

Research and development expenses

Research and development expenses increased by $0.9 million, or 9.2%, to $10.2 million in fiscal 2011 compared to $9.3 million in fiscal 2010. The overall increase was primarily related to an increase in labor costs of $0.5 million as the result of the reinstatement of our employee benefit plans as noted above and increased professional services of $0.2 million related to new product development projects.

Impairment charges

We recorded approximately $0.8 million of impairment charges in fiscal 2010 as a result of the write off of inventory management software that was not being used. No impairment charges were recorded in fiscal 2011.

Income from operations

As a result of the factors discussed above, our consolidated income from operations increased $29.9 million to $41.8 million in fiscal 2011 compared to $11.9 million in fiscal 2010. As a percentage of net sales, income from operations increased to 6.0% in fiscal 2011 from 1.9% in fiscal 2010.

Net foreign currency exchange loss

Our net foreign currency exchange loss increased by $2.6 million, to $3.8 million in fiscal 2011 from $1.2 million in fiscal 2010. The increase was the result of an increase in losses primarily related to our Euro and Mexican Peso denominated foreign exchange hedging activity of approximately $3.4 million, net of a decrease in losses from our Canadian Dollar, Japanese Yen and British Pound denominated foreign exchange hedging activity of approximately $0.8 million.

Interest expense

Interest expense increased by $2.2 million, or 17.6%, to $14.9 million in fiscal 2011 compared to $12.7 million in fiscal 2010. The increase was primarily related to additional interest expense of $2.9 million resulting from our interest rate swap agreement, net of a decrease in interest expense under our term loan and revolver of $0.3 million.

Other, net

Other, net increased by $0.7 million to $1.1 million in fiscal 2011 compared to $0.4 million in fiscal 2010. The change in other, net was due to higher interest income of $0.3 million and $0.4 million relating to miscellaneous immaterial items in fiscal 2011.

Income taxes expense (benefit)

Income tax expense increased by $5.9 million to $5.2 million in fiscal 2011 compared to an income tax benefit of $0.7 million in fiscal 2010. Effective tax rates were 21.5% and 27.9% for fiscal 2011 and fiscal 2010, respectively.

 

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The effective tax rate in fiscal 2011 was impacted by a favorable resolution of a tax dispute resulting in a refund of $1.9 million and the utilization of research and development tax credits of approximately $1.0 million. This accounted for approximately 12.0 percentage points of the effective tax rate. Excluding these items, the effective tax rate for fiscal 2011 would have been approximately 34.0%. The effective tax rate in fiscal 2010 was impacted by a change in our position regarding undistributed earnings of our European subsidiaries which we began to remit to the United States in fiscal 2010, resulting in additional tax expense of $0.5 million. Additionally, the add-back of meals and entertainment expenses, which historically has not been material to our total tax expense, resulted in additional tax expense of $0.2 million. Offsetting these amounts were additional tax benefits of $0.6 million primarily related to the difference in domestic and foreign tax rates and dividends, net of foreign tax credits, paid to us from foreign subsidiaries. Excluding these items, the effective tax rate for fiscal 2010 would have been approximately 35.0%.

Net income

As a result of the factors above, net income increased $20.7 million to $19.0 million in fiscal 2011 compared to a net loss of $1.7 million in fiscal 2010.

Fiscal 2010 compared to fiscal 2009

Net sales

Net sales remained relatively flat at $617.8 million in fiscal 2010 compared to $612.5 million in fiscal 2009. The slight increase was primarily the result of higher sales volume of $20.7 million in fiscal 2010, which increased despite the unfavorable impact of the paint supply issue discussed in the “—Opportunities, challenges and risks” section above. We did not face any similar supply issues in fiscal 2009. This sales volume increase was offset by the effects of unfavorable currency movements of $7.6 million in fiscal 2010, $6.6 million paid in higher rebates for sales volume growth and higher sales allowances due to customer mix in fiscal 2010 compared to fiscal 2009 and a $1.2 million increase in discounting on both discontinued product and freight in fiscal 2010 compared to fiscal 2009.

Net sales from FMI increased by $9.2 million, or 2.2%, to $434.3 million in fiscal 2010 compared to $425.1 million in fiscal 2009. The increase was primarily the result of higher sales volume of $25.0 million in fiscal 2010, which increased despite the unfavorable impact of the paint supply issue discussed above. This sales volume increase was partially offset by the effects of unfavorable currency movements of $9.3 million and a decrease in net sales in fiscal 2010 as a result of $6.6 million paid in higher rebates for sales volume growth and higher sales allowances due to customer mix in fiscal 2010 compared to fiscal 2009.

Net sales from KMC decreased by $3.9 million, or 2.1%, to $183.6 million in fiscal 2010 compared to $187.4 million in fiscal 2009. The decrease was primarily related to lower sales volume of $4.6 million in fiscal 2010 and an increase in price discounting on both discontinued product and freight of $1.2 million in fiscal 2010 compared to fiscal 2009. These decreases were partially offset by the effects of favorable currency movement of $1.7 million in fiscal 2010.

Cost of goods sold

Cost of goods sold increased by $26.4 million, or 6.3%, to $447.3 million in fiscal 2010 from $420.9 million in fiscal 2009. The increase in cost of goods sold was driven by a volume increase

 

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of $21.4 million. Additionally, cost of goods sold increased due to manufacturing variances of $10.3 million in fiscal 2010. We estimate that the majority of the manufacturing variances were attributable to the paint supply issue. Cost of goods sold also increased in fiscal 2010 compared to fiscal 2009 by $3.5 million as a result of idle facility charges in fiscal 2010 related to the paint supply issue. These increases were partially offset by a decrease in cost of goods sold of approximately $6.8 million due to the effects of foreign currency movements, as well as lower inventory provisions of $2.1 million in fiscal 2010 compared to fiscal 2009.

Cost of goods sold from FMI increased by $29.2 million, or 10.2%, to $315.4 million in fiscal 2010 from $286.2 million in fiscal 2009. The increase in cost of goods sold was driven primarily by a volume increase of $23.9 million. In addition, cost of goods sold increased due to manufacturing variances of $10.3 million in fiscal 2010. We estimate that the majority of the manufacturing variances were attributable to the paint supply issue. Cost of goods sold also increased in fiscal 2010 compared to fiscal 2009 by $3.5 million as a result of idle facility charges in fiscal 2010 related to the paint supply issue. These increases were partially offset by a decrease in cost of goods sold of approximately $6.4 million due to the effects of foreign currency movements, as well as lower inventory provisions of $2.1 million in fiscal 2010 compared to fiscal 2009.

Cost of goods sold from KMC decreased by $2.9 million, or 2.2%, to $131.9 million in fiscal 2010 from $134.8 million in fiscal 2009. The decrease in cost of goods sold was driven by a volume decrease of $2.5 million and a decrease of approximately $0.4 million due to the effects of foreign currency movements in fiscal 2010.

Gross profit/gross margin

Gross profit decreased by $21.0 million, or 11.0%, to $170.6 million in fiscal 2010 compared to $191.6 million in fiscal 2009. Gross margin of 27.6% in fiscal 2010 declined 370 basis points from fiscal 2009 gross margin of 31.3%. A majority of the gross profit decrease in fiscal 2010 was attributable to the paint supply issue. Additionally, the decrease resulted from idle facility charges of $3.5 million, a decrease in gross profit in fiscal 2010 as a result of $6.6 million paid in higher rebates for sales volume growth and higher sales allowances due to customer mix in fiscal 2010 compared to fiscal 2009, and a $1.2 million increase in discounting on both discontinued product and freight in fiscal 2010 compared to fiscal 2009. Gross profit was also lower due to the effects of unfavorable currency movements of $0.7 million. These decreases were partially offset by a volume increase, which contributed $3.9 million of gross profit in fiscal 2010.

FMI gross profit declined by $20.0 million or 14.4%, to $118.9 million in fiscal 2010 from $138.9 million in fiscal 2009. Gross margin of 27.4% declined 530 basis points compared to fiscal 2009 of 32.7%. A majority of the gross profit decrease in fiscal 2010 was attributable to the paint supply issue. Additionally, the decrease resulted from idle facility charges of $3.5 million and a decrease in gross profit in fiscal 2010 as a result of the $6.6 million paid in higher rebates for sales volume growth and higher sales allowances due to customer mix in fiscal 2010 compared to fiscal 2009. Gross profit in fiscal 2010 was also lower due to the effects of unfavorable currency movements of $2.9 million. These decreases in FMI gross profit were partially offset by a volume increase, which contributed $5.5 million of gross profit in fiscal 2010.

KMC gross profit declined by $1.0 million, or 1.8%, to $51.7 million in fiscal 2010 compared to $52.7 million in fiscal 2009. Gross margin of 28.2% decreased 10 basis points compared to fiscal 2009 gross margin of 28.1%. The decrease was primarily related to lower sales volume of $0.3 million in fiscal 2010, sales through lower margin channels in fiscal 2010 of $1.7 million and $1.2

 

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million in greater price discounts given on discontinued products and freight in fiscal 2010 compared to fiscal 2009. Partially offsetting this reduction in gross profit was $2.1 million related to the effects of favorable currency movements in fiscal 2010.

Selling, general and administrative expenses

Selling, general and administrative expenses decreased by $4.1 million, or 3.2%, to $121.7 million in fiscal 2010 compared to $125.7 million in fiscal 2009. The overall decrease was due primarily to a decrease in labor-related expense of $3.2 million in fiscal 2010, of which $2.2 million was related to lower wages, $0.9 million was related to the discontinuation of our 401(k) employer matching contribution and $0.2 million related to lower temporary labor expenses. The decrease in wages was due to lower head count in fiscal 2010. The remaining decrease was primarily related to lower depreciation and amortization compared to fiscal 2009.

Warehouse expenses

Warehouse expenses increased by $1.8 million, or 7.1%, to $27.7 million in fiscal 2010 compared to $25.9 million in fiscal 2009. This increase was primarily due to an increase in warehouse building rent of approximately $2.7 million, partially offset by a decline in outside services costs of $0.5 million. The increase in building rent was due to the expansion of our Ontario, California warehouse as we added approximately 300,000 additional square footage of leased space. The decrease in outside services was related to lower amounts paid to our third party warehouse provider in Europe due to lower volume.

Research and development expenses

Research and development expenses increased by $0.3 million, or 3.3%, to $9.3 million in fiscal 2010 compared to $9.0 million in fiscal 2009. The increase in research and development expenses was primarily due to increased labor-related expenses of $0.3 million as a result of higher benefit charges and an increased use of temporary labor.

Impairment charges

In fiscal 2010, we recorded approximately $0.8 million in impairment charges to write off inventory management software that was not being used. In fiscal 2009, we recorded $1.2 million in impairment charges. Due to a deterioration in economic conditions, and the reduction of forecasted sales and estimated cash flows, we determined that several of our indefinite-lived trademarks were impaired. As a result, we recorded an impairment charge of $1.0 million in fiscal 2009 related to indefinite-lived trademarks. We also determined that certain customer list intangible assets were impaired and, as a result, recorded $0.2 million in impairment charges related to these assets in fiscal 2009.

Income from operations

As a result of the factors discussed above, income from operations decreased by $18.7 million, or 62.6%, to $11.1 million in fiscal 2010 from $29.8 million in fiscal 2009. Income from operations as a percentage of net sales decreased 3.1 percentage points to 1.8% in fiscal 2010 from 4.9% in fiscal 2009.

 

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Net foreign currency exchange loss

Our net foreign currency exchange loss decreased by $2.4 million, to $1.2 million in fiscal 2010 compared to $3.6 million in fiscal 2009. The decrease was primarily the result of a decrease in losses from our Euro denominated foreign exchange hedging activity of approximately $1.9 million and a decrease of approximately $0.7 million in losses related to the foreign currency effect of the remeasurement of certain assets and liabilities of our foreign subsidiaries.

Interest expense

Interest expense decreased by $2.9 million, or 18.9%, to $12.7 million in fiscal 2010 from $15.6 million in fiscal 2009 primarily due to a mandatory pre-payment under our term loan agreement of approximately $34.3 million made in May 2010 lowering the weighted average term loan balance to $271.1 million in fiscal 2010 from $295.5 million in fiscal 2009, or a decrease in the weighted average term loan balance of approximately 8.3%. Also, a decrease in the London Interbank Offered Rate, or LIBOR, decreased the interest rate under our credit facility in fiscal 2010 and contributed to the overall decrease in interest expense.

Other, net

Other, net decreased by $1.3 million to $0.4 million in fiscal 2010 from $1.7 million in fiscal 2009. The decrease in other income was due primarily to interest income of approximately $1.0 million earned in fiscal 2009 as a result of a settlement reached with the IRS for audits conducted for our 2005 through 2008 tax years.

Income taxes expense (benefit)

Income tax expense decreased by $2.2 million to $0.7 million in tax benefit in fiscal 2010 from $1.5 million in tax expense in fiscal 2009. The effective tax rates were 27.9% in fiscal 2010 and 12.3% in fiscal 2009.

The effective tax rate in fiscal 2010 was impacted by a change in our position regarding undistributed earnings of our European subsidiaries which we began to remit to the United States in fiscal 2010, resulting in additional tax expense of $0.5 million. Additionally, the add-back of meals and entertainment expenses, which historically has not been material to our total tax expense, resulted in additional tax expense of $0.2 million. Offsetting these amounts were additional tax benefits of $0.6 million primarily related to the difference in domestic and foreign tax rates and dividends, net of foreign tax credits, paid to us from foreign subsidiaries. Excluding these items, the effective tax rate for fiscal 2010 would have been approximately 35.0%.

The effective tax rate in fiscal 2009 was impacted by a favorable resolution of a tax dispute of $2.5 million. Excluding this item, our effective tax rate in fiscal 2009 would have been 32.4%.

Net income (loss)

As a result of the factors discussed above, we incurred a net loss of $1.7 million and net income of $10.8 million in fiscal 2010 and fiscal 2009, respectively.

 

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Quarterly results of operations data

The following table sets forth our unaudited quarterly consolidated statement of operations data for the nine fiscal quarters ended April 1, 2012. The information from each quarter is derived from our unaudited interim consolidated financial statements, which we have prepared on the same basis as the audited consolidated financial statements appearing elsewhere in this prospectus. This information includes all adjustments, consisting of normal, recurring adjustments, that management considers necessary for the fair presentation of such data. The quarterly data should be read together with our consolidated financial statements and related notes appearing elsewhere in this prospectus. Our historical unaudited quarterly consolidated results of operations are not necessarily indicative of results for any future fiscal quarters or fiscal years.

 

Fiscal quarter ended

(in thousands)

  Apr. 4,
2010
    Jul. 4,
2010
(1)
    Oct. 3,
2010
(1)
    Jan. 2,
2011
    Apr. 3,
2011
(1)
    Jul. 3,
2011
(1)
    Oct. 2,
2011
    Jan. 1,
2012
   

Apr. 1,

2012

 

 

 
                                                 

Net sales

  $ 147,666      $ 126,388      $ 164,534      $ 179,242      $ 170,106      $ 167,747      $ 175,395      $ 187,306      $ 173,769   

Cost of goods sold

    104,371        95,115        118,020        129,744        117,848        115,162        120,431        129,579        119,459   
 

 

 

 

Gross profit

    43,295        31,273        46,514        49,498        52,258        52,585        54,964        57,727        54,310   
 

 

 

 

Operating expenses:

                 

Selling, general and administrative

    33,413        28,644        29,599        29,995        33,917        32,678        34,285        36,248        39,294   

Warehouse

    6,578        6,569        7,005        7,561        7,044        7,166        7,103        7,113        7,045   

Research and development

    2,495        2,265        2,335        2,204        2,397        2,622        2,477        2,661        2,679   

Impairment charges

                         777                                      
 

 

 

 

Total operating expenses

    42,486        37,478        38,939        40,537        43,358        42,466        43,865        46,022        49,018   
 

 

 

 

Income (loss) from operations

    809        (6,205     7,575        8,961        8,900        10,119        11,099        11,705        5,292   

Other income (expense):

                 

Net foreign currency exchange gain (loss)

    144        (820     (96     (403     (269     6        (2,547     (997     1,042   

Interest expense

    (3,681     (3,543     (3,745     (1,719     (2,815     (5,325     (3,280     (3,507     (3,388

Other, net

    23        197        67        99        371        177        158        424        (96
 

 

 

 

Total other income (expense)

    (3,514     (4,166     (3,774     (2,023     (2,713     (5,142     (5,669     (4,080     (2,442
 

 

 

 

Income (loss) before income taxes

    (2,705     (10,371     3,801        6,938        6,187        4,977        5,430        7,625        2,850   

Income tax expense (benefit)

    (901     (1,915     145        2,019        (756     1,564        1,586        2,814        990   
 

 

 

 

Net income (loss)

  $ (1,804   $ (8,456   $ 3,656      $ 4,919      $ 6,943      $ 3,413      $ 3,844      $ 4,811      $ 1,860   
 

 

 

 

 

 

 

(1)   Our second and third fiscal quarters of 2010 were adversely impacted by the paint supply issue at our Corona, California manufacturing facility discussed under “—Opportunities, challenges and risks.” Similarly, our first and second fiscal quarters of 2011 were favorably impacted by filling the cancellable backlog created by this issue. The majority of this backlog was filled in the first fiscal quarter of 2011.

 

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Seasonality

We have historically experienced relatively low seasonal variations in our net sales and operating income. However, as we further expand our net sales into international markets and grow our business, we may experience greater levels of seasonality in our results of operations.

Liquidity and capital resources

Our primary cash needs are to support inventory purchases, working capital and capital expenditures. Historically, we have generally financed these needs with operating cash flows and borrowings under our credit facilities. These sources of liquidity may be impacted by fluctuations in demand for our products, ongoing investments in our infrastructure, fluctuations in foreign currencies and expenditures on marketing and advertising. A summary of our operating, investing and financing activities are shown in the following table:

 

      Fiscal year     13 weeks ended  
     2009     2010     2011     April 3,
2011
    April 1,
2012
 

 

 
                       (unaudited)  
     (in thousands)  

Net cash provided by (used in) operating activities

   $ 80,557      $ 4,385      $ 29,213      $ (5,687   $ (6,783

Net cash used in investing activities

     (5,276     (5,308     (10,576     (1,280     (1,848

Net cash (used in) provided by financing activities

     (50,344     (27,398     (21,589     3,128        9,341   

Effect of exchange rate changes on cash and cash equivalents

     655        (650     (67     (665     108   
  

 

 

 

Increase (decrease) in cash and cash equivalents

   $ 25,592      $ (28,971   $ (3,019   $ (4,504   $ 818   
  

 

 

 

 

 

We expect that proceeds from this offering, cash on hand, cash flow from operations and availability under our credit facilities will be sufficient to fund our operations for at least the next 18 months.

Net cash provided by operating activities

Cash provided by operating activities primarily consists of net income, adjusted for certain non-cash items including provision for allowances for accounts receivable (including product returns and cash discounts), depreciation and amortization, stock based compensation, deferred income taxes, amortization of loan costs, impairment charges and the effect of changes in working capital and other activities.

In the first quarter of fiscal 2012, net cash used in operating activities was $6.8 million and consisted of net income of $1.9 million plus non-cash items of $8.5 million less changes in working capital and other activities of $17.2 million. Non-cash items consisted primarily of provisions of allowances for accounts receivable (including product returns and cash discounts) of $3.8 million, depreciation and amortization of $2.4 million, stock based compensation of $2.1 million and amortization of a de-designated interest rate swap derivative of $1.0 million. Cash used for working capital and other activities consisted primarily of an increase in accounts receivable of $7.9 million, a decrease in accounts payable and accrued liabilities of $17.8 million as a result of payments made for our bonus and 401(k) plans and timing of payments made to

 

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our vendors and suppliers, partially offset by a decrease in inventory of $4.0 million related to reductions of inventory levels of certain product lines and a decrease in prepaid expenses and other current assets of $5.6 million primarily related to changes in the fair value of our foreign currency derivative portfolio.

In the first quarter of fiscal 2011, net cash used in operating activities was $5.7 million and consisted of net income of $6.9 million plus non-cash items of $7.5 million less changes in working capital and other activities of $20.1 million. Non-cash items consisted primarily of provisions of allowances for accounts receivable (including product returns and cash discounts) of $4.0 million, depreciation and amortization of $2.2 million and amortization of a de-designated interest rate swap derivative of $1.1 million. Cash used for working capital and other activities consisted primarily of an increase in accounts receivable of $9.9 million as a result of increased sales volume, an increase in inventory of $13.6 million related to the development of new products and the resolution of the paint supply issue we experienced in fiscal 2010, partially offset by a decrease in prepaid expenses and other current assets of $2.4 million primarily related to changes in the fair value of our foreign currency derivative portfolio.

In fiscal 2011, net cash provided by operating activities was $29.2 million and consisted of net income of $19.0 million plus non-cash items of $39.9 million less changes in working capital and other activities of $29.7 million. Non-cash items consisted primarily of provision of allowances for accounts receivable (including product returns and cash discounts) of $14.9 million, depreciation and amortization of $8.7 million, stock based compensation of $5.0 million and amortization of a de-designated interest rate swap derivative of $4.2 million. Cash used for working capital and other activities consisted primarily of an increase in accounts receivable of $19.7 million as a result of increased sales volume, an increase in inventory of $17.6 million related to development of new products and the resolution of the paint supply issue we experienced in fiscal 2010, and an increase in prepaid expenses and other current assets of $8.4 million related to the expansion of our foreign currency derivative portfolio and an increase in the fair value of such derivatives, partially offset by an increase in accounts payable and accrued expenses of $17.2 million primarily related to the timing of payments made to our vendors and suppliers.

In fiscal 2010, net cash provided by operating activities was $4.4 million and consisted of a net loss of $1.7 million plus $28.4 million of non-cash items less $22.3 million for changes in working capital and other activities. Non-cash items consisted primarily of provision of allowances for accounts receivable (including product returns and cash discounts) of $13.5 million, depreciation and amortization of $10.8 million and stock based compensation of $1.7 million. Cash used for working capital and other activities consisted primarily of an increase in accounts receivable of $15.8 million as a result increased sales volume compared to fiscal 2009, an increase in inventory of $18.1 million as we were making efforts to increase our inventory levels to support sales demand and an increase in prepaid expenses and other current assets of $2.3 million, partially offset by an increase in accounts payable and accrued expenses of $16.0 million as the result of an increase in purchases from suppliers compared to fiscal 2009.

In fiscal 2009, net cash provided by operating activities was $80.6 million and consisted of net income of $10.8 million plus non-cash items of $30.8 million and changes in working capital and other activities of $38.9 million. Non-cash items consisted primarily of provision of allowances for accounts receivable (including product returns and cash discounts) of $11.9 million, depreciation and amortization of $12.1 million and stock based compensation of $2.6 million. Cash provided by working capital and other activities consisted primarily of a decrease in inventory of

 

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$56.8 million primarily due to our efforts to reduce inventory levels in connection with declining economic conditions and a decrease in accounts receivable of $13.5 million related to decreased sales volume, partially offset by a decrease in accounts payable and accrued expenses of $30.2 million as the result of reductions in our inventory purchases.

Net cash used in investing activities

Cash used in investing activities primarily relates to capital expenditures.

In the first quarter of fiscal 2012 and the first quarter of fiscal 2011, cash used in investing activities consisted almost entirely of capital expenditures of $1.8 million and $1.3 million, respectively. In fiscal 2011, cash used in investing activities was primarily the result of capital expenditures of $8.4 million primarily related to investments in our manufacturing facilities and information technology, as well as the acquisition of trademarks of $2.0 million. In fiscal 2010 and fiscal 2009, net cash used in investing activities consisted almost entirely of capital expenditures of $5.3 million in both years primarily related to investments in our manufacturing facilities and information technology. We estimate that our capital expenditures for fiscal 2012 will be approximately $10.0 million to $12.0 million, primarily related to improvements in our manufacturing facilities, warehouses and information technology systems.

Net cash used in financing activities

Net cash used in financing activities primarily relates to the repayment of debt related to our term and revolving facility credit agreements. Net cash provided by financing activities was $9.3 million in the first quarter of fiscal 2012 and $3.1 million in the first quarter of fiscal 2011, in each case primarily related to the issuance of debt, net of payments. Net cash used in financing activities was $21.6 million in fiscal 2011, $27.4 million in fiscal 2010, and $50.3 million in fiscal 2009 primarily related to payments, net of issuances, of debt.

Long-term debt

On June 7, 2007, we entered into a Term Facility Credit Agreement, or the Term Loan, and a Revolving Facility Credit Agreement, or the Revolver, with a syndicate of lenders, which we refer to collectively as the Credit Facilities. The Credit Facilities provide for committed senior secured financing of $400 million, consisting of the following: the Term Loan in an aggregate original principal amount of $300 million; and the Revolver, available for loans and letters of credit, with an aggregate revolving commitment of up to $100 million based on borrowing-based eligibility criteria as described below.

The Term Loan consists of an initial loan of $200 million, which was drawn at closing, and a delayed draw loan of $100 million, which was drawn in connection with our acquisition of KMC on December 31, 2007. We may request one or more additional tranches of debt under the Term Loan of up to $75 million, subject to a consolidated senior secured debt ratio requirement. The $200 million initial loan is repayable in quarterly installments of $500,000 through June 9, 2014, the maturity date of the Term Loan, at which time the remaining principal balance is due. The $100 million delayed draw is repayable in quarterly installments of $250,000 through the maturity date, at which time the remaining principal balance is due.

The Term Loan bears interest based, at our option, at either (1) LIBOR plus an applicable margin of 2.25% per annum, or (2) an alternate base rate plus an applicable margin of 1.25% per annum. If our consolidated senior secured debt ratio is less than or equal to 3.5 to 1.0, the

 

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applicable margin applied to either the LIBOR or the alternative base rate is reduced to 2.00% and 1.00%, respectively. As of April 1, 2012, the interest rate on the Term Loan was 2.50% and we had $241.8 million outstanding under the Term Loan.

The Revolver, which was amended in April 2011, matures on April 27, 2016, if the Term Loan has been refinanced, extended or repaid in full by March 9, 2014; otherwise the Revolver matures on March 9, 2014. Borrowing eligibility under the Revolver is subject to a monthly borrowing base calculation based on (i) certain percentages of eligible accounts receivable and inventory, less (ii) certain reserve items, including outstanding letters of credit and other reserves. We may at any time, on not more than four occasions, request an increase to the Revolver of up to an aggregate amount of $50.0 million. The Revolver bears interest at a rate based on either (1) LIBOR plus an applicable margin, or (2) an alternate base rate. The margin applied to LIBOR is either 2.00% or 2.25%, depending on our commitment utilization percentage under the Revolver. As of April 1, 2012, we had $14.0 million outstanding on the Revolver and our availability under the Revolver was approximately $79.0 million.

All borrowings and other extensions of credit under the Credit Facilities are subject to the satisfaction of customary conditions, including absence of defaults and accuracy in material respects of representations and warranties. In addition, the Credit Facilities contain customary restrictive covenants for facilities and transactions of this type, including, among others, certain limitations on:

 

 

incurrence of additional debt and guarantees of indebtedness;

 

 

creation of liens;

 

 

mergers, consolidations or sales of substantially all of our assets;

 

 

sales or other dispositions of assets;

 

 

distributions or dividends and repurchases of our common stock;

 

 

restricted payments, including, without limitation, certain restricted investments;

 

 

engaging in transactions with our affiliates; and

 

 

sale and leaseback transactions.

As of April 1, 2012, we were in compliance with these covenants. Our U.S. assets and a portion of the stock of our foreign subsidiaries have been pledged as collateral and secure our indebtedness under the Credit Facilities.

The Credit Facilities require mandatory prepayments in amounts equal to (1) 100% of the net cash proceeds of any indebtedness incurred in violation of the Credit Facilities; (2) the net proceeds from the sale or other disposition of property in excess of specified values (other than in the ordinary course of business and subject to other exceptions) by us or our subsidiaries, unless we intend and expect to use all or a portion of the proceeds to acquire or repair assets used in the business; and (3) with respect to the Term Loan only, a percentage ranging from 0% to 50%, depending on our consolidated leverage ratio, of excess cash flow, as defined in the Credit Facilities. Our consolidated leverage ratio was 4.4 as of April 1, 2012. As of January 3, 2010, we had a mandatory prepayment due on the Term Loan of approximately $34.3 million. This

payment was made in May 2010. No mandatory prepayment was required as of January 2, 2011.

 

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As of January 1, 2012, we had a mandatory prepayment due on the Term Loan of approximately $3.6 million. This payment was made in March 2012 with cash on hand.

We may voluntarily prepay loans under the Credit Facilities, in whole or in part, without premium or penalty. Any voluntary prepayment of loans will be subject to reimbursement of the lenders’ breakage costs in the case of a prepayment of Eurodollar rate borrowings other than on the last day of the relevant interest period. We intend to use a portion of the proceeds from this offering to prepay a portion of our outstanding loans under the Credit Facility. See the “Use of proceeds” section for further discussion.

Critical accounting policies

Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires estimates and judgments that affect the reported amounts of our assets, liabilities, net sales and expenses, and disclosure of contingent assets and liabilities. Management bases estimates on historical experience and other assumptions it believes to be reasonable given the circumstances and evaluates these estimates on an ongoing basis. Actual results could be significantly different from these estimates. We believe that the following discussion addresses the critical accounting policies that are necessary to understand and evaluate our reported financial results.

Revenue recognition

We recognize revenue when products are delivered, collection of the receivable is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Our revenue is reported on a net sales basis, which is computed by deducting from our gross sales actual cash discounts, allowances established for anticipated sales returns and rebates earned by our customers. Provisions for discounts, rebates, sales incentives, returns and other adjustments are provided for in the period the related sales are recorded based on an assessment of historical trends and current projections of future results.

Our estimated allowance for sales returns is a subjective critical estimate that has a direct impact on reported net sales. This allowance is calculated based on a history of actual returns, estimated future returns and any significant future known or anticipated events. Consideration of these factors results in an estimated allowance for sales returns. We allow returns from our customers if properly requested and approved.

Accounts receivable allowances

We establish reserves for cash discounts, product returns and allowances for doubtful accounts. The allowance for doubtful accounts is based on trade receivables that are not probable of collection. The allowance for doubtful accounts is determined using estimated losses on accounts receivable based on historical write-offs and evaluation of the aging of the receivables as well as the specific circumstances associated with the credit risk and materiality of the receivable balance. The reserves for cash discounts and product returns are based on historical experience. We assess the adequacy of our reserves at least quarterly and we adjust our estimates as needed.

Inventories

We value our inventories at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. We record inventory write-downs for

 

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estimated obsolescence or unmarketable inventories based on our forecast of future demand. If our inventory on hand is in excess of our forecast of future demand, the excess amounts are written down.

We also review inventory to determine whether its carrying value exceeds the net amount realizable upon the ultimate sale of the inventory. This requires us to determine the estimated selling price of our products less the estimated cost to convert inventory on hand into a finished product.

Property and equipment

Property and equipment are stated at cost and depreciated/amortized using the straight-line method over the following estimated useful lives:

 

Building

   30-39 years

Machinery and equipment

   3-10 years

Furniture and fixtures

   3-7 years

Computer hardware and software

   3-5 years

Leasehold improvements

   Lesser of estimated useful life or life of lease

Our estimates relating to the anticipated useful lives of our property and equipment is a subjective critical estimate that directly impacts the value of our assets reflected on our consolidated balance sheets. Should these estimates prove inaccurate, we may be required to write down the excess value of these assets.

Goodwill and indefinite-lived intangible assets

Goodwill represents the excess of purchase price over the fair value of the net assets of businesses acquired. Indefinite-lived intangible assets consist of trademarks. Goodwill and intangible assets with indefinite lives are not amortized but are subject to impairment tests at least annually at a reporting unit level. We conduct the annual impairment test of goodwill and other intangibles at the end of each fiscal year or more frequently if there are any impairment indicators identified during the year. To determine if goodwill and other intangibles are impaired, we use our best judgment and estimates and we review various factors, such as discounted cash flows analysis and comparable acquisition analysis. Trademarks are valued using the relief from royalty method of the income approach. We conducted our most recent annual impairment tests during the fourth quarter of fiscal 2011, and concluded that there were no impairment charges to record in fiscal 2011.

Impairment of long-lived assets

We evaluate the recoverability of our intangible assets and other long-lived assets with finite useful lives for impairment when events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. These trigger events or changes in circumstances include, but are not limited to, a significant decrease in the market price of a long-lived asset, a significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition, significant adverse changes in legal factors or in the business climate that could affect the value of our long-lived assets, a significant adverse deterioration in the amount of revenue or cash flows we expect to generate from an asset group, an accumulation of costs significantly in excess of the amount originally expected for the

 

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acquisition or development of a long-lived asset, current or future operating or cash flow losses that demonstrate continuing losses associated with the use of our long-lived assets, or a current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. Our long-lived assets consist of property and equipment and amortizable intangible assets. When factors indicate that the assets should be evaluated for possible impairment, we evaluate the recoverability of such assets by comparing the carrying amount of the asset or group of assets to the estimated undiscounted future cash flows expected to result from the use of the asset or group of assets and their eventual disposition. If the undiscounted cash flows are less than the carrying value of the asset or group of assets being evaluated, an impairment loss is recorded. The loss is measured as the difference between the fair value and the carrying value of the asset or group of assets being evaluated. Fair value is determined using the excess earnings method of the income approach.

Product warranties

We accrue warranty reserves at the time products are sold. Warranty reserves include management’s best estimate of the projected costs to repair or to replace any items under warranty, based on actual warranty experience as it becomes available and other known factors that may impact our evaluation of historical data. We review the adequacy of our reserves at least quarterly and adjust our estimates as needed.

Self-insurance reserves

We maintain an insured large deductible program for workers’ compensation, whereby we have a liability of up to $350,000 per claim, with any amounts in excess of this limit covered by stop-loss excess insurance coverage. In addition, we maintain a self-insurance program for medical and dental insurance, whereby we have a liability of up to $125,000 per member, with any amounts in excess of this limit covered by stop-loss excess insurance coverage. Estimated costs under these programs, including incurred but not reported claims, are recorded as expenses based upon actuarially determined liabilities, which are based on historical experience and trends of paid and incurred claims. Accounting for insurance liabilities that are self-insured involves uncertainty because estimates and judgments are used to determine the liability to be recorded for reported claims and claims incurred but not reported. If the current claim trends were to differ significantly from our historic claim experience, a corresponding adjustment would be made to the self-insurance reserves.

Derivative instruments

As a global company, we are exposed in the normal course of business to foreign currency and interest rate risks that could affect our net assets, financial position, results of operations and cash flows. We use derivative instruments to hedge against certain of these risks, and hold derivative instruments for hedging purposes only, not for speculative or trading purposes.

We record all derivative instruments on the balance sheet at fair value. Changes in the fair value of the derivative instruments are recognized in earnings unless we elect to designate the derivative in a hedging relationship and apply hedge accounting and the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated

 

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and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. Certain of the derivatives contracts we have entered into are designated as cash flow hedges. We have not used derivative contracts designated as fair value hedges or as hedges of the foreign currency exposure of a net investment in a foreign subsidiary, although we could elect to do so in the future. We may enter into derivative contracts that are intended to economically hedge certain risks, even though hedge accounting does not apply, or we elect not to apply hedge accounting.

Foreign currency exchange risk

We sell our products internationally, and, in many of those markets, primarily Europe, the sales are made in the foreign country’s local currency. In addition, many of the purchases by the company and its subsidiaries from international vendors are denominated in currencies that are different from the relevant functional currency. Furthermore, we are exposed to gains and losses resulting from the effect that fluctuations in foreign currency exchange rates have on the reported results in our consolidated financial statements due to the translation of the operating results and financial position of our international subsidiaries. Our most significant foreign currency risk relates to the Euro, the British Pound, the Japanese Yen, the Canadian Dollar and the Mexican Peso. We use foreign currency derivatives to hedge a portion of these exposures. The foreign currency derivatives are entered into with banks and allow us to exchange a specified amount of foreign currency with U.S. dollars at a future date, based on a fixed exchange rate.

Certain foreign currency derivatives have been designated as cash flow hedges. The effective portion of changes in the fair value of foreign currency derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income (loss) and subsequently reclassified into net sales in the period the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the foreign currency derivative is recorded directly in earnings.

In addition, certain of our foreign currency derivatives used to manage the exposure related to our international sales and purchases are not designated as cash flows hedges. These hedges are economic hedges of identified risks to us to which we have elected not to apply hedge accounting. Hedges not designated as cash flows hedges are recorded at fair value on our consolidated balance sheets and any changes in fair value are recorded directly in earnings.

Certain of our subsidiaries’ assets (primarily accounts receivables) are denominated in currencies other than the functional currency of the particular subsidiary. Changes in the exchange rate between the subsidiary’s functional currency and the currency in which the asset is denominated can create fluctuations in our reported consolidated financial position, results of operations and cash flows. Accordingly, we enter into foreign currency derivatives to hedge a portion of the balance sheet exposure against the short-term effect of currency exchange rate fluctuations. We do not apply hedge accounting to these foreign currency derivatives and their gains and losses will offset all or part of the transaction gains and losses that are recognized in earnings on the

 

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related foreign currency asset. Any changes in the fair value of these foreign currency derivatives are recorded directly in earnings.

Interest rate risk

We use interest rate swap agreements to manage our exposure to interest rate fluctuations by effectively fixing the interest rate on a portion of our floating-rate debt. The effective portion of the change in fair value of the interest rate swap designated as a cash flow hedge is recorded in accumulated other comprehensive income (loss) and is subsequently reclassified to interest expense in the period the hedged forecasted transactions affect earnings. Any ineffective portion of the interest rate swap is recorded directly in earnings.

Income taxes

We utilize the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

We operate in various tax jurisdictions and are subject to audit by various tax authorities. We provide tax contingencies whenever it is deemed probable that a tax asset has been impaired or a tax liability has been incurred for events such as tax claims or changes in tax laws. Tax contingencies are based upon our assessment of the technical merits of the relevant tax position, based on the relevant tax law and the specific facts and circumstances as of each reporting period. Changes in law or in the relevant facts and circumstances could result in material changes to the amounts recorded for such tax contingencies.

Significant management judgment is required in determining our income tax expense and our deferred tax assets and liabilities. We make these estimates and judgments about our future taxable income based on assumptions that are consistent with our future plans.

Stock based compensation

We account for stock based compensation using the fair value measurement guidance. We may grant stock options for a fixed number of shares to certain employees, directors and non-employees with an exercise price equal to or greater than the estimated fair value of the shares at the date of grant. We also may grant restricted stock and restricted stock units with fair value determined on or around the date of grant.

The fair value for stock options is estimated at the date of grant using a Black-Scholes option pricing model. We recognize compensation expense over the option vesting period, net of estimated forfeiture rates, for each separately vesting portion (or tranche) of the award as if the award is, in substance, multiple awards. If actual forfeitures differ from management estimates, additional adjustments to compensation expense may be required in future periods.

 

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The fair values of stock options are estimated using the following assumptions:

Expected dividend yield: The expected dividend yield is based on our historical practice of not paying dividends.

Risk free interest rate: The risk free interest rate for the expected term of the option is based on the U.S. Treasury yield curves.

Expected average volatility: We use an average of historical volatility of similar publicly traded companies over the expected term.

Expected term: The expected term represents the period of time that options granted are expected to be outstanding.

 

   
     Fiscal
2009
     Fiscal
2010
     Fiscal
2011
 

 

 

Expected dividend yield

     None         None         None   

Risk free interest rate

     3.01%         2.07%         1.67%   

Expected average volatility

     48.96%         49.95%         50.42%   

Expected term (years)

     5.5 to 7.0         5.5 to 6.5         5.3 to 7.5   

 

 

Stock based compensation expense related to stock options was $5.0 million, $1.6 million, $2.3 million and $2.1 million for fiscal 2011, 2010 and 2009 and the first quarter of fiscal 2012, respectively. We also recognized stock based compensation expense related to restricted stock units of $89,000, $178,000, $289,000 and $10,000 for fiscal 2011, 2010 and 2009 and the first quarter of fiscal 2012, respectively. As of April 1, 2012, our total amount of unamortized stock based compensation was $10.6 million. This expense will be recognized over the remaining weighted average vesting period of these securities of 1.3 years.

If different assumptions are used, stock based compensation expense may differ significantly from what we have recorded in the past. If there is a difference between the assumptions used in determining stock based compensation expense and the actual factors which become known over time, we may change the input factors used in determining stock based compensation costs for future grants. Any such changes may materially impact our results of operations in the period such changes are made. We expect to continue to grant stock options in the future, and to the extent that we do, our actual stock based compensation expense recognized in future periods will likely increase.

We have historically granted stock options with exercise prices equal to the fair value of our common stock as determined by our Board of Directors, based in part on valuation studies performed by an independent third party valuation firm. In determining its valuation analysis, the valuation firm engaged in discussions with management, analyzed our historical and forecasted financial performance, reviewed our corporate documents and considered a number of objective and subjective factors, including trends in our industry and the lack of liquidity of our capital stock. The valuation firm established an enterprise value using generally accepted valuation methodologies, including discounted cash flow analysis, comparable public company analysis and, when data deemed relevant was available, comparable acquisitions analysis. These methodologies are discussed in greater detail below. Total equity value was determined by adding cash and deducting debt from the enterprise value. The equity value was allocated among the securities that comprise the capital structure using an option-pricing method, which takes into account the liquidity preference of our class C common stock and the rights of holders

 

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of our class B common stock and class C common stock to convert their shares into common stock upon an initial public offering. The option-pricing method also considers volatility, term and risk-free interest rate inputs. The term input was established based on management’s expectations of a liquidity event and the risk-free interest rate corresponds to the term. The volatility of our equity was estimated by examining the standard deviation of publicly traded companies that were deemed to be comparable. Had different estimates of volatility been used, the allocations among the classes of securities that comprise our capital structure would have been different and would have resulted in different valuations. In allocating equity value among the securities that comprise our capital structure, the valuation firm also applied discounts for non-voting shares and lack of marketability.

The discounted cash flow analysis used in determining our enterprise value was based on the estimated present value of future cash flows our business is expected to generate over a forecasted period and an estimate of the present value of cash flows beyond that period, which is known as the terminal value. The terminal value was determined by applying an EBITDA multiple range based on a review of the multiples calculated in the comparable public company analysis and comparable acquisition analysis, as described below. The estimated present value was calculated using a discount rate based on our estimated weighted average cost of capital, which accounts for the time value of money and the degree of risks inherent in our business.

The comparable public company analysis used in determining our enterprise value involved analyzing transaction and financial data of publicly-traded companies to develop multiples of financial metrics. The valuation firm then applied these multiples to our own financial metrics to develop an indication of our enterprise value. The multiples that were used to value FMIC were (i) enterprise value for the latest twelve-month period and estimated enterprise value for the current and subsequent fiscal years, to (ii) EBITDA. Comparable companies were selected based on a number of criteria, including the comparability of their operations, size and growth prospects to ours. The valuation firm considered peer companies in the musical instruments industry, as well as companies that are associated with lifestyle brands.

The valuation firm also used, when appropriate, a comparable acquisition analysis to determine our enterprise value, which involved analyzing sales of controlling interests in comparable companies in the musical instruments industry. For comparable transactions, the valuation firm calculated multiples of the latest-twelve-month enterprise value to EBITDA.

Valuations of our common stock were performed as of April 1, 2012, January 1, 2012, June 1, 2011, January 2, 2011, January 3, 2010 and December 28, 2008. The following table summarizes, by grant date, the number of stock options, restricted stock units and shares of restricted stock granted since January 1, 2009, and the associated per share exercise price, which was not less than the estimated fair value of our common stock for each of these grants.

 

   
Grant date    Type of award
granted
   Number of
awards granted
    

Exercise price

per share of
common
stock

     Estimated fair value
per share of
common stock
 

 

 

June 17, 2009

   stock options      30,380       $ 6.40 to $8.63       $ 6.40   

May 5, 2010

   restricted stock units      29,400         7.20         7.20   

August 1,2010

   stock options      380,436         7.20         7.20   

June 9, 2011

   stock options      2,095,044         10.07         10.07   

August 15, 2011

   stock options      982,450         10.07         10.07   

October 3, 2011

   stock options      49,000         10.07         10.07   

June 13, 2012

   restricted stock      49,000         14.11         14.11   

 

 

 

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In determining the estimated fair value of our common stock for stock options and RSUs granted on May 5, 2010, and August 1, 2010, our Board of Directors considered, in part, a valuation performed by the independent third party valuation firm as of January 3, 2010. The valuation performed as of January 3, 2010 used a discount rate of 16.0% and an EBITDA multiple range of 8.5x to 9.5x, compared to a discount rate of 14.0% and an EBITDA multiple range of 7.0x to 8.0x for the valuation performed as of December 28, 2008. The discount rate increased due to a higher equity weight in the weighted average cost of capital and higher risk-free rate. The EBITDA multiple range increase reflected improvements in comparable companies’ prices and the overall stock market. A discount for lack of marketability of 26.2% was used for the valuation performed as of January 3, 2010, compared to 26.5% for the valuation performed as of December 28, 2008. The increase in the estimated fair value per share of common stock from June 2009 to May 2010 was primarily due to an increase in our cash balance and a decrease in our debt balance, both of which directly increased our equity value. The higher cash and lower debt balances more than offset a decline in enterprise value that resulted from weaker historical performance and a decline in forecasted financial performance.

In determining the estimated fair value per share of our common stock granted on June 9, 2011, August 15, 2011, and October 3, 2011, our Board of Directors considered, in part, a valuation performed by the independent third party valuation firm as of June 1, 2011. The valuation performed as of June 1, 2011 used a discount rate of 17.0% and an EBITDA multiple range of 9.5x to 10.5x, compared to a discount rate of 16.0% and an EBITDA multiple range of 8.5x to 9.5x for the valuation performed as of January 3, 2010. The discount rate increased due to a higher equity risk premium. The EBITDA multiple range increase reflected improvements in comparable companies’ prices and the overall stock market. A discount for lack of marketability of 15.7% was used for the valuation performed as of June 1, 2011, compared to 26.2% for the valuation performed as of January 3, 2010. The lower discount for lack of marketability resulted from a shorter expected holding period. The increase in the estimated fair value per share of common stock from August 2010 to June 2011 was primarily due to an increase in our enterprise value attributable to stronger forecasts and improved historical performance. The estimated fair value per share was also favorably impacted by a shorter expected holding period of our equity, which resulted in a lower discount for lack of marketability. The discounted cash flow analysis indicated an increase in enterprise value due to higher revenue growth projections, offset in part by a slight increase in the discount rate due to a higher equity risk premium. The comparable public company analysis indicated an increase in enterprise value due to an increase in the forecast multiples of our musical instruments industry peers and lifestyle brand peers, and higher EBITDA performance for comparable companies for both the historical and forecast periods. The comparable acquisitions analysis was considered for this valuation but not utilized due to the lack of transactions in the musical instruments industry since 2007.

In determining the estimated fair value per share of our common stock for restricted stock granted on June 13, 2012, our Board of Directors considered, in part, a valuation performed by the independent third party valuation firm as of April 1, 2012. The valuation performed as of April 1, 2012, used a discount rate of 17.0% and an EBITDA multiple range of 9.5x to 10.5x, which were the same as the discount rate and EBITDA multiple range used in the valuation performed as of June 1, 2011. A discount for lack of marketability of 7.0% was used for the valuation performed as of April 1, 2012, compared to a discount for lack of marketability of 15.7% for the valuation performed as of June 1, 2011. The lower discount for lack of marketability resulted from a shorter expected holding period. The increase in the estimated fair value per share of common stock from October 2011 to June 2012 was due to an increase in our enterprise value

 

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attributable to favorable time value effect in the discounted cash flow analysis and higher market multiples, as well as an increase in our cash balance and a decrease in our debt balance. The estimated fair value per share was also favorably impacted by the lower discount for lack of marketability.

As of April 1, 2012, we had outstanding options to purchase 6,609,708 shares of common stock at a weighted average exercise price of $9.72 per share, of which 3,086,510 represented vested options to purchase shares with a weighted average exercise price of $9.49 per share.

Contractual obligations and commitments

The following table summarizes our contractual obligations as of January 1, 2012, and the effect such obligations will have on our liquidity and cash flows in future periods.

 

    

Payments due by period

(in thousands)

   Total      Less than one
year
     1 – 3
years
     3 – 5 years      More than 5
years
 

 

 

Principal repayment

   $ 246,205       $ 6,607       $ 239,598       $       $   

Interest payment (1)

     15,138         5,773         9,365                   

Capital lease obligations

     1,370         728         566         76           

Operating lease obligations

     63,505         11,638         18,369         15,543         17,955   

Royalty agreements (2)

     1,500         1,500                           

Purchase commitments (3)

     10,100         10,100                           
  

 

 

 

Total contractual obligations

   $ 337,818       $ 36,346       $ 267,898       $ 15,619       $ 17,955   
  

 

 

 

 

 

 

(1)   These amounts are an estimate of future interest payments due on our long-term debt outstanding as of January 1, 2012, based on the interest rate in effect as of such date.

 

(2)   Represents required contractual minimums related to a royalty contract with a third party. We have several artist royalty arrangements that require us to pay the artists primarily based upon sales volumes; however, none of these arrangements have contractual minimums.

 

(3)   Represents a purchase commitment with a supplier of percussion accessories.

Off-balance sheet arrangements

We have no material off-balance sheet arrangements.

Inflation

Historically, inflation has not had a material effect on our results of operations. However, significant increases in inflation, particularly those related to wages in Asian labor markets and the cost of raw materials, could have an adverse impact on our business, financial condition and results of operations.

Quantitative and qualitative disclosures about market risk

Foreign exchange risk

We sell our products internationally and in most markets those sales are made in the foreign country’s local currency. In addition, while our expenses are primarily in U.S. dollars, we incur certain manufacturing costs and purchase certain finished goods in foreign currencies. As a result of these exposures, our earnings can be affected by fluctuations in the value of the U.S. dollar

 

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relative to foreign currency. Our most significant foreign currency risk relates to the Euro, the British Pound, the Japanese Yen, the Canadian Dollar and the Mexican Peso. We utilize foreign currency derivatives contracts to mitigate the effect of the Euro, the British Pound, the Japanese Yen, the Canadian Dollar and the Mexican Peso fluctuations on earnings. All hedging transactions are authorized and executed pursuant to regularly-reviewed policies and procedures, which prohibit the use of financial instruments for speculative trading purposes. The foreign currency derivatives contracts are entered into with banks and allow us to exchange a specified amount of foreign currency for U.S. dollars at a future date, based on a fixed exchange rate. At April 1, 2012, the notional U.S. dollar value of outstanding Euro, British Pound, Japanese Yen, Canadian Dollar and Mexican Peso foreign currency derivatives contracts was approximately $178.5 million. We estimate that a uniform 10% weakening in the value of the U.S. dollar relative to the currencies underlying these contracts would result in a decrease in the fair value of the contracts of approximately $12.3 million as of April 1, 2012.

Interest rate risk

We are subject to interest rate risk in connection with our long-term debt. As of April 1, 2012, our outstanding debt balance consisted of $241.8 million due on our Term Loan and $14.0 million due on our Amended Revolver. We estimate that a 100 basis point increase in the interest rate on our long-term debt would have increased our interest expense by approximately $1.0 million for fiscal 2011. The balance of our long-term debt at April 1, 2012, is not indicative of future balances that may be subject to fluctuations in interest rates.

Recent accounting pronouncements

In May 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-04, “Amendments to Achieve Common Fair value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU 2011-04 provides additional guidance on fair value measurements that clarifies the application of existing guidance and disclosure requirements, changes certain fair value measurement principles and requires additional disclosures about fair value measurements. The updated guidance is effective on a prospective basis for our interim and annual periods beginning after December 15, 2011. The adoption of this standard did not have a material impact on our consolidated financial position or results of operations.

In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income.” ASU 2011-05 requires the components of net income and other comprehensive income to be either presented in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive statements. An entity is also required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statements where the components of net income and the components of other comprehensive income are presented. While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance. This new guidance is effective for us beginning December 31, 2012, and requires retrospective application. As this guidance only amends the presentation of the components of comprehensive income, the adoption will not have an impact on our consolidated financial position or results of operations.

 

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In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment.” ASU 2011-08 allows entities testing goodwill for impairment the option of performing a qualitative assessment to determine the likelihood of goodwill impairment and whether it is necessary to perform the two-step impairment test currently required. The updated guidance is effective for our interim and annual periods beginning after December 15, 2011; however, early adoption is permitted. The adoption of this standard did not have a material impact on our consolidated financial position or results of operations.

We qualify as an “emerging growth company” pursuant to the provisions of the JOBS Act, enacted on April 5, 2012. The JOBS Act provides that an “emerging growth company” can utilize the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. However, we are choosing to “opt out” of that extended transition period, and, as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for companies that are not “emerging growth companies.” Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

 

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Business

Overview

We are a leading, global musical instruments company whose portfolio of music lifestyle brands brings the passion of music to life. Since the founding of our predecessor company by Leo Fender in 1946, we have built a comprehensive portfolio of brands led by the iconic Fender brand and other brands such as Squier, Jackson, Guild, Ovation and Latin Percussion, which we own, and Gretsch, EVH (Eddie Van Halen) and Takamine, for which we are the licensee. We believe that the Fender brand in particular is closely associated with the birth of rock ‘n roll and has a strong legacy in music and in popular culture. We believe our brands benefit from the fact that numerous current and historical musicians and groups use or have used our products, including:

 

• Avril Lavigne

 

• John Mayer

• Brad Paisley

 

• Kurt Cobain/Nirvana

• Brian Setzer

 

• Marcus Miller

• Bruno Mars

 

• Mark Morton

• Buddy Holly

 

• Melissa Etheridge

• The Eagles

 

• Merle Haggard

• Eddie Van Halen

 

• Randy Rhoads

• Eric Clapton

 

• Sheryl Crow

• Green Day

 

• Stevie Ray Vaughan

• Iron Maiden

 

• Sting

• Jeff Beck

 

• The Strokes

• Jimi Hendrix

 

• The Who

We generally provide one or two free instruments to musicians with whom we have relationships, including the musicians whose names are listed above and whose images are included in this prospectus, at the beginning of the relationship, followed by limited opportunities for the musicians to purchase products from us at a discount of 50% off of the manufacturer suggested retail price, or MSRP. These arrangements typically result in musicians receiving one or two discounted products per year, and do not apply to our Custom Shop instruments.

While a number of our brands, including Fender, have broad appeal, other brands in our portfolio offer products with distinct sounds or styles targeted at musicians in particular genres, including rock ‘n roll, country, jazz, heavy metal, blues and world music.

Our broad product portfolio includes fretted instruments (comprised of electric, acoustic and bass guitars, banjos, ukuleles, mandolins and resonator guitars), guitar amplifiers, percussion instruments and accessories. We believe our guitars and guitar amplifiers, including the iconic Stratocaster guitar, the Telecaster guitar, the Precision Bass and Jazz Bass guitars and the Fender Bassman and Twin Reverb guitar amplifiers, revolutionized the way music is written, played and heard. We design and market our products to a variety of musicians from beginners to professionals across a broad range of prices.

 

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In 2011, we had the #1 market share by revenue in the United States in electric, acoustic and bass guitars and electric and bass guitar amplifiers, according to data provided by MI Sales Trak as of December 2011. In addition, since the acquisition of Kaman Music Corporation (now known as KMC Musicorp), or KMC, in 2007, we believe we have been one of the largest independent distributors of musical instrument accessories in the United States. To support our brands and product leadership, we continue to bring new and innovative products to market that inspire our consumers and enhance brand loyalty.

We distribute our products globally in over 85 countries through what we believe to be one of the largest direct-to-retail sales forces in the musical instruments industry in the United States, Canada, Europe and Mexico, as well as through a network of distributors in selected international markets. We sell our products through independent and national music retailers, mass merchants, online and catalog retailers and third party distributors. In fiscal 2011, we generated 58.7% of our gross sales before discounts and allowances from the independent channel (representing over 13,000 independently owned music stores), 23.5% collectively from the national channel, mass merchants and online and catalog retailers and 17.8% from third party distributors. Gross sales before discounts and allowances is comprised of product sales but, unlike net sales, does not include licensing income and dealer freight collection, and is not net of cash discounts, sales return allowances and rebates.

Our strategically managed global supply chain is comprised of a network of our own manufacturing facilities in the United States and Mexico, distribution and warehouse facilities in North America (the United States and Canada) and Europe, and established sourcing relationships with OEMs and suppliers in Asia, Europe, North America and Mexico. We primarily manufacture our products that are sold at higher price points in the United States.

Our brand portfolio, broad selection of quality products, longstanding culture of ongoing innovation and new product development, global supply chain and distribution network and strong consumer loyalty have been key drivers of our financial performance. Our net sales were $612.5 million in fiscal 2009, $617.8 million in fiscal 2010 and $700.6 million in fiscal 2011; our net income was $10.8 million in fiscal 2009, a net loss of $1.7 million in fiscal 2010 and net income of $19.0 million in fiscal 2011; and our adjusted EBITDA was $43.8 million in fiscal 2009, $23.6 million in fiscal 2010 and $52.9 million in fiscal 2011. For the first quarter of fiscal 2012, our net sales were $173.8 million, our net income was $1.9 million and our adjusted EBITDA was $10.7 million, compared to net sales of $170.1 million, net income of $6.9 million and adjusted EBITDA of $11.6 million for the first quarter of fiscal 2011. See “Summary consolidated financial data—Non-GAAP financial measures” for the definition of adjusted EBITDA and a reconciliation from net income (loss) to adjusted EBITDA.

Our history

After producing his first amplifier in 1945, Leo Fender founded Fender Electric Instrument Company in 1946 in Fullerton, California. In 1951, he introduced the Telecaster, the first single-cut, solid-body guitar to be mass produced and the Precision Bass, which we believe was the first commercially successful electric bass guitar. These initial products combined simplicity and technology with manufacturing techniques that we believe transformed the solid body electric guitars and bass guitars into commercially viable products. In 1952, Leo Fender introduced the Fender Bassman, one of our flagship guitar amplifiers, and in 1954, Mr. Fender introduced the now iconic Stratocaster guitar. The Fender Stratocaster was the only instrument named as an “American Icon” in the 35th Anniversary issue of Rolling Stone magazine published in May 2003.

 

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In 1965, Leo Fender sold Fender Electric Instrument Company to Columbia Records Distribution Corp., a division of Columbia Broadcasting System, Inc., or CBS. The business reemerged as a stand-alone company when the late William Schultz and current Board member, William (“Bill”) Mendello, formed Fender Musical Instruments Corporation to purchase the business from CBS in 1985. Under the leadership of William Schultz, Bill Mendello and current Chief Executive Officer, Larry Thomas, we have grown to become a global leader in the musical instruments industry. Since 1985, we have rebuilt our infrastructure, augmented our brands and product offerings and expanded the reach of our products, both domestically and internationally.

Market opportunity

We operate in the global musical instruments and accessories industry, which generated approximately $15.8 billion in global retail sales and $6.4 billion in U.S. retail sales in 2010, according to the December 2011 edition of Music Trades magazine. The musical instruments and accessories industry generated approximately $6.6 billion in U.S. retail sales in 2011, according to the April 2012 edition of Music Trades magazine. The categories of our retail musical products, including fretted instruments, instrument amplifiers, percussion products and general accessories, generated an estimated $5.0 billion in U.S retail sales in 2011, according to the April 2012 edition of Music Trades magazine.

The following chart illustrates U.S. retail sales by product type in 2011, according to the April 2012 edition of Music Trades magazine.

 

LOGO

 

1   Even though we participate in this segment, we have not historically generated significant net sales from pro audio products. Pro audio products include speaker enclosures, mixers, microphones and cables.

 

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We believe opportunities for sales growth are supported by several long-term trends that we think will increase consumer demand for our products, including:

 

 

Popular culture:    We believe that the musical instruments industry generally, and the fretted instruments market in particular, benefits from the continuing popularity of guitar-based music and bands, as well as the visibility of guitars in other areas of popular culture such as video games, television shows and movies.

 

 

Accessibility of musical instruments:    Improvements in manufacturing techniques and an increase in non-domestic production result in high-quality instruments at relatively low retail prices, which provide an affordable entry point for new potential players, particularly from younger generations, and better enable musicians to upgrade their instruments and/or purchase multiple instruments.

 

 

Changing technology:    Technological advancements in computing, portable media devices and social media enhance a consumer’s ability to access, learn, create, personalize and distribute music while integrating it into everyday life.

 

 

Opportunities for growth in emerging markets:    The musical styles in some large, emerging global markets like China and India have not traditionally incorporated the guitar. We believe that guitar-based music will gradually increase in popularity in these emerging markets and help drive demand for our products.

 

 

Music education:    We believe the availability of guitar-based music education programs, including software- and internet-based lesson programs, and alternative music education programs such as “Kids Rock Free,” “Little Kids Rock” and others supported by the Fender Music Foundation (a charitable foundation that is not affiliated with us) have increased. We believe that interest in music education programs in schools and these alternative sources will continue, and that these programs will continue to receive support due to the important role of music in childhood development.

We cannot be certain, however, whether or when these market and industry trends will increase the demand for, or sales of, our products.

The musical instruments industry is highly fragmented and is served by a variety of companies, including independent instrument makers, large multinational corporations, technology-based electronics manufacturers and print publishers. To the extent that there is future industry consolidation, we believe that our previous experience with acquisitions and partnerships will enhance our ability to make strategic acquisitions and enter into strategic partnerships as opportunities arise.

Our competitive strengths

Portfolio of lifestyle brands and associations with leading musicians

We have a portfolio of some of the most recognized global music lifestyle brands and products. In addition to the iconic Fender brand, our comprehensive brand portfolio includes brands such as Squier, Gretsch, Jackson, Charvel, EVH, Starcaster, Hamer, Guild, Ovation, Takamine, SWR, Genz Benz, Latin Percussion, Toca, Gibraltar, Sabian and Groove Tubes that we have developed, acquired or licensed, or for which we are the exclusive distributor in select territories. With this portfolio, we believe we are well-positioned to address different consumer segments through

 

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brands such as Fender that have broad appeal, and other brands that offer products with distinct sounds or styles that are important in specific genres of music, and products at a range of price points. Our brands are used by many of the world’s best known musicians and groups, both current and historical. We believe that the use of our products by these professional musicians, whose popularity and actions often influence consumers, results in consumers aspiring to own our products and inspires them to create their own music using our products. We collaborate with many of these famous musicians through our Signature Artist Program, in which these musicians provide specifications for instruments bearing their signatures and endorse their signature instruments, which are then marketed and sold to our customers. We also have a dedicated Artist Relations group that works closely with professional musicians to meet their musical instrument needs, including through custom made products.

Industry leader with broad product portfolio

In 2011, we had the #1 market share by revenue in electric, acoustic and bass guitars and electric and bass guitar amplifiers according to data provided by MI Sales Trak as of December 2011, and were the leading U.S.-based supplier to the overall musical instruments industry, according to the April 2012 edition of Music Trades magazine. In fiscal 2011, fretted instruments, guitar amplifiers, percussion products, and accessories and other products represented 59.9%, 12.1%, 9.1% and 18.9%, respectively, of our gross sales before discounts and allowances. We believe the broad and diversified range of products in our portfolio helps to mitigate the impact of economic cycles, as sales of some product categories are less affected than others by economic downturns. We have expanded our product portfolio through a combination of innovation, strategic acquisitions and licensing arrangements. We believe that our range of brands and products positions us to be a strategic and reliable supplier to our retail partners and consumers.

Heritage of innovation and new product introductions

We began a tradition of innovation over 60 years ago, which we believe has had a profound influence on the music industry, with:

 

 

The Telecaster Guitar (1951), the first single-cut, solid-body guitar to be mass produced;

 

 

The Precision Bass Guitar (1951), which we believe was the first commercially successful electric bass guitar and a key enabler of rock ‘n roll music;

 

 

The Fender Bassman Amplifier (1952), originally introduced as a bass amplifier for the Precision Bass, this product became a leading amplifier for guitar players in a variety of music genres;

 

 

The Stratocaster Guitar (1954), combined enhanced sonic versatility with bold visual design and became one of the most recognized and iconic instruments in many musical styles;

 

 

The Jazz Bass Guitar (1960), provided a collection of player-centric innovations, which we believe inspired electric bassists to create bold new tones and more sophisticated playing techniques;

 

 

The Deluxe Reverb Amplifier (1963), delivered a mix of features and power for rehearsal, small club performances and recording; and

 

 

The Twin Reverb Amplifier (1965), incorporated innovative electronic design to meet the needs of professional musicians of the day.

 

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These products remain some of our best-selling products today. Our ability to develop and introduce innovative products and features has continued with:

 

 

The Fretless Precision Bass (1970), allowed bass players to achieve sounds similar to the acoustic stand-up bass;

 

 

The 5-Way Pickup Selector Switch for Stratocaster (1977), allowed easy access to two additional in-between tones by combining pickups on the Stratocaster guitar;

 

 

The American Standard Stratocaster (1986), featured a classic appearance with modern features, and demonstrated improved manufacturing capability;

 

 

The Cyber-Twin Amplifier (2001), featured a combination of tube, solid-state and digital processing for enhanced levels of musical performance and was named the Music Sound Retailer Product of the Year in 2002;

 

 

The G-DEC Amplifier (2006), named the Music Trades Product of the Year in 2006, was the first guitar amplifier to include a virtual “back-up band” with synthesized drums, bass and other instruments;

 

 

The Mustang Amplifier (2010), included USB connectivity for high-quality, low-latency audio output as well as the Fender FUSE application for the PC and MAC, which lets musicians connect to an online community where they can play, edit and share their own music;

 

 

The Squier Stratocaster Guitar and Controller (2011), the world’s first real guitar that works with the Rock Band 3 video game and any musical instrument digital interface, or MIDI, device; and

 

 

The Fender Select Guitar (2012), launched this year and positioned just below our top-of-the-line Custom Shop products, is artfully constructed of luthier-selected choice tonewoods and handcrafted finishes, combining high-quality materials and player-centric features.

In addition, we often collaborate with leading artists through our Signature Artist Program and incorporate their ideas into our designs. Our Custom Shop, where we design and build custom and limited edition electric and bass guitars, also serves as a laboratory for the generation of ideas that can be more widely incorporated in our products.

Leading global footprint

We have developed global design, production and distribution capabilities and longstanding customer relationships that we believe would be difficult to replicate. We believe the scale and quality of our direct-to-retail sales force and distributor network enhance the loyalty of our retail partners and position us to become an increasingly important manufacturer and supplier in the industry. By facilitating a positive in-store experience at our retail partners and providing a variety of customer service programs, we believe we further enhance our brands and build consumer loyalty. Our manufacturing platform provides scalability and volume flexibility as we have a balanced mix of products manufactured internally and sourced externally. This infrastructure allows us to rapidly respond to the changing needs of consumers in our key markets, while maintaining the quality of our products.

 

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Experienced senior management team and skilled workforce

We have assembled an experienced senior management team led by Larry Thomas, our Chief Executive Officer. Complementing Mr. Thomas are James Broenen, our Chief Financial Officer and Corporate Treasurer, and Mark Van Vleet, our Chief Legal Officer, Corporate Secretary and Senior Vice President of Business Development, who have joined our company in the past five and ten years, respectively, as well as Edward Miller, President of KMC, who has been affiliated with KMC since 1972, Gordon Raison, our Managing Director of Europe, who has been with our company for five years, and Andrew Rossi, our Senior Vice President of Global Sales, who has been with our company for 20 years. Our senior management team brings together a deep knowledge of our industry, products, mission and culture, and an execution-oriented operating philosophy that are critical to our success. This extensive experience goes beyond senior management and deep into the organization. We believe that our company culture and the strength of our brands enable us to attract and retain highly talented employees who share our passion for music and interact with our retail partners and consumers in an authentic and credible way.

Our strategy

Increase awareness and consumer loyalty as lifestyle brands

We intend to continue to develop our brands as lifestyle brands by:

 

 

Increasing brand presence outside of our normal retail channels, such as at global music festivals, where consumers can directly interact with our products.

 

 

Increasing our social media presence through tools such as Facebook and Twitter, and engaging directly with consumers through online lifestyle communities focused on artist-driven music content.

 

 

Using targeted segmentation and enhanced web-based profile tools and analytics to tailor marketing communications to our consumers to cultivate the aspirational lifestyle images of our brands and develop products to meet specific consumer preferences. For example, based on our analysis of historical consumer click patterns in prior e-mail messaging, we are now able to tailor marketing communications to individual consumers based on those patterns.

 

 

Applying the marketing and branding strategies that have been successful with our Fender brand to our other brands that we believe have potential to generate additional revenue and increase market share, including Gretsch, Jackson, Charvel and EVH. For example, we are promoting Gretsch at several music festivals such as the Lake Havasu Rockabilly Festival. In addition, in fiscal 2012, we intend to create a specialty sales force in North America to focus on selling our non-Fender branded instruments and accessories. We cannot be certain, however, whether or when our marketing and branding strategies will generate additional revenue or increase market share.

 

 

In fiscal 2011, we established the Fender Visitor Center which features historic displays as well as a showroom featuring product offerings and sales of apparel, accessories, guitars and guitar amplifiers.

 

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Expand our product offering through continued innovation

We intend to continue our tradition of innovation to bring new products and features to consumers, while maintaining the standards of quality with which our brands are associated. Over the last two years we have increased the pace at which we bring new products to market through more robust innovation processes and have expanded the breadth of new products introduced. A recent example is our Fender Select line of hand-crafted production guitars, which we introduced in January 2012 and which utilize premium materials and are priced at a higher price point than our standard line of Fender guitars. These new product releases can produce additional revenue streams, as well as provide us with an opportunity to update and refresh our existing product lines. We believe that new product releases also create an aspirational desire for consumers to upgrade and purchase new products. We cannot be certain, however, whether or when our new product releases will produce additional revenue streams.

Accelerate our international growth

We intend to extend our reach to a broader global consumer base that might not otherwise be exposed to our products. In fiscal 2011 and the first quarter of fiscal 2012, net sales outside of the United States constituted approximately 46.7% and 43.4% of our net sales, respectively. Over the past 10 years, we have experienced international sales growth as we have entered new markets and introduced additional products into established international markets. Our gross sales before discounts and allowances in markets outside of the United States grew from $81.5 million in fiscal 2001 to $329.7 million in fiscal 2011. We believe that international markets will provide growth opportunities in the near to intermediate term. We have a three-pronged strategy related to growing internationally: expanding our reach into countries where we have not historically focused our sales efforts; increasing sales of our KMC products outside the United States, where KMC has not historically had a significant presence; and implementing and growing a direct-to-retail channel model internationally in markets where we already have a presence and in which we believe we have an opportunity for additional growth. We cannot be certain, however, whether or when these market and industry trends will increase the demand for, or sales of, our products.

Expand our licensing and co-branding activities

We believe licensing our trademarks such as Fender and others builds brand awareness and furthers our strategy of reaching new consumers, while developing additional relationships with existing consumers through new products. We believe that these licensing agreements typically offer low investment costs and attractive margin opportunities without the risk of cannibalizing existing product sales. We believe we have a significant opportunity to expand this aspect of our business given that royalty income from licensing accounted for less than 1% of our net sales during fiscal 2011 and the first quarter of fiscal 2012. In addition, these activities provide us with a valuable source of advertising. We intend to expand beyond our existing licensed products to additional products in existing categories and new categories, including apparel, consumer electronics, mobile communication, home décor and bags and luggage. We have licensing agreements in place in all of these categories except bags and luggage. We also intend to further expand our licensing program to markets beyond the United States. In addition, we believe our non-revenue generating co-branding initiatives, such as those with Apple Inc., which used our intellectual property in a promotional campaign that featured the Amplitube Fender application

 

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for the iPhone, Hard Rock Cafe International, Inc. and SAP Global Marketing, Inc., which we authorized to use certain names, trademarks, products and logos in a campaign that highlighted well-known companies that utilize SAP’s enterprise software, position our products as lifestyle brands by leveraging our partners’ resources and consumer reach beyond the musical instruments industry.

Continue to be a partner of choice for strategic relationships

We believe that our experience in acquisitions and partnerships and our global scale enhance our ability to complete acquisitions and form strategic relationships within the musical instruments industry. We intend to build on our experience in acquisitions and strategic relationships by continuing to evaluate potential acquisition opportunities, license agreements, distribution arrangements and other strategic relationships. We evaluate these opportunities based on the potential to leverage our marketing, sales, distribution, sourcing and manufacturing capabilities to add value and contribute to growth with new brands and products. Over the last 15 years, we have executed a variety of acquisitions, including the acquisitions of Guild, Jackson, Charvel, SWR, Tacoma, KMC and Groove Tubes, and entering into manufacturing and/or distribution relationships with Gretsch, EVH and Sabian. We believe that our success with strategic relationships is due, in part, to our ability to work with family-owned companies to provide financial liquidity while also protecting the brand heritage and family name, such as in our licensing agreement with Gretsch Guitars, a 129-year-old family-owned company, for its guitars and drums. In other instances, we have been able to structure arrangements with companies that seek to leverage our broad distribution network. We also are the exclusive U.S. distributor for Sabian and the distributor in the United States and in select other countries for Takamine.

Promote operational efficiencies

We intend to continue to drive operational efficiencies to improve our operating margin while maintaining or enhancing the quality of our products. In addition, we intend to continue investing in manufacturing technologies, such as robotic painting, to improve product quality, increase capacity and lower cost. We also plan to improve our wood storage, climate control and wood grading practices and expand our capability to manufacture the raw pieces of wood used in the manufacture of guitars. We continually evaluate shifting additional production to manufacturing facilities with lower or more stable costs. For example, our Ensenada, Mexico manufacturing facility provides us with products at stable, relatively low costs, and we intend to explore opportunities to move additional production to that facility.

 

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Our brands and products

Brands

We market products under a broad portfolio of brands, which we believe appeals to all levels of musicians, from beginners to professional musicians and enthusiasts, and reaches across music styles and genres, including rock ‘n roll, country, jazz, punk, heavy metal, blues and world music. We indicate in the table below those brands that we own. We market the remaining brands through licensing and other agreements with third parties pursuant to which we act as manufacturer, sales representative and/or exclusive distributor in selected geographic territories.

 

Brand   Owned   Description   Fretted
instruments
    Guitar
amplifiers
    Percussion   Accessories
/ other
 

 

 
LOGO   ü  

•Our iconic brand, associated with all musical genres and serving beginners through elite professional players

    ü        ü            ü   
LOGO   ü  

•Entry-to-mid level extension of the Fender line of instruments

    ü        ü            ü   
LOGO      

•A classic American brand founded in 1883, known for electric guitars and drums

    ü        ü      ü     ü   
LOGO   ü  

•Guitars known for their aggressive styling favored by many heavy-metal guitarists around the world

    ü                    ü   
LOGO   ü  

•Customized versions of traditional guitar designs favored by many rock guitarists for their quality, visual appeal and ease of playing

    ü                       
LOGO      

• Designed to Eddie Van Halen’s exacting specifications and used by musicians in a variety of genres

  ü        ü            ü     

 

 

 

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Brand   Owned   Description   Fretted
instruments
    Guitar
amplifiers
    Percussion   Accessories
/ other
 

 

 
LOGO   ü  

• Sold through KMC, the Starcaster by Fender brand generally targets new musicians

  ü        ü            ü     
LOGO   ü  

• Offers consumers alternatives to traditional guitar designs

  ü                         
LOGO   ü  

• One of the original American acoustic guitars, recognized for its quality craftsmanship, durability and classic sound

  ü                    ü     
LOGO   ü  

• The first modern acoustic/electric guitars, famous for their roundback design, high-tech components and electronic systems

  ü                    ü     
LOGO      

• An early innovator in flat-back guitars and in acoustic/electric models, having pioneered embedded preamp technology

  ü                    ü     
LOGO   ü  

• Offers bass and acoustic guitar amplifiers targeted at the professional market

          ü                 

 

 

 

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Brand   Owned   Description   Fretted
instruments
  Guitar
amplifiers
    Percussion     Accessories
/ other
 

 

 
LOGO   ü  

• Offers a range of acoustic and bass amplifiers targeted at music professionals

      ü                     
LOGO   ü  

• A brand of choice among many hand-percussion musicians across the world

              ü        ü     
LOGO   ü  

• Popular among consumers ranging from beginners to professionals performing Latin, African and Middle Eastern music

              ü        ü     
LOGO   ü  

• Offers hardware solutions for drums and percussion set-ups, supporting many brands of drums

              ü        ü     
LOGO      

• One of the world’s largest cymbal designers and manufacturers offering products for musicians of skill levels from beginners to professionals

              ü        ü     
LOGO   ü  

• A brand of replacement vacuum tubes for all applications in musical instrument amplifiers

        ü     

 

 

We became affiliated with many of the brands listed above through acquisitions and other strategic relationships. For more than 15 years, our management team has demonstrated the ability to execute these transactions and integrate these new brands into our U.S. and international operations. Examples of our acquisitions include Guild in 1995, Jackson and Charvel in 2002, SWR in 2003, Tacoma in 2004 and Groove Tubes in 2008. In December 2007, we acquired KMC, through which we gained ownership of, or distribution rights for, over 100 brands, including the Ovation, Latin Percussion, Toca, Gibraltar, Genz Benz and Hamer brands, which we own, and Sabian, Gretsch drums and Takamine, for which we act as distributor. This acquisition, our single largest, enabled us to significantly expand our product offerings, particularly in percussion and accessories. Since this acquisition, we believe we have been one of the largest independent distributors of musical instrument accessories in the United States.

 

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Our products

Our products fall into four major categories.

 

 

Fretted instruments:    This category consists of electric, acoustic and bass guitars, as well as banjos, ukuleles, mandolins and resonator guitars. The fretted instrument brands we own include Fender, Squier, Jackson, Charvel, Guild, Tacoma, Ovation, Hamer and Starcaster. We also control worldwide production, marketing and distribution of Gretsch and EVH guitars, and distribute Takamine guitars in the United States, Europe, Latin America and parts of Africa. Our flagship guitars include the iconic Telecaster, Stratocaster, Precision Bass and Jazz Bass models and the popular Jazzmaster, Jaguar and Mustang models. Our fretted instruments have MSRPs that typically range from $99 for entry-level models to $3,000 for intermediate to professional models. In addition, we offer electric guitars and basses produced in our Custom Shop that are targeted towards professional musicians and affluent players and collectors and have MSRPs ranging from $3,750 to $24,000 for high-end limited edition guitars. We also periodically produce one-of-a-kind guitars that can, on rare occasions, sell for a retail price of as much as $90,000.

 

 

Guitar amplifiers:    This category includes our Fender, Squier, SWR and Genz Benz brands, which are designed for electric, acoustic and bass guitars, as well as EVH guitar amplifiers that are designed for electric guitars. Our flagship guitar amplifiers include the Fender Bassman, Fender Twin Reverb and Fender Deluxe Reverb. We are known for both our tube guitar amplifiers as well as our solid-state and digital guitar amplifiers. We offer a variety of guitar amplifiers that cover a wide range of styles and genres, including rock ‘n roll, blues, country and heavy metal. We also offer popular vintage reissue models, which recreate some of our most popular guitar amplifiers from the 1950s and 1960s. We license our guitar amplifier sounds in software form to third parties with whom we have licensing relationships.

 

 

Percussion:    We offer a wide variety of percussion products, including drum sets, hand percussion (such as congas and bongos), cymbals, educational percussion, drum sticks, drum heads, tambourines and percussion accessories. Our principal brands in this category are Latin Percussion, Toca and Gibraltar. We are also the exclusive U.S. distributor for Sabian Cymbals and the exclusive worldwide manufacturer and distributor for Gretsch drums.

 

 

Accessories/other:    Over time, we have expanded our product selection to include a wide variety of accessories, including strings, picks, pickups, pedals, cables, cases and straps, and have developed a business in replacement parts. We also offer a variety of other products, including pro audio products such as Passport Public Address (PA) products, educational musical instruments, including stringed instruments and band and orchestral accessories, drums and drum heads and lighting. We distribute, on an exclusive and non-exclusive basis, brands including Elixir strings, Remo drum heads, Hohner harmonicas, Dunlop products and Hercules music stands. In addition, through our website, we offer merchandise and products such as clothing and collectibles for several of our brands. Our licensees further sell other products that embody the Fender lifestyle, such as the Fender Premium Audio System, which is included in select Volkswagen vehicles globally.

 

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The table below sets forth the percentage of gross sales before discounts and allowances represented by our primary product categories in fiscal 2011:

 

Category    Products    % of gross
sales
before
discounts
and
allowances
 

 

 
Fretted instruments    LOGO      59.9
Guitar amplifiers    LOGO      12.1
Percussion    LOGO      9.1
Accessories/other    LOGO      18.9

 

 

Sales channels

We primarily sell our products through five sales channels—the independent channel, the national channel, the mass merchant channel, the online and catalog channel and the distributor channel.

 

 

Independent channel:    The independent channel is comprised of over 13,000 independently owned music stores that typically offer personalized customer service. We select these independent retailers based on location, expertise, commitment to the product line, financial

 

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integrity and other factors. We qualify each retail location separately, and retailers are approved to handle only those parts of our product lines that we believe they have demonstrated the expertise and ability to effectively market and sell. Some of our independent retailers are also authorized to sell our products on their websites. The independent channel is our largest channel in North America and Europe and is a smaller channel in our other international markets.

 

 

National channel:    The national channel is comprised of large, multi-unit musical instrument retailers such as Guitar Center and Sam Ash, who have nationwide store networks. These stores offer a variety of our products, providing consumers the opportunity to view large portions of our product lines, and must maintain an agreed-upon inventory of our products. The national channel is one of our largest channels in North America, and is a smaller channel for our international operations. Some of our national channel retailers are also authorized to sell our products on their websites. Our contracts with our national retailers are typically short term, can be terminated by either party on short notice and do not obligate the retailer to purchase fixed amounts of our products.

 

 

Mass merchant channel:    The mass merchant channel is comprised of large-format, multi-unit stores that purchase our products from us and then resell these products to consumers. Costco was our most significant mass merchant customer in fiscal 2011. Mass merchant stores offer us access to parts of the general population that we believe typically do not visit traditional music stores. We generally offer entry-level products that are branded solely for the mass merchant stores in this channel, which helps to introduce our brands to a potentially wider base of consumers. We believe we can instill brand loyalty in these consumers and benefit as they buy additional instruments and accessories or upgrade from their current instruments in the future. Our largest mass merchant customers are located in North America, with smaller mass merchant customers located in certain countries in Europe.

Contracts with our mass merchant customers are generally short term, may be terminated by either party on short notice and do not obligate our mass merchant customers to purchase a fixed amount of our products. Some of these contracts entitle our mass merchant customers to our most favorable prices, benefits or allowances that we offer to similarly-situated dealers.

 

 

Online and catalog channel:    We also sell some of our products to certain online, mail order, catalog and telesales companies, including Musician’s Friend, American Music Supply and Amazon. Our products are featured in both the online and catalog campaigns of most of these retailers and often are presented on the home page or front cover space resulting in nationwide exposure to consumers who seek out our products in these channels. In the United States, in addition to third party sites, such as Musician’s Friend, certain of our products are sold by independent dealers directly to consumers through websites they have developed. Although we market clothing and collectibles directly through the Fender.com website, we do not sell musical instruments through this website.

 

 

Distributor channel:    Within Asia, Latin America and certain other markets, we sell our products primarily through distributors who, in turn, sell to retailers within their authorized distribution area. Some of these distributors are the sole distributor of certain of our products and others are one of several non-exclusive distributors within their territory. Our largest markets that are covered by third party distributors are Japan, Australia and Italy. Our strategy in entering new international markets is to identify and partner with local distributors who understand the market and consumers. We continually monitor the markets in which we

 

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operate, and, when we believe a market opportunity to be of appropriate size, we evaluate whether to establish our own direct sales operations within that market.

Our contracts with our distributors generally prohibit them from selling competing products other than certain competing products authorized by us. The distribution agreements are generally short term, typically with durations of one year or less and terminable by either party on short notice. Two of our stockholders act as our distributors in Japan. See “Transactions with related persons.”

In fiscal 2011, we generated 58.7% of gross sales before discounts and allowances from the independent channel, 23.5% collectively from the national channel, mass merchants and online and catalog retailers and 17.8% from third party distributors.

Global brand management and sales forces

We recently realigned our brand management strategy and created five global brand management positions for Fender/Squier, Specialty Brands (Gretsch, Jackson, Charvel, EVH, SWR and Genz-Benz), Acoustic Guitars (Fender, Squier, Guild, Takamine and Ovation), Percussion (Gretsch, LP, Toca, Gibraltar and Sabian) and Accessories. These global brand managers manage their brands and products under their brands across all markets and channels.

Our sales efforts are focused on building close relationships with musical instrument distributors and retailers and educating their sales forces about our products. In addition, we maintain sales management and sales teams organized to focus on particular retail channels, which we believe enables them to create strong customer relationships in each channel.

 

 

Sales teams for the independent channel:    In the independent channel, we separate our sales force into distinct categories, each dedicated to a particular brand portfolio in order to help maintain focus on taking orders, building product knowledge, providing dealers with highly personalized service and support and maximizing the growth potential of our brands. We also maintain inside telesales groups to support our field sales forces, adding a secondary level of service for both dealers and our field staff. In addition, our sales force focuses on various online, mail order and catalog companies within our independent channel.

 

 

Sales teams for the national, mass merchant and online and catalog channels:    We support the national and mass merchant retailers with a sales management team dedicated solely to these channels and experienced in the business model of nationwide, multi-location retailers. This enables us to maintain close relationships with these retailers and to reduce channel conflict. In addition, our field staff infrastructure allows us to be involved with retailers in merchandising decisions, product training and inventory management, while also providing us with important market feedback. Our national accounts sales group also focuses on national online retailers such as Musician’s Friend to ensure appropriate merchandising and product presentation.

 

 

Sales teams for the distributor channel:    In certain markets such as Asia, Latin America, Australia, Russia and Italy, and others where we do not have direct offices, we maintain management and sales groups that work directly with the authorized distributors we have chosen to represent us in those markets. Our focus is to create close relationships with our distributors and work with them to provide product knowledge, marketing material, sales plans, product mix guidance and other assistance to help them increase sales of our products.

 

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Marketing and advertising

Our marketing and advertising programs are focused on enhancing relationships with consumers by increasing the exposure of our core brands to the population in general and reinforcing the positive lifestyle appeal of our brands. We also implement marketing and advertising programs relating to our specialty and niche brands targeted towards musicians active in the genres with which those brands are identified. Our marketing and advertising campaigns cover a wide variety of activities, including the Signature Artist Program, licensing and co-branding efforts, media advertising and our websites and other social media and consumer activation activities, such as hosting after-hours parties near the Lollapalooza music festival featuring bands and artists playing our products. We also conduct various promotions in cooperation with our retailers, including artist appearances, product education clinics and other special events. We provide point-of-purchase advertising materials, display and merchandising fixtures and other materials designed to highlight our products at the retail level.

Signature Artist Program and Artist Relations

Our Signature Artist Program is a key component of our marketing strategy. Through this program, over 100 famous musicians across a variety of popular music styles provide specifications for unique instruments bearing their signatures and permit us to use their images in selected advertisements or on our websites, typically in exchange for royalties based on sales of their signature instruments. Some of our Signature Series artists also attend tradeshows to help market our products. In addition, some of our artists play their signature instruments at concerts and personal appearances, adding to the exposure of our products in live music venues. These musicians also mention their support of our brands in interviews, and are often seen with our brands in print publications where album or performance reviews include photographs of these artists and their instruments during performances. We believe that by associating our brands with these artists, we further enhance how consumers perceive our brands.

To support our Signature Artist Program as well as our entire artist outreach effort, our Artist Relations group focuses on fostering and maintaining relationships with professional musicians, including signature, emerging and well-known artists supporting our brands. This group coordinates closely with other parts of our organization, including our product marketing group and the Custom Shop, to provide customized products and services for professional musicians, as well as to support other aspects of our marketing and advertising programs.

Licensing and co-branding

We believe licensing our trademarks such as Fender and others builds brand awareness and furthers our strategy of reaching new consumers, while developing additional relationships with existing consumers through new products. We believe that these licensing agreements typically offer low investment costs and attractive margin opportunities without the risk of cannibalizing existing product sales. In addition, these activities provide us with a valuable source of advertising. We intend to expand beyond our existing licensed products to additional products in new and existing categories. In addition, we believe our non-revenue generating co-branding initiatives such as those with Apple Inc., which used our intellectual property in a promotional campaign that featured the Amplitube Fender application for the iPhone, Hard Rock Cafe International, Inc. and SAP Global Marketing, Inc., which we authorized to use certain names, trademarks, products and logos in a campaign that highlighted well-known companies that

 

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utilize SAP’s enterprise software, further increase our exposure and position our products as lifestyles brands through leveraging our partners’ resources and consumer reach beyond the musical instruments industry.

 

 

Community co-branding activities:    We seek to identify opportunities to partner with communities to support philanthropic activities that we believe contribute to our brands’ awareness and appeal. For example, we have collaborated with charities to create GuitarMania—a charitable community public art project. GuitarMania enlists local artists and national celebrities to transform blank nine or ten foot tall fiberglass Fender Stratocaster guitars into works of art that are displayed on city streets for several months, and then auctioned for charity. We also support The Fender Music Foundation, a charity unaffiliated with us that provides funding and resources for music programs across America, and “Kids Rock Free,” a non-profit music education program.

 

 

Lifestyle licensing activities:    We have license agreements with a variety of brands and retailers, such as a license arrangement with Panasonic Automotive to create, promote and sell Fender Premium Audio Systems in select Volkswagen vehicles globally. We also have license arrangements with Lucky Brand Jeans and Uniqlo to sell Fender and music lifestyle branded apparel, and Harmonix Music Systems through its Rock Band video games.

 

 

Corporate co-branding activities:    In recent years, we have undertaken a number of initiatives to partner with leading corporations with whom we see mutual value in developing an affiliation or joint initiative. In 2011, we partnered with Hard Rock Cafe International, Inc. to create the “Picks” campaign enabling guests at certain Hard Rock Hotels to check out a Fender guitar to their room during their stay and even purchase it. In 2011 and 2012, the Fender Music Lodge in Park City, Utah has served as a destination for media, celebrities and musicians at the Sundance Film Festival.

Media and promotion

In an effort to expand awareness of our brands to target audiences and the population in general, we also conduct advertising campaigns. We maintain a staff dedicated to product placement and advertising campaign creation. These activities include purchasing ads in trade and broader interest publications, submitting products for reviews by various publications, as well as product placements in movies and television shows that contribute to awareness of our brands in an audience that may not necessarily be familiar with our core products.

We coordinate our advertising campaigns to support product introductions, company milestones and events and other areas that we believe are meaningful to consumers.

Website, social media and other online activity

In addition to traditional print media, we maintain an active social media platform to help expose our products, service, support and community forums to consumers as well as various artists to foster loyalty and build a community of users who share a passion for our guitars and other products. We maintain brand-specific websites that are tailored to each brand’s attributes. Many of our websites feature a community forum section where our consumers and others can communicate with each other, including sharing tips and anecdotes. The community forum section and social media also allow us to communicate directly with our consumer base and receive feedback directly from our consumers. Our websites feature product pages where

 

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consumers can research and investigate our products and where they will find extensive product information, specifications, dealer locations and other important details about our products. To support various artists and maintain excitement for our brands and to encourage consumers to return to our websites, our websites also feature news relevant to the brand, artist activity, links to useful websites and new product announcements. Through our websites, consumers also can access our customer service department to ask questions and receive assistance regarding our products. Our social media strategy across all of our brands connects directly with consumers via unique content delivered through various social media tools worldwide, including Facebook, Twitter, Flickr and YouTube, as well as e-mail blasts and social media contests through our websites. We consider our overall online effort to be a critical component of our marketing efforts to end consumers and intend to maintain focus in this area.

Product design and development

To support our brands and product leadership, we continue to bring new and innovative products to market that inspire our consumers and enhance brand loyalty. We strive to ensure that our products are built efficiently to achieve high quality at each price point. We design our products to satisfy our consumers’ desire for instruments that are easy to use, maintain, upgrade and customize. In the past 20 years, we have received numerous industry awards for our product leadership. In a recent example, Vintage Guitar magazine announced in its March 2012 issue that the Fender Deluxe Reverb amplifier was inducted into its Hall of Fame.

Our team of over 85 research and development professionals reports directly to our Chief Executive Officer. Our product development led to the introduction of 127, 235 and 356 new products in fiscal 2009, 2010 and 2011, respectively, and, as of May 7, 2012, we had more than 600 ongoing projects. In fiscal 2011, sales of products introduced within the year represented 10.8% of gross sales before discounts and allowances. Over the last two years, we have also increased the pace at which we bring new products to market through more robust innovation processes. Our research and development expenditures were $9.0 million, $9.3 million, $10.2 million and $2.7 million in fiscal 2009, 2010, 2011 and the first quarter of fiscal 2012, respectively.

Custom Shop

Through our Custom Shop, our skilled craftspeople design and develop custom, specialty and limited-edition electric guitars and bass guitars. In addition, the Custom Shop produces a general line of products, often employing new techniques and incorporating features drawn from artist instruments as well as new designs and hardware, pickups and finishes that can be utilized in our other facilities and products. We believe our Custom Shop generates incremental higher margin business and enhances the images of our brands. Our Custom Shop also serves as a laboratory for the generation of ideas that can be more widely incorporated in our products.

Sourcing, manufacturing and logistics

Our strategically managed global supply chain is comprised of a network of our own manufacturing facilities in the United States and Mexico, distribution and warehouse facilities in North America and Europe, and established sourcing relationships with OEMs in Asia, Europe, North America and Mexico. We primarily manufacture our products that are sold at higher price points in the United States. We believe that effectively managing our supply chain to achieve efficient and timely delivery of our products to our retail partners is critical to our success.

 

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Sourcing

Our principal suppliers are providers of imported finished goods as well as raw materials and components.

 

 

Imported finished goods:    We use approximately 97 OEMs as of April 1, 2012 to produce a significant majority of our fretted instruments, guitar amplifiers, percussion products and accessories. Our OEMs are primarily located in China, India, Indonesia, Japan, South Korea, Taiwan, Thailand and Vietnam. Our supply chain personnel visit our OEMs and we have established procedures to inspect samples of products that are manufactured by our OEMs. In fiscal 2011 and the first quarter of fiscal 2012, products manufactured by OEMs accounted for approximately 64% and 62%, respectively, of our gross sales before discounts and allowances.

With many of our OEMs we do business on a purchase order basis rather than pursuant to formal written contracts. Where we do have contracts with our OEMs, they are short term. Most of our OEM agreements can be terminated only upon breach of contract. Most of these contracts require our OEMs to provide us with a “favored nations” pricing policy whereby we get the benefit of any more favorable prices offered to other customers of our OEMs. In addition, our OEMs that use subcontractors cannot subcontract the manufacturing of our products unless we provide advance written consent and certain other criteria are met. Although some of our OEM contracts prevent the OEM from making or dealing in competitors’ products, others do not. In our OEM contracts, our OEMs represent to us that they are in compliance with applicable laws, including local labor, environmental and safety laws, in connection with their performance of the contract. Although our supply chain employees occasionally visit our OEMs’ facilities, we do not require our OEMs to abide by any formal code of conduct as a condition of doing business with us.

 

 

Raw materials:    For our owned manufacturing facilities in the United States and Mexico, the primary raw material that we use is hardwood, particularly poplar, ash and alder for bodies, and maple and rosewood for necks. In certain of our specialty fretted instruments, we use more exotic woods. Especially in the case of rosewood and these more exotic woods, we have in the past, and may in the future, experience supply constraints. Poplar, ash, alder and maple are sourced primarily from North America whereas rosewood and other exotic woods are primarily imported from various countries outside of North America. Prior to fiscal 2011, we purchased wood spreads, which are pre-cut blocks of wood that have been glued and planed for use in the production of electric guitars and electric bass guitar bodies. We began manufacturing spreads ourselves in fiscal 2011 to control quality and cost and intend to increase the percentage of spreads we manufacture ourselves over time. We believe that multiple sources for these spreads, as well as raw wood, exist and we do not believe that we are dependent on any one supplier for wood.

 

 

Components:    We source certain components used in our fretted instruments, guitar amplifiers and certain of our other products from third party vendors. These components include fretted instrument cases, tubes used for our guitar amplifiers, strings for our guitars, drum heads, printed circuit boards, amplifier speakers, certain bridges, selected pick-ups, machine heads and other plastic and metal components such as control knobs. We believe there are only three primary manufacturers of the tubes used in certain of our guitar amplifiers—located in Russia, China and the Czech Republic, and some of these manufacturers are the sole source of certain types of tubes. We do not have long-term supply agreements with any of these manufacturers. Although we have taken steps, such as keeping additional inventory on hand to mitigate the risk, with respect to suppliers or OEMs that are the sole

 

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source of a particular component or finished product, these steps may not be sufficient if a supplier or OEM were to stop providing us with components or finished products that we require.

 

 

Planning:    Our primary planning, sourcing and purchasing offices are located in Scottsdale, Arizona and New Hartford, Connecticut in the United States and in our U.K. offices in Europe. We also have a procurement office in Ensenada, Mexico. We utilize Logility and SAP software for our demand, supply and manufacturing requirements planning. Global management of transportation of goods from our suppliers to our warehouses and from our warehouses to our retail consumers is handled out of our Scottsdale, Arizona offices.

Manufacturing

Our products are manufactured by our OEMs, and by us at our owned manufacturing facilities. We believe this combination of facilities provides us with increased manufacturing capacity and the flexibility and scale to more efficiently and quickly respond to consumer demand. We have manufacturing operations in Corona, California; New Hartford, Connecticut; Ensenada, Mexico; Scottsdale, Arizona; and Ridgeland, South Carolina. We opened our Ensenada facility in 1987 and our current Corona facility in 1998. Our 176,000 square foot Corona facility and 167,000 square foot Ensenada facility manufacture guitars, guitar amplifiers and replacement parts. In addition to the more automated manufacturing operations, our Corona facility also houses our Custom Shop, which makes Fender, Gretsch, Jackson, Charvel and EVH custom guitars. We acquired our New Hartford and Ridgeland facilities through our acquisition of KMC. Our New Hartford facility primarily manufactures acoustic guitars. Our Ridgeland facility manufactures higher-end Gretsch drums. We have invested significant resources to establish and modernize these facilities.

Our products, particularly our guitars, require a significant amount of labor and handiwork by a skilled and well-trained workforce to achieve and maintain high quality, although we also employ automated guitar and guitar amplifier production and robotic paint processes.

Our manufacturing facilities are designed to provide us with manufacturing flexibility. In times of high demand, our management is able to add shifts and make other production line adjustments to vary production levels at each of our facilities. This ability, combined with the capabilities of our OEMs, allows us to vary capacity to respond to changing demand. We believe that our manufacturing facilities provide us with sufficient flexibility to expand production in the near and medium term.

We continually evaluate shifting additional production to manufacturing facilities with lower or more stable costs. For example, our Ensenada, Mexico manufacturing facility provides us with products at stable, relatively low costs, and we intend to explore opportunities to move additional production to that facility.

Logistics

We utilize five warehouses with a total capacity of approximately 1.8 million square feet for the storage and distribution of our products. In the United States, we have three warehouses—one located in Ontario, California, one in Portland, Tennessee and one in Louisville, Kentucky. In fiscal 2011, we announced the closure of our Louisville warehouse, which was consolidated into our Portland facility in the first quarter of fiscal 2012. We also have a facility in Ontario, Canada to service Canada. We operate all of our North American warehouse facilities. To support our

 

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European sales efforts, we have a facility in the Netherlands, which is operated by DSV Solutions and managed by us. This network of distribution and warehouse centers enables us to move products quickly and efficiently to our retail consumers.

Competition

The musical instruments industry is highly fragmented and is served by a variety of companies, including independent instrument makers, large multinational corporations, technology-based electronics manufacturers and print publishers. We also compete with online sellers of new and used products, the market for which we believe has grown with the increasing popularity of websites such as eBay. In addition, from time to time, national music retailers as well as mass merchants have carried their own private-label products that compete with ours. Companies compete based on price, style of instrument, sound and sound quality, features and brand recognition. In the markets for fretted instruments and guitar amplifiers, we and our significant competitors are each associated with particular musicians and groups. We believe that our brands’ strong recognition, innovative products and associations with leading musicians and groups provide us with significant competitive advantages. We believe our primary competitors within the electric guitar and bass guitar markets include Gibson Guitar Corp. and its Epiphone subsidiary and Ibanez, a subsidiary of Hoshino USA. In the acoustic guitar market, our primary competitors include Martin & Co., Taylor Guitars and Yamaha Corporation. In guitar amplifiers, our primary competitors include Line 6, Inc. and Marshall Amplification PLC.

Intellectual property

Our trademarks, including Fender and those associated with our other brands, are a critical component of the value of our business. Trade dress, which refers to the visual appearance of our products, also is an important part of our intellectual property rights. As described under “—Legal proceedings” below, we currently have a case pending before the U.S. Patent and Trademark Office with respect to registered trademarks covering some of our headstock designs.

Where we are the distributor for third parties’ products, including the Gretsch and EVH product lines, we license trademarks associated with those brands for use in our sales and distribution activities.

We do not have a written agreement that governs our distributorship arrangement with Takamine. Our distribution agreement with Sabian will expire on August 12, 2012, after which it will automatically renew for successive one-year periods, and will be terminable by either party for any reason upon 90 days prior written notice. Sabian may at any time stop permitting us to distribute its products upon 30 days prior written notice. For some products, this is true only if Sabian ceases manufacturing them. For other products, Sabian may stop permitting us to be a distributor of those products even if Sabian is still manufacturing them.

We also license our trademarks and related intellectual property rights to OEMs of our products from time to time, as well as in connection with licensing, co-branding or similar activities.

We hold patents for some aspects of our products and have patent applications pending. As of April 1, 2012, we had 48 issued patents and 9 patent applications pending in the United States and 32 corresponding issued patents and 10 patent applications pending in foreign countries. We cannot be certain that our patent applications will be issued or that any issued patents will provide us with any competitive advantage or will not be challenged by third parties. We also

 

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