UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark one)

For the quarterly period ended March 31, 2004

OR

For the transition period from _____ to _____

Commission File Number 0-22446

DECKERS OUTDOOR CORPORATION

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

DECKERS OUTDOOR CORPORATION
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Table of Contents

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See accompanying notes to condensed consolidated financial statements.

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See accompanying notes to condensed consolidated financial statements.

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(Continued)

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Condensed Consolidated Statements of Cash Flows, Continued
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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Notes to Condensed Consolidated Financial Statements
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Notes to Condensed Consolidated Financial Statements
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Notes to Condensed Consolidated Financial Statements
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Notes to Condensed Consolidated Financial Statements
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Notes to Condensed Consolidated Financial Statements
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Notes to Condensed Consolidated Financial Statements
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This report and the information incorporated by reference in this report contain forward-looking statements. We sometimes use words such as “anticipate,” “believe,” “continue,” “estimate,” “expect,” “intend,” “may,” “project,” “will” and similar expressions, as they relate to us, our management and our industry, to identify forward-looking statements. Forward-looking statements relate to our expectations, beliefs, plans, strategies, prospects, future performance, anticipated trends and other future events. Specifically, this report and the information incorporated by reference in this report contain forward-looking statements relating to, among other things:

We have based our forward-looking statements largely on our current expectations and projections about future events and financial trends affecting our business. Actual results may differ materially. Some of the risks, uncertainties and assumptions that may cause actual results to differ from these forward-looking statements include:

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         In addition, our stock price may be affected by:

In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this report and the information incorporated by reference in this report might not happen.

You should read this report, the documents that we filed as exhibits to this report and the documents that we incorporate by reference in this report completely and with the understanding that our future results may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements and we assume no obligation to update such forward-looking statements publicly for any reason.

Overview

We are a leading producer and brand manager of innovative high-quality footwear and the category creator in the sport sandal and luxury sheepskin footwear segments. Our products are marketed under three recognized brand names that we own:

We sell our three brands through our retail customers and directly to our end-user consumers through our Internet and catalog retailing business. We sell our footwear in both the domestic market and the international markets. Independent third parties manufacture all of our footwear.

Our business has been impacted by several important trends affecting our end markets:

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By emphasizing our brand image and our focus on comfort, performance and authenticity, we believe we can better maintain a loyal consumer following that is less susceptible to fluctuations caused by changing fashions and changes in consumer preferences.

Set forth below is an overview of the various components of our business, including some of the important factors that affect each business and some of our strategies for growing each business.

Teva Overview

Our Teva lines experienced strong market acceptance in the recent years. Teva’s products have benefited recently from several factors, but most prominently a general shift in consumer preferences and lifestyles to include more outdoor recreational activities. At the same time, our consumers are increasingly purchasing our Teva products for everyday wear, and our Teva brand now includes several closed-toe footwear lines. As a result, our brand remains popular among professional and amateur outdoorsmen seeking authentic, performance-oriented footwear, as well as general footwear consumers seeking high quality, durable and comfortable styles for everyday use.

To capitalize on the growth of outdoor recreational activities and the acceptance of certain footwear products for everyday use, we have selectively expanded the distribution of our Teva product lines outside our core outdoor specialty and sporting goods channels. Through effective channel management, we believe we can continue to expand into new distribution channels without diluting our outdoor heritage and our appeal to outdoor enthusiasts. Through channel appropriate product line expansion, we plan to continue to broaden our product offerings beyond sport sandals to new products that meet the style and functional needs of our consumers.

UGG Overview

Since early 2003, our UGG brand has received increased media exposure, which contributed to broader public awareness of the UGG brand and significantly increased demand for the collection. We believe that the increased media focus on UGG was driven by the product’s unique styling and resulting brand name identification, Australian heritage and adoption by high-profile film and television celebrities as a favored footwear brand. We believe this increased media attention has enabled us to introduce the brand to consumers much faster than we would have ordinarily been able to. As a result of the subsequent rapid growth in demand, we sold out of key UGG products early in the Fall 2003 season, and given the long lead times required to replenish our inventory levels, we have been unable to fill many retailer reorders and many direct Internet and catalog orders in late 2003 and early 2004. Continuing a strategy utilized with our UGG casual line, we have been shifting a portion of our traditional UGG sheepskin boot production from factories in Australia to several factories in China where the production capacity is much greater and quality standards are comparable.

We believe the fundamental comfort and functionality of UGG products will continue to drive long-term consumer demand. Recognizing that there is a significant fashion element to UGG and that footwear

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fashions fluctuate, our strategy seeks to prolong the longevity of the brand by offering a broader product line of luxurious and distinctive sheepskin fabrications suitable for wear in a variety of climates and occasions and by limiting distribution to selected higher-end retailers. As part of this strategy, we have expanded our product line to 69 models in 2004 from 52 models in 2002.

Increased media exposure has also broadened appeal for our UGG products. UGG has been a well-known brand in California for many years and over the last few few years has become a recognized brand across the remainder of the country. We believe that a portion of UGG’s increased demand is due to our continued geographical expansion across the U.S. In addition, we will expand our distribution and marketing overseas in order to satisfy virtually untapped international demand. We believe the international markets represent an attractive opportunity to build upon UGG’s broad U.S. appeal.

We depend on a limited number of key resources for sheepskin, the principal raw material for our UGG products. Three suppliers currently provide all of the sheepskin purchased by our independent manufacturers. The top grade sheepskin used in UGG footwear is in high demand and limited supply. In addition, sheep are susceptible to hoof and mouth disease, which can result in the extermination of the infected herd and could have a material adverse effect on the availability of sheepskin for our products. Additionally, the supply of sheepskin can be adversely impacted by drought conditions. Our potential inability to obtain top grade sheepskin for UGG products could impair our ability to meet our production requirements for UGG in a timely manner and could lead to inventory shortages, which can result in lost potential sales, delays in shipments to customers, strain on our relationships with customers and diminished brand loyalty. Additionally, there have been significant increases in the prices of footwear quality sheepskin as the demand for this material has increased. Any further price increases will likely raise our costs, increase our costs of sales and decrease our profitability unless we are able to pass higher prices on to our customers. Over the next year, we expect demand for top grade sheepskin to continue to outpace supply, leading to shortages and our inability to produce as much of certain styles as our customers would like to order. Looking beyond the next year, if demand continues to be strong, we would expect the supply of top grade sheepskin to increase in response to the demand. However, we have little control over the supply or the overall demand for top grade sheepskin and, accordingly, can provide no assurances about the sufficiency of future sheepskin supplies.

Simple Overview

After three consecutive years of net sales declines in our Simple product line, we recently implemented a strategy to improve Simple’s results of operations and generate renewed interest in the Simple brand. We began a process of repositioning our Simple product line by focusing on our successful legacy collections, including clogs and sneakers, and narrowing the number of styles available. In addition, we have begun to implement a strategy whereby we leverage our Teva and UGG expertise to produce Simple branded sandals and suede, fleece-lined products. The Simple products will generally be sold at price points lower than our Teva and UGG brands and, in some cases, through distribution channels that are precluded from offering our Teva and UGG brands. We expect our Simple brand to experience growth as we successfully implement our product line rationalization and channel management strategies.

Internet and Catalog Retailing Overview

We acquired our Internet and catalog retailing business in November 2002. Our Internet and catalog retailing business, which today sells all three of our brands, enables us to meet the growing demand for all of these products and also provides us with an opportunity to add significant incremental contribution margin. Managing our Internet business requires us to focus on generating Internet traffic to our websites, effectively convert website visits into orders and maximize average order sizes. To drive our catalog order business, we distribute approximately 300,000 catalogs semi-annually. Overall, our consumer direct

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business benefits from the strength of our brands, and as we grow our brands over time, we expect our Internet and catalog retailing business to increase.

Licensing Overview

We have recently embarked on a strategy to license our well-known and respected footwear brands to complementary products outside of footwear, generally in the apparel and accessories categories. To date, we have entered into four licensing agreements for Teva, including domestic licenses for men’s sportswear, timepieces, eyewear and headwear, and one domestic licensing arrangement for UGG handbags and other small leather goods. We are pursuing additional licensing opportunities for our brands both in the U.S. and abroad. This licensing strategy is in its early stages, and due to the lead times required to bring the products to market, we have received no revenues from licensing to date and we do not expect significant incremental net sales and profits from licensing in the near future. However, we believe licensing revenues may become a more significant portion of our net sales and profits over time. The minimum net annual royalties that we are scheduled to receive under the five existing licensing agreements, assuming renewal options are exercised, are $216,000 in 2004, $325,000 in 2005, $649,000 in 2006, $850,000 in 2007 and $868,000 in 2008. The activity within the licensing segment is very small in relation to the consolidated operation, therefore separate segment information is not presented.

Seasonality

Our business is seasonal, with the highest percentage of Teva net sales occurring in the first and second quarters of each year and the highest percentage of UGG net sales occurring in the third and fourth quarters, while the quarter with the highest percentage of annual net sales for Simple has varied from year to year.

In previous years we have experienced our highest sales level in the first quarter, which has been Teva’s strongest selling season, while the third quarter has historically had the lowest sales volume. The seasonally low third quarter sales volume has also historically resulted in a third quarter loss from operations. In the third quarter of 2002, this seasonality, combined with the costs of the litigation settlement, resulted in a loss from operations of $4,309,000. However, in 2003, as a result of the continued growth in UGG and the introduction of the fall closed-toe Teva offering, the first and fourth quarters had comparable sales volumes and the second and third quarters had comparable sales volumes. Given our expectations for each of our brands in 2004, we currently expect this trend to continue and anticipate that net sales in the last half of 2004 will likely exceed net sales during the first half of 2004. Nonetheless, actual results could differ

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materially depending upon consumer preferences, availability of product, competition and our customers continuing to carry and promote our various product lines, among other risks and uncertainties. See “Forward Looking Statements.”

Results of Operations

The following table sets forth certain operating data for the periods indicated.

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The following table sets forth certain operating data as a percentage of net sales for the periods indicated.

Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003

Overview. For the three months ended March 31, 2004, we had net sales of $44,272,000 and income from operations of $9,628,000 compared to net sales of $36,102,000 and income from operations of $8,087,000 for the three months ended March 31, 2003. These results were due in part to increased demand for our Teva and UGG product lines, partially offset by a decline in net sales of our Simple product line.

Net Sales. Net sales increased by $8,170,000, or 22.6%, to $44,272,000 for the three months ended March 31, 2004 from $36,102,000 for the three months ended March 31, 2003. Net sales increased for the three months ended March 31, 2004 due primarily to: (1) an increase in the number of units sold of Teva and UGG offset in part by a decline in the number of units sold of Simple, resulting in a 23.1% overall increase in the volume of footwear sold to 2,215,000 pairs for the three months ended March 31, 2004 from 1,800,000 pairs for the three months ended March 31, 2003, and (2) the expansion of the Internet and catalog retailing business obtained as part of the Teva Rights acquisition. This increase in unit sales volume was partially offset by a 4.3% decline in average wholesale selling price per unit to $18.61 for the three months ended March 31, 2004 from $19.44 for the three months ended March 31, 2003.

Net wholesale sales of Teva increased by $5,417,000, or 17.4%, to $36,506,000 for the three months ended March 31, 2004 from $31,089,000 for the three months ended March 31, 2003. This increase was primarily due to increased sales volume of sport sandals resulting from an improvement in retail sell-through, increased sales in the international markets, selective addition of new distribution channels in our domestic market, increased sales volume of thongs and slides and increased sales volume of certain styles of the recently introduced closed-toe footwear offerings. See “— Overview — Teva Overview” above.

Net wholesale sales of UGG increased by $1,450,000, or 121.1%, to $2,647,000 for the three months ended March 31, 2004 from $1,197,000 for the three months ended March 31, 2003. This was largely as a result of heightened demand in the first quarter of 2004 caused by the growing popularity of the brand, significantly increased brand awareness and considerable celebrity exposure. The UGG sales volume increase was also due to strong retail sell-through, expansion of the product line to include more casual footwear styles and continued geographical expansion across the U.S. See “— Overview — UGG Overview” above.

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Net wholesale sales of Simple decreased by $1,197,000, or 44.1%, to $1,515,000 for the three months ended March 31, 2004 from $2,712,000 for the three months ended March 31, 2003. This decline was caused by a variety of factors, including competition in the casual footwear market and a decrease in the volume of closeout sales during the first quarter of 2004. See “— Overview — Simple Overview” above.

Net sales of the Internet and catalog retailing business increased by $2,500,000, or 226.4%, to $3,604,000 for the three months ended March 31, 2004 from $1,104,000 for the three months ended March 31, 2003. For the three months ended March 31, 2004, net sales of the Internet and catalog retailing business included retail sales of Teva of $935,000, UGG of $2,501,000 and Simple of $168,000. For 2003, the breakdown included sales of Teva of $611,000, UGG of $383,000 and Simple of $110,000. The increase in net sales of the Internet and catalog retailing business was due to the increased demand for the underlying brands, as well as increased consumer acceptance of online purchasing. See “— Overview — Internet and Catalog Retailing Overview” above.

International sales for all of our products increased by $2,255,000, or 21.2 %, to $12,874,000 for the three months ended March 31, 2004 from $10,619,000 for the three months ended March 31, 2003, representing 29.1 % of net sales for the three months ended March 31, 2004 and 29.4% of net sales for the three months ended March 31, 2003. The higher dollar amount of international sales resulted from our international expansion strategy combined with the favorable impact of the strong Euro while the lower percentage of international sales to net sales reflects the growth of our domestic business.

Gross Profit. Gross profit increased by $4,166,000, or 25.7%, to $20,406,000 for the three months ended March 31, 2004 from $16,240,000 for the three months ended March 31, 2003. As a percentage of net sales, gross profit margin increased to 46.1% for the three months ended March 31, 2004 from 45.0% for the three months ended March 31, 2003. The increase in gross profit margin was largely due to the strong increase in the higher gross margin Internet and catalog retailing business, combined with a lower volume of closeout sales in the Simple division compared to last year.

Selling, General and Administrative Expenses. Selling, general and administrative expenses, or SG&A, increased by $2,625,000, or 32.2%, to 10,778,000 for the three months ended March 31, 2004 from $8,153,000 for the three months ended March 31, 2003. As a percentage of net sales, SG&A increased to 24.3% for the three months ended March 31, 2004 from 22.6% for the three months ended March 31, 2003. The increase in the dollar amount of SG&A expenses was primarily due to increased costs of our growing Internet and catalog retailing business, increased payroll costs, higher legal costs associated with increased efforts to protect our intellectual property rights, and increased sales commissions on the higher sales volume.

Income from Operations. Income from operations increased by $1,541,000, or 19.1%, to $9,628,000 in the period ended March 31, 2004 from $8,087,000 in the period ended March 31, 2003. This was due primarily to increased gross profit contribution of $4,166,000, partially offset by increased costs of our growing Internet and catalog retailing business, increased payroll costs, higher legal costs associated with increased efforts to protect our intellectual property rights, and increased sales commissions on the higher sales volume.

Income from operations of Teva wholesale increased by $1,650,000, or 15.0%, to $12,655,000 for the three months ended March 31, 2004 from $11,005,000 for the three months ended March 31, 2003. This increase was largely due to the $5,417,000 increase in net sales, and a decrease in Teva advertising and marketing costs. These were partially offset by increases in payroll and selling commissions on the higher sales volume.

Income from operations of UGG wholesale increased by $1,025,000, or 652.9%, to an income of $868,000 for the three months ended March 31, 2004 from a loss of $157,000 for the three months ended March 31,

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2003. This was largely due to the $1,450,000 increase in net sales, and a $443,000 decrease in bad debt expense.

Income from operations of Simple wholesale decreased by $298,000 to a loss from operations of $163,000 for the three months ended March 31, 2004 from income from operations of $135,000 for the three months ended March 31, 2003. This was primarily due to a $1,197,000 decline in net sales during the period attributed to both the domestic and international markets.

Income from operations of our Internet and catalog business increased by $888,000, or 785.8%, to $1,001,000 for the three months ended March 31, 2004 from $113,000 for the three months ended March 31, 2003. This was largely due to the increase in net sales of $2,501,000 during the period primarily from the continued growth in popularity of online sales and the strength of our underlying brands.

Income from operations included unallocated overhead costs, which increased by $1,724,000, or 57.3%, to $4,733,000 for the three months ended March 31, 2004 from $3,009,000 for the three months ended March 31, 2003. These costs included increased payroll costs and increased legal costs associated with the protection of our intellectual property rights that support our business segments.

Other Expense (Income). Net interest expense for the first quarter was $1,118,000 for the three months ended March 31, 2004 compared with a net interest expense of $1,097,000 for the three months ended March 31, 2003. The interest expense results principally from the borrowings incurred to finance our purchase of the Teva Rights in November 2002. The slight increase in interest expense reflects two offsetting factors. First, in connection with early repayments of $3,000,000 of subordinated notes in January 2004, we incurred approximately $300,000 of expenses, including prepayment penalties and the write-off of a pro rata share of the previously capitalized loan costs. The resulting increase in interest expense was nearly offset by the impact of lower average outstanding borrowings in the first quarter of 2004 compared to the first quarter of 2003. Other income exclusive of net interest expense was not material in either period.

Income Taxes. For the three months ended March 31, 2004, income tax expense was $3,134,000, representing an effective income tax rate of 36.8%. For the three months ended March 31, 2003, income tax expense was $2,802,000 representing an effective income tax rate of 40.0%. The decrease in the effective tax rate was primarily due to the restructuring of our international operations which resulted in a reduced effective tax rate.

Net Income. We had net income of $5,382,000, or $0.49 per diluted share, for the three months ended March 31, 2004 versus net income of $4,203,000, or $0.37 per diluted share, for the three months ended March 31, 2003.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements other than operating leases. See “— Contractual Obligations” below. We do not believe that these operating leases are material to our current or future financial condition, results of operations, liquidity, capital resources or capital expenditures.

Liquidity and Capital Resources

Prior to the acquisition of the Teva Rights, we financed our working capital and operating needs using a combination of the cash generated from operations and the credit availability under our $20,000,000 revolving credit facility. In addition to these sources of financing, in connection with the acquisition of the Teva Rights in 2002, we obtained approximately $34,000,000 of incremental financing from additional senior and subordinated debt arrangements. This additional financing was used solely to fund the Teva

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acquisition, whereas the cash from operations and the available credit under the revolving credit facility continue to provide the cash required for our working capital and operating needs.

The seasonality of the individual brands requires us to build inventory levels in anticipation of the sales at different times of the year. Teva generally begins to build inventory levels beginning in the fourth quarter and first quarter in anticipation of the spring selling season, which occurs in the first and second quarters, whereas UGG begins to build its inventories in the second quarter and third quarter to support sales for the fall and winter selling seasons, which historically occur during the third and fourth quarters. Our Simple product line is less seasonal than our Teva and UGG lines and has significantly fewer inventory fluctuations.

Our cash flow cycle includes the purchase of these inventories, the subsequent sale of the inventories and the eventual collection of the resulting accounts receivable. As a result, our working capital requirements begin when we purchase the inventories and continue until we ultimately collect the resulting receivables. Given the seasonality of our Teva and UGG brands, our working capital requirements fluctuate significantly throughout the year. The cash required to fund these working capital fluctuations is generally provided using a combination of our internal cash flows and borrowings under our revolving credit facility.

Cash from Operating Activities. Net cash provided by operating activities increased to $7,331,000 for the three months ended March 31, 2004 from $3,834,000 for the three months ended March 31, 2003. The increase in net cash provided by operating activities in the first quarter of 2004 was largely due to an improvement in net earnings of $1,179,000 and an improvement in cash collections of $7,087,000, partially offset by an increase in cash used to purchase inventories during the three months ended March 31, 2004 as compared to the same period in 2003. Net working capital remained essentially the same at March 31, 2004 and 2003, although many components of working capital fluctuated significantly.

Cash Used in Investing Activities. For the three months ended March 31, 2004, net cash used in investing activities was $457,000, which was comprised almost entirely of cash used for capital expenditures. For the three months ended March 31, 2003, net cash used in investing activities was $149,000.

Cash Used in Financing Activities. For the three months ended March 31, 2004, net cash used in financing activities was $2,702,000 compared to net cash used in financing activities of $2,832,000 for the three months ended March 31, 2003. In both periods, the net cash used in financing activities was largely a result of the repayment of long-term debt, which was offset by cash received from the issuances of common stock.

Our liquidity consists primarily of cash, trade accounts receivable, inventories and a revolving credit facility. At March 31, 2004, working capital was $24,923,000 including $10,848,000 of cash. Cash provided by operating activities aggregated $7,331,000 for the three months ended March 31, 2004. Trade accounts receivable increased by 29.8% to $24,331,000 at March 31, 2004 from $18,745,000 at December 31, 2003, largely due to normal seasonality. Accounts receivable turnover improved to 6.3 times in the twelve month period ended March 31, 2004 from 6.1 times in the twelve month period ended December 31, 2003.

During the same period, inventories decreased by 1.9% to $17,657,000 at March 31, 2004 from $18,004,000 at December 31, 2003, reflecting a $1,646,000 decrease in Teva inventory, a $1,717,000 increase in UGG inventory and a $418,000 decrease in Simple inventory at quarter end. Overall, inventory turnover improved to 4.3 times for the twelve months ended March 31, 2004 from 4.0 times for the twelve months ended December 31, 2003. The $1,646,000 decrease in Teva inventory occurred because historically the first quarter is Teva’s strongest selling period. Teva’s inventory levels are higher at year end in preparation for the first quarter sales. The $1,717,000 increase in UGG inventory at March 31, 2004 was largely due to anticipated higher sales in the

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second quarter of 2004. The $418,000 decrease in Simple inventory at March 31, 2004 reflects our continuing efforts to reduce the levels of our closeout inventories and to bring our Simple inventory into stock closer to when it is expected to be shipped to our customers.

Our revolving credit facility with Comerica Bank-California provides for a maximum availability of $20,000,000 subject to a borrowing base. In general, the borrowing base is equal to 75% of eligible accounts receivable, as defined, and 50% of eligible inventory, as defined. Up to $10,000,000 of borrowings may be in the form of letters of credit. The facility bears interest at the lender’s prime rate (4.00% at March 31, 2004) or, at our option, at LIBOR (1.09% at March 31, 2004) plus 3.25%, and is secured by substantially all of our assets. The facility included an upfront fee of $230,000 and includes subsequent annual commitment fees of $100,000. The facility expires on June 1, 2005. At March 31, 2004, we had no outstanding borrowings under the facility, no foreign currency reserves for outstanding forward contracts and no outstanding letters of credit. We had credit availability under the facility of $20,000,000 at March 31, 2004.

On November 25, 2002, we completed the acquisition of the Teva Rights from Mark Thatcher and his wholly owned company, Teva Sport Sandals, Inc., for approximately $62,300,000, including transaction costs of approximately $300,000. We paid cash in the amount of $43,000,000 and issued to Mr. Thatcher a junior subordinated note in the principal amount of $13,000,000, convertible preferred stock of $5,500,000, 100,000 shares of common stock valued at approximately $368,000 and options to purchase 100,000 shares of common stock valued at approximately $187,000. The $13,000,000 of junior subordinated note includes a coupon interest rate of 7.00% and an additional interest rate of 2.00%, which is to be accrued and paid at the maturity date in 2008. The note may be prepaid without penalty. Concurrent with the acquisition, we entered into an employment agreement for advice on Teva matters with Mr. Thatcher through November 2007, which provides for an annual base salary of $276,875, and we received a non-compete agreement from Mr. Thatcher, which expires two years after termination of employment.

In connection with the Teva Rights acquisition, we entered into two additional financing arrangements, including a $7,000,000 term loan from Comerica Bank-California and a $14,000,000 subordinated note from The Peninsula Fund III Limited Partnership, both unrelated parties. Based on intercreditor agreements between the various parties, we generally were not permitted to repay the subordinated note or the junior subordinated note or repurchase the convertible preferred stock without the prior approval and consent of Comerica Bank-California. Likewise, we generally were not permitted to repay the junior subordinated note or repurchase the convertible preferred stock without the prior approval and consent of both Comerica Bank-California and the holder of the subordinated notes.

Since initially entering into these financing arrangements, we have taken several steps to improve our capital structure. After obtaining the requisite approvals discussed above, we made the following changes:

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The renegotiated $7,000,000 term loan is secured by all of our assets and bears interest at the prime rate (4.00% at March 31, 2004) plus 2.50%, or, at our option, at LIBOR (1.09% at March 31, 2004) plus 3.25%. In accordance with the amended payment terms, interest is payable monthly, an initial principal payment of $1,750,000 is payable May 31, 2004 and the remaining principal is payable in monthly installments of approximately $292,000 from June 2004 to November 2005. We incurred a fee of $35,000 in connection with the increase in term loan borrowings in December 2003.

The remaining $7,000,000 of the subordinated note outstanding at March 31,2004 is secured by a secondary security position in all assets, with principal payable in quarterly installments of $1,500,000 beginning in November 2007 and the balance due in full in November 2008. The subordinated note bears interest at 16.75%, of which 12.00% is payable monthly and 4.75% can be deferred at our option and compounds monthly until the 2008 maturity date. During the first quarter of 2004, we elected not to defer any interest costs and as a result paid all interest as it was incurred. In the event that we decide to prepay all or a portion of the subordinated note, we will be required to pay prepayment penalties of 4.00% of the portion prepaid prior to November 25, 2004, with no penalties for prepayments thereafter. In connection with the issuance of the subordinated note, we incurred costs of approximately $1,000,000, including investment banking fees, loan commitment fees and legal costs. These origination costs are included in other assets in the accompanying condensed consolidated financial statements and are being amortized over the term of the loan.

The $13,000,000 junior subordinated note is due in November 2008. The junior subordinated note bears interest at 9.00%, of which 7.00% is payable annually and 2.00% may be deferred at our option and compounds annually until the 2008 maturity date. During the first quarter of 2004, we elected to defer payment of the 2.00% deferred interest component. The junior subordinated note is unsecured and subordinated to the subordinated note, the term loan and the bank credit facility and does not have prepayment penalties. The junior subordinated note provides the holder with the right to designate one member of our board of directors. At March 31, 2004, the outstanding balance on the junior subordinated note was $13,000,000, plus the deferred interest of $351,000.

The agreements underlying the bank credit facility, the term loan and the subordinated note contain several financial covenants including a quick ratio requirement, profitability requirements and cash flow coverage requirements, among others, as well as a prohibition on the payment of dividends. We were in compliance with all covenants at March 31, 2004 and remain so as of the date of this report.

We have announced that we have filed a registration statement with the Securities and Exchange Commission to sell up to 1,500,000 shares of our Common Stock and up to 2,000,000 shares of our Common Stock held by selling stockholders (not counting any exercise of the over-allotment option to purchase up to 525,000 shares of Common Stock granted by the selling stockholders to the underwriters).

We expect to pay off the remaining $7,000,000 of the term loan, $7,000,000 of the subordinated note and $13,000,000 of the junior subordinated note from the proceeds of the potential offering. Upon the completion of this potential offering and repayment of our outstanding debt, the borrowing availability under our revolving credit facility will be the full $20,000,000 amount of the facility, subject to the borrowing base lending requirements.

Capital expenditures totaled $458,000 for the three months ended March 31, 2004 and related primarily to the replacement of certain computer equipment and the upgrade of our internal phone system. We currently have no material commitments for future capital expenditures but estimate that the remaining capital

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expenditures for 2004 will range from $250,000 to $550,000 and will include an upgrade of the distribution center computer system, new trade show booths and replacements and upgrades of certain other computer equipment. The actual amount of capital expenditures for the remainder of 2004 may differ from this estimate, largely depending on any unforeseen needs to replace existing assets.

Contractual Obligations. The following table summarizes our contractual obligations at March 31, 2004 and the effects such obligations are expected to have on liquidity and cash flow in future periods.

Additionally, we have significant interest payment requirements on the long-term debt obligations discussed above. Assuming we continue to pay both the current interest portion (12.00%) and the deferred interest portion (4.75%) of the subordinated note on a monthly basis and assuming we continue to pay annually only the current interest portion (7.00%) while deferring the deferred interest portion (2.00%) of the junior subordinated note, the annual interest payment requirements for our long-term debt obligations are as follows:

The above table does not include interest on the bank credit facility, as the outstanding borrowings on the facility are variable. While there were no outstanding borrowings under the facility at March 31, 2004, we anticipate that we may borrow under the facility later in 2004 in order to meet our seasonal working capital needs. In 2003, the average outstanding borrowings under the facility were $2,136,000 and the aggregate interest costs under the facility were $103,000.

In February 2002, we agreed to guarantee up to $1,000,000 of a bank loan of Doug Otto, our Chairman of the Board, Chief Executive Officer and President, which matures June 1, 2004. The guarantee is through the maturity date of the loan, and we would have to pay under the guarantee should Mr. Otto default on the loan. As of March 31, 2004, approximately $1,000,000 was outstanding under the loan. The fair value of the guarantee was immaterial at March 31, 2004.

We believe that internally generated funds, the available borrowings under our existing credit facilities, cash on hand and the net proceeds of the potential offering will provide sufficient liquidity to enable us to meet our current and foreseeable working capital requirements. However, risks and uncertainties that could impact our ability to maintain our cash position include our growth rate, the continued strength of our brands, our ability to respond to changes in consumer preferences, our ability to collect our receivables in a timely manner, our ability to effectively manage our inventories and the volume of letters of credit used to purchase product, among others. See “Forward Looking Statements” for a discussion of additional factors that may affect our working capital position.

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Impact of Inflation

We believe that the relatively moderate rates of inflation in recent years have not had a significant impact on our net sales or profitability.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures about contingent liabilities and the reported amounts of net sales and expenses during the reporting period. Management bases these estimates and assumptions upon historical experience, existing, known circumstances, authoritative accounting pronouncements and other factors that management believes to be reasonable under the circumstances. Management reasonably could use different estimates and assumptions, and changes in estimates and assumptions could occur from period to period, with the result in each case being a material change in the financial statement presentation of our financial condition or results of operations. We have historically been accurate in our estimates used for the reserves and allowances below. We believe that the estimates and assumptions below are among those most important to an understanding of our consolidated financial statements contained in this report.

Allowance for Doubtful Accounts. We provide a reserve against trade accounts receivable for estimated losses that may result from customers’ inability to pay. We determine the amount of the reserve by analyzing known uncollectible accounts, aged trade accounts receivables, economic conditions, historical experience and the customers’ credit-worthiness. Trade accounts receivable that are subsequently determined to be uncollectible are charged or written off against this reserve. The reserve includes specific reserves for accounts which are identified as potentially uncollectible, plus a general reserve for the balance of accounts. Reserves have been fully established for all expected or probable losses of this nature. The gross trade accounts receivable balance was $26,496,000 and the allowance for doubtful accounts was $1,786,000 at March 31, 2004. Our use of different estimates and assumptions could produce different financial results. For example, a 1.0% change in the rate used to estimate the reserve for the accounts not specifically identified as uncollectible would change the allowance for doubtful accounts by $252,000.

Reserve for Sales Discounts. A significant portion of our domestic net sales and resulting trade accounts receivable reflects a discount that the customers may take, generally based upon meeting certain order, shipment and payment timelines. We estimate the amount of the discounts that are expected to be taken against the period-end trade accounts receivable and we record a corresponding reserve for sales discounts. We determine the amount of the reserve for sales discounts considering the amounts of available discounts in the period-end accounts receivable aging and historical discount experience, among other factors. At March 31, 2004 the reserve for sales discounts was approximately $379,000. Our use of different estimates and assumptions could produce different financial results. For example, a 10% change in the estimate of the percentage of accounts that will ultimately take their discount would change the reserve for sales discounts by $38,000.

Allowance for Estimated Returns. We record an allowance for anticipated future returns of goods shipped prior to period-end. In general, we accept returns for damaged or defective products but discourage returns for other reasons. We base the amount of the allowance on any approved customer requests for returns, historical returns experience and any recent events that could result in a change in historical returns rates, among other factors. The allowance for returns at March 31, 2004 was $1,222,000. Our use of different estimates and assumptions could produce different financial results. For example, a 1.0% change in the rate used to estimate the percentage of sales expected to ultimately be returned would change the reserve for returns by approximately $300,000.

Inventory Write-Downs. Inventories are stated at lower of cost or market. We review the various items in inventory on a regular basis for excess, obsolete and impaired inventory. In doing so, we write the inventory down to the lower of cost or estimated future net selling prices. Inventories were stated at $17,657,000, net

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of inventory write-downs of $732,000 at March 31, 2004. Our use of different estimates and assumptions could produce different financial results. For example, a 10% change in estimated selling prices of our potentially obsolete inventory would change the inventory write-down amount by approximately $154,000.

Valuation of Goodwill, Intangible and Other Long-Lived Assets. We periodically assess the impairment of goodwill, intangible and other long-lived assets based on assumptions and judgments regarding the carrying value of these assets. We consider the assets to be impaired if we determine that the carrying value may not be recoverable. Among other considerations, we consider the following factors:

If we consider the assets to be impaired, we recognize an impairment loss equal to the amount by which the carrying value of the assets exceeds the estimated fair value of the assets. In addition, as it relates to long-lived assets, we base the useful lives and related amortization or depreciation expense on the estimate of the period that the assets will generate sales or otherwise be used by us.

Recent Accounting Pronouncements

In January 2003, the FASB issued Interpretation, or FIN, No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. FIN No. 46 addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. FIN No. 46 generally applies immediately to variable interests in variable interest entities created after January 31, 2003 and to variable interests in variable interest entities obtained after January 31, 2003. The application of FIN No. 46 did not have a material effect on our consolidated financial statements. In December 2003, the FASB revised FIN No. 46 to exempt certain entities from its requirements and to clarify certain issues arising during the implementation of FIN No. 46. The adoption of this revised interpretation in the first quarter of 2004 is not expected to have any impact on our consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for how a company classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that companies classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. The provisions of this Statement are generally effective for financial instruments entered into or modified after May 31, 2003, and otherwise are effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this Statement did not have a material effect on our consolidated financial statements.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Except as discussed in the following paragraphs, we do not engage in trading market risk sensitive instruments nor do we purchase, whether for investment, hedging or purposes “other than trading,” instruments that are likely to expose us to market risk, whether foreign currency exchange rate, interest rate, commodity price or equity price risk. We have not issued any debt instruments, entered into any forward or future contracts, purchased any options or entered into any swaps, except as discussed in the following paragraphs.

Derivative Instruments

Our sales are currently denominated almost entirely in United States dollars. As of March 31, 2004, the Company had no outstanding foreign currency forward contracts.

Market Risk

The Company’s market risk exposure with respect to financial instruments is to changes in the “prime rate” in the United States and changes in the Eurodollar, or LIBOR, rate. The Company’s revolving line of credit and senior term debt provide for interest on outstanding borrowings at rates tied to prime rate, or at the Company’s election tied to the Eurodollar, or LIBOR, rate. At March 31, 2004, the Company had outstanding borrowings aggregating $7,000,000 under these two credit facilities. A 1% increase in interest rates on current borrowings would have a $70,000 impact on income before income taxes.

Item 4. Controls and Procedures

Our Chief Executive Officer, Douglas B. Otto, and Chief Financial Officer, M. Scott Ash, with the participation of the Company’s management, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15). Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in timely making known to them material information relating to us (including our consolidated subsidiaries) required to be included in this report.

Disclosure controls and procedures, no matter how well designed and implemented, can provide only reasonable assurance of achieving an entity’s disclosure objectives. The likelihood of achieving such objectives is affected by limitations inherent in disclosure controls and procedures. These include the fact that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human failures such as simple errors, mistakes or intentional circumvention of the established processes.

There was no change in our internal control over financial reporting, known to our Chief Executive Officer or our Chief Financial Officer, that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Part II. OTHER INFORMATION

     Item 1. Legal Proceedings. Not applicable

     Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities. Not applicable

     Item 3. Defaults upon Senior Securities. Not applicable

     Item 4. Submission of Matters to a Vote of Security Holders. Not applicable

     Item 5. Other Information. Not applicable

     Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits.

(b) Reports on Form 8-K

None

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Signatures

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

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