UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

 

Form 10-K

 

 

Commission File Number 0-26524

 

LOUD TECHNOLOGIES INC.

(Exact name of registrant as specified in its charter)

 

 

 

16220 Wood-Red Road, N.E., Woodinville, Washington 98072

(Address of Principal Executive Offices)

 

Registrant’s telephone number, including area code: (425) 487-4333

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

Securities registered pursuant to Section 12(g) of the Act: Common Stock, no par value

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o     No þ

 

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 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. Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes o     No þ

 

The aggregate market value of common stock held by non-affiliates of registrant at June 30, 2007 was approximately $11,101,965 based upon the closing price of the registrant’s common stock as quoted on the Nasdaq Capital Market on June 30, 2007 of $8.89. Per-share data contained in this report reflect the 1-for-5 reverse split effected on November 17, 2005.

 

On March 28, 2008, 4,858,941 shares of common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement for the 2008 annual meeting of stockholders (including amendments thereto) are incorporated by reference into Part III of this Form 10-K

 

 

LOUD TECHNOLOGIES INC.
FORM 10-K

 

For the Year Ended December 31, 2007

INDEX

 

 

Certain statements set forth in or incorporated by reference into this Annual Report on Form 10-K for the year ended December 31, 2007, particularly including but not limited to the section entitled Management’s Discussion and Analysis of Financial Condition and Results of Operations, contain “forward-looking statements” within the meaning of Section 21D of the Securities Exchange Act of 1934, as amended. Such statements are based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. Such forward-looking statements include among others, those statements including the words “expect,” “anticipate,” “intend,” “believe” and similar expressions. Actual results could differ materially and adversely from those discussed in this report. Factors that could cause or contribute to such differences include but are not limited to the risks discussed in the “Risk Factors” section in Item 1A. Readers are cautioned not to place undue reliance on these forward-looking statements, and should recognize that these statements are accurate only as of the date of this report and will not be updated to reflect future developments.

 

 

Overview

 

LOUD Technologies Inc. (“LOUD” or the “Company”) was founded in 1988. The Company was incorporated in Washington under the name Mackie Designs Inc., and subsequently changed its name to LOUD Technologies Inc. LOUD is one of the world’s largest dedicated professional audio and music products companies. As the corporate parent for world-recognized brands Alvarez^®, Ampeg^®, Crate^®, EAW^®, Knilling^®, Mackie^®, Martin Audio^®, SIA^® and TAPCO^®, LOUD engineers, manufactures, markets and distributes a wide range of professional audio and musical instrument products worldwide. Additionally, LOUD is a distributor of branded professional audio and music accessories through our SLM Marketplace catalog.

 

Our product lines include sound reinforcement speakers, analog mixers, guitar and bass amplifiers, professional loudspeaker systems, and branded musical instruments. These products can be found in professional and project recording studios, video and broadcast suites, post-production facilities, sound reinforcement applications including churches and nightclubs, retail locations, and on major musical concert tours. We distribute our products primarily through retail dealers, mail order outlets and installed sound contractors. Our primary operations are in the United States with other operations in the United Kingdom, Canada, China and Japan.

 

On March 4, 2005, we acquired all of the shares of St. Louis Music, Inc., a Missouri-based manufacturer, distributor and importer of guitar and bass amplifiers, branded musical instruments, and professional audio products. This transaction is explained in more detail in Note 16 of the accompanying financial statements.

 

On April 11, 2007, we acquired all of the outstanding capital stock of Martin Audio, Ltd. (“Martin Audio”), a UK-based manufacturer of loudspeakers and related equipment. This transaction is explained in more detail in Note 16 of the accompanying financial statements. In order to facilitate this acquisition, on March 30, 2007 we completed a refinancing and closed on a new $112 million senior secured credit facility. The financial covenants related to this credit facility were amended on March 6, 2008. These transactions are explained in more detail in Note 10 of the accompanying financial statements.

 

As a condition to entering into a waiver and amendment to the senior secured credit facility on March 6, 2008 waiving certain defaults of the financial covenants of the senior secured credit facility, the lender requested that the Company seek $7.5 million in subordinated financing. In response to this request, on March 18, 2008 we issued a $7.5 million Convertible Senior Subordinated Secured Promissory Note due 2012 to our controlling stockholder, Sun Mackie that is secured by all of the assets of the Company now owned and thereafter acquired. This transaction is explained in more detail in Note 18 of the accompanying financial statements.

 

As of December 31, 2007, 3,409,382 shares, representing 73.8% of our outstanding common stock, were owned by affiliates of Sun Capital Partners, Inc., a private investment firm. Accordingly, we are a controlled company within the meaning of the NASD rules governing companies listed on the Nasdaq Capital Market

and, as discussed in greater detail below and in our proxy statement for our 2007 annual shareholder meeting, we are therefore exempt from application of certain of the corporate governance rules, particularly including those relating to independent board composition and compensation and nominating committee requirements.

 

Our stock trades on the Nasdaq Capital Market^tm under the symbol “LTEC”.

 

“MACKIE,” the running man figure, “TAPCO,” “EAW,” and “SIA” are registered trademarks or “common law” trademarks of LOUD Technologies Inc. “Alvarez”, “Ampeg”, “Crate”, and “Knilling” are registered trademarks of our wholly owned subsidiary, St. Louis Music, Inc. “Martin Audio” is a registered trademark of our wholly owned subsidiary, Martin Audio, Ltd. To the extent our trademarks are unregistered, we are unaware of any conflicts with trademarks owned by third parties. This document contains names and marks of other companies, and we claim no rights in the trademarks, service marks and trade names of entities other than those in which we have a financial interest or licensing right.

 

Marketing

 

LOUD focuses on innovative marketing for each LOUD brand. As a result, each brand holds a unique position in its respective marketplace. Each brand is supported by a dedicated team of brand-specific product, business and communication resources handling all media planning, buying, print literature and advertising design, web design, public relations, product documentation, product training, as well as end-user and dealer trade shows and special events.

 

Our Major Brands

 

Alvarez is an acoustic guitar line geared to players of all levels — from entry-level to professional.

 

Ampeg is the industry standard in bass amplification for more than 50 years.

 

Crate is an entry-level brand of musical instrument amplification products.

 

EAW represents precision engineered, technologically superior loudspeakers and digital mixers. EAW systems are found in public spaces including sporting arenas, churches, nightclubs, and on major musical concert tours.

 

Mackie is innovative professional audio systems for both recording and sound reinforcement applications.

 

Martin Audio is world-class loudspeaker systems with leading edge designs.

 

Distribution and Sales

 

Sales to customers in the United States represented 53%, 66% and 63% of our total net sales in 2007, 2006 and 2005, respectively. In the United States, for EAW products, we use a network of independent representatives. These products are sold in musical instrument stores, professional audio outlets and several mail order outlets. For Alvarez, Ampeg, Crate, Mackie, St. Louis Music Accessories, Tapco, Knilling and Martin Audio products, we use a dedicated, domestic employee sales force (we employed approximately 22 salespersons as of December 31, 2007) that sells to musical instrument stores, retail locations, professional audio outlets and several mail order outlets. Sales to our top 10 U.S. dealers represented approximately 23%, 29% and 27% of net sales made in 2007, 2006 and 2005, respectively. One dealer, Guitar Center, Inc., accounted for approximately 16%, 19% and 17% of net sales in 2007, 2006 and 2005, respectively. Guitar Center, Inc. was the only dealer accounting for over 10% of net sales during any one year during this period.

 

Internationally, our products are offered direct to dealers in the United Kingdom, Canada, France, Germany, Belgium, Netherlands and Luxembourg primarily through our subsidiaries in the United Kingdom and Canada. We also sell direct to dealers in Japan. Our products are also distributed through local distributors in countries where we do not have direct operations. No single international distributor accounted for more than 10% of international net sales during any one year in this period.

Customer Support

 

Customer support programs are designed to enhance brand loyalty by building customer understanding of product use and capabilities. The customer service and support operation also provides us with a means of understanding customer requirements for future product enhancements. This understanding comes through direct customer contact, as well as through close analysis of responses to various product registration surveys.

 

Product support specialists are located in Woodinville, Washington and Whitinsville, Massachusetts to provide direct technical service and support. Technical support is provided either through a toll-free number or web-based support during scheduled business hours, and via the website after business hours. Customers requiring warranty service or repair on products sold in the United States are instructed to contact Technical Support via telephone or the web. Once Technical Support validates the warranty claim, depending on the product and the nature of the problem, we offer an advance replacement unit or a warranty repair at one of our authorized service center locations throughout the United States. Internationally, our subsidiaries in the United Kingdom, as well as our independent distributors, are utilized to provide product support and are also responsible for warranty repairs for products sold into their markets. Additionally, certain products returned to stock are processed through a contract repair facility in Shanghai, China.

 

Research and Development

 

We pride ourselves on employing the top engineering and product design talent in the professional-audio and musical instrument industries. Research and development teams are located in Woodinville, Washington; Whitinsville, Massachusetts; High Wycombe, United Kingdom; Shenzhen, China; and Victoria, B.C., Canada. We also utilize contract engineering service groups to supplement our in-house personnel. Research and development activities by LOUD Technologies during 2007, 2006 and 2005 was approximately $11.6 million, $11.8 million, and $10.3 million, respectively.

 

Competition

 

The professional audio and musical instrument industries are fragmented and highly competitive. There are numerous manufacturers, which run the gamut from large to small manufacturers both domestic and international, and offer products that vary widely in price and quality and are distributed through a variety of channels. LOUD competes primarily on the basis of product quality and reliability, price, ease of use, brand name recognition and reputation, ability to meet customers’ changing requirements and customer service and support. We compete with a number of professional audio and musical instrument manufacturers, several of whom have significantly greater development, sales and financial resources. Our primary market competitors are subsidiaries of Bosch GmbH; Fender Musical Instruments Corporation; Harman International Industries; and Yamaha Corporation.

 

Proprietary Technologies

 

We have a strong interest in protecting the intellectual property that reflects our original research, creative development and product development. As such, we have sought protection through patents, copyrights, trademarks and trade secrets and have applied and filed for various design and utility patents, both domestically and internationally. We have actively used certain trademarks, and have applied for and registered specific trademarks in the United States and in foreign countries. While the registration of patents and trademarks, and the use of copyrights, trade secrets and other intellectual property protections provides us with certain legal rights, there can be no assurance that any such registration will prevent others from infringing upon these trademarks.

 

Manufacturing

 

In 2006, we began the process of transferring our remaining domestic manufacturing overseas. All of our domestic manufacturing plants were closed by the end of the second quarter of 2007 as our overseas contract manufacturers ramped up to full production of our products. Our overseas manufacturers are supported by a team of our employees, located in China, who are responsible to audit quality procedures, manage and

facilitate the transition of products from design to manufacturing and to ensure timely delivery of purchased product.

 

Employees

 

As of December 31, 2007, we had 533 full-time equivalent employees, including 111 in marketing, sales and customer support; 143 in research and development; 191 in manufacturing, manufacturing support and manufacturing engineering; and 88 in administration and finance. Of our employees as of December 31, 2007, 396 were located in the United States, 25 were located in Canada, 70 were located in Europe and 42 were located in Asia. Also as of December 31, 2007, 33 were members of an organized labor union. We laid off approximately 226 employees during 2007, primarily in the manufacturing and manufacturing support areas.

 

Website Access to Reports

 

Our website address is www.loudtechinc.com. The contents of our website are not incorporated into this report or into any of our filings with the Securities and Exchange Commission. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, the Forms 3, 4 and 5 filed by our executive officers, directors and certain shareholders pursuant to Section 16(a) of the Exchange Act, and any amendments to those reports are available free of charge on our website, as soon as is reasonably practicable, after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. The SEC also maintains a website, http://www.sec.gov, at which you may access all of our filings of other persons who are required to file reports with respect to the ownership, disposition, and voting of our equity securities.

 

 

Controlled Company.  As of March 25, 2008 approximately 76% of our voting stock was beneficially owned by Sun Mackie, LLC, an affiliate of Sun Capital Partners, Inc., a Florida-based private equity firm. As a result of our issuance of a convertible debt obligation to Sun Mackie, LLC, Sun Mackie, LLC may increase its beneficial ownership to approximately 85% of outstanding common stock upon conversion of the principal balance of our Senior Subordinated Secured Convertible Note. By virtue of that ownership Sun Mackie has the power to nominate and designate all of the members of our board of directors, and directly or indirectly control substantially all aspects of our operations. Because of its concentration of ownership, for example, Sun Mackie, LLC, has the ability to require or prohibit any action over which our shareholders have control, including the approval of significant corporate transactions, a sale of our company, decisions about our capital structure and the composition of our board of directors. As a result, Sun Mackie, LLC, may vote its shares of capital stock to cause us to take actions that may conflict with the best interests of our unaffiliated stockholders, which could adversely affect our results of operations and the trading price of our common stock.

 

Moreover, as a result of this ownership arrangement, we rely on exemptions from certain Nasdaq corporate governance standards. Under the Nasdaq Marketplace Rules, a company of which more than 50% of the voting power is held by a single person or a group of people is a “controlled company” and may elect not to comply with certain Nasdaq Global Select Market corporate governance requirements, including (1) the requirement that a majority of the board of directors consist of independent directors, (2) the requirement that the compensation of officers be determined, or recommended to the board of directors for determination, by a majority of the independent directors or a compensation committee comprised solely of independent directors, and (3) the requirement that director nominees be selected, or recommended for the board of directors’ selection, by a majority of the independent directors or a nominating committee comprised solely of independent directors with a written charter or board resolution addressing the nomination process. Unless we cease to rely on these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the Nasdaq Global Select Market corporate governance requirements.

 

Liquidity and Debt Obligations.  We are highly leveraged and maintain a number of credit arrangements that are critical to our growth and to our ongoing operations. These credit agreements include certain financial

covenants and ratios and require that we maintain adequate levels of eligible collateral to support our borrowing level. Our substantial debt subjects us to numerous risks, including the following:

 

 

The agreements also provide, among other matters, restrictions on additional financing, dividends, mergers, acquisitions, and an annual capital expenditure limit. The covenants in these credit agreements may restrict our operations. If we are unable to generate adequate levels of sales and operating profit, our lenders could declare us to be in default of our obligations. As discussed below in greater detail, in February 2007 we notified our senior lender that we were in breach of certain financial covenants in our senior credit facility. We received a forbearance from this lender that continued in effect until we completed the refinancing of our March 30, 2007 credit facility. Also discussed below in greater detail, we failed to meet our EBITDA targets, fixed charge coverage ratio, and consolidated leverage ratio at September 30, 2007 and December 31, 2007. On October 17, 2007 and March 6, 2008, we entered into waiver agreements with the lenders with respect to the defaults. Also discussed below in greater detail, on March 6, 2008, we entered into an amendment to our current credit agreement. We believe we will maintain compliance with the terms of our current credit facility and with our other financing arrangements, but if we fail to comply, there is no assurance that the lenders would grant waivers or agree to restructure our debt or that we would be able to obtain other financing. If we default on our debt, our lenders have a variety of remedies against us including accelerating all amounts so that they come due immediately and foreclosing on their security interests, which would allow the creditors to take possession of all of our assets. Moreover, certain of our debt obligations are cross-defaulted, which means that a default under one of the agreements causes a default against each other credit agreement. In such instances, if we were required to obtain alternate financing in a very short period of time, we might have to suspend or discontinue our operations, liquidate our assets or take other measures that would result in a material adverse effect upon our financial condition and results of operations.

 

We were in default of certain financial covenants in our senior secured loan facility at December 31, 2006. On March 5, 2007 we entered into a Forbearance and Consent Agreement with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc. as lender, whereby Merrill Lynch Business Financial Services Inc. agreed to forbear from exercising its rights and remedies for default under the credit facility. The Forbearance and Consent Agreement ended on March 30, 2007, when we refinanced the principal balances owing under this credit facility through a structured financial transaction with Ableco Finance LLC (“Ableco”) and certain other lenders (including our controlling stockholder) for up to $112 million in the form of a senior secured credit facility. This transaction and the impact to our liquidity are explained in more detail in Note 10 of the accompanying financial statements.

 

We failed to meet our EBITDA target, fixed charge coverage ratio, and consolidated leverage ratio related to the Ableco credit facility as of September 30, 2007 and December 31, 2007. With respect to the September 30, 2007 default, we entered into a waiver agreement on October 17, 2007 with the lenders effective as of September 30, 2007. We paid a fee of $225,000 upon execution of the waiver and the interest rates on Term Loan A increased to Chase Manhattan Bank’s prime rate plus 0.85% or LIBOR plus 3.35% and the interest rates on Term Loans B increased to Chase Manhattan Bank’s prime rate plus 2.95% or LIBOR plus 5.2%. With respect to the December 31, 2007 default, we entered into a waiver agreement on March 6, 2008 with the lenders effective as of December 31, 2007. We paid a fee of $100,000 upon execution of the waiver.

On March 6, 2008, we entered into an Amendment related to the Ableco credit facility. The Amendment modifies certain definitions used in the Financing Agreement and requires us to reduce the balance outstanding under the Financing Agreement by $7.5 million. The Amendment modifies the definition of “Consolidated EBITDA” and “Consolidated Funded Indebtedness” to change the calculations pursuant to these terms, as well as other terms used in the Financing Agreement.

 

As a condition to entering into the Amendment, our lender has requested that we seek $7.5 million of subordinated financing. On March 18, 2008, we issued to our controlling stockholder, Sun Mackie, a $7.5 million Convertible Senior Subordinated Secured Promissory Note due 2012 (the “Note”) that is secured by all of the assets of the Company now owned and thereafter acquired. The Note bears interest at a rate of 15.25% per annum, payable in kind until maturity, and is convertible into common stock at a conversion price of $5.00. We paid Sun Mackie a fee of $150,000 upon issuance of the Note, and have agreed to pay all of Sun Mackie’s expenses associated with its entry into the note. This transaction is explained in more detail in Note 18 of the accompanying financial statements.

 

Our credit arrangements generally accrue interest based on variable short-term interest rates. Increases in the prime rate or LIBOR would increase our interest expense, which would adversely affect our profitability and cash flows.

 

Related Party Transactions.  We are party to certain contracts with Sun Mackie, LLC, our controlling shareholder, and certain contracts with affiliates of Sun Mackie, LLC. These relationships may create actual or potential conflicts of interest.

 

For example, on March 18, 2008, after the period covered by this report, we issued a Senior Subordinated Secured Convertible Note in the principal amount of $7,500,000. That note bears interest at a rate of 15.25% per annum and is payable in kind, meaning that accruing interest not paid in cash is payable in additional notes having the same terms. The notes are convertible at any time at the election of Sun Mackie, LLC, into shares of our common stock, and the number of shares issuable upon conversion is equal to the then-outstanding principal balance (including interest) of the notes, divided by $5.00. This conversion rate represents a discount from the reported market price of our common stock at the close of business on March 17, 2008, the day prior to our issuance of that note. This discount causes the Note to have a beneficial conversion feature which will cause additional interest expense to be recorded in future periods that is not factored into the 15.25% rate.

 

Additionally, we pay an affiliate of Sun Mackie, LLC, an annual management fee of $400,000, or 6% of EBITDA, not to exceed $1,000,000 plus expense reimbursements which totaled approximately $948,000 and $1,048,000 in 2007 and 2006, respectively, in exchange for their contributions to our management and for the service of Sun Mackie’s affiliates on our board of directors. In addition, Sun Mackie, LLC, and its affiliates face only limited restrictions on their ability to compete with us. Accordingly, there may arise conflicts of interest that restrict or inhibit our ability to operate our business, make acquisitions and obtain financing.

 

Finally, we have had in the past, and may in the future enter into, commercial agreements or financing arrangements with one or more companies in which Sun Mackie, LLC, or its affiliates, has an interest. There can be no assurance that any such transactions has approximated, or in the future will approximate, benefits or value that might be obtained from unrelated parties bargaining at arms’ length.

 

Sales Concentration.  One customer, Guitar Center, Inc., represents a significant portion of our sales. In 2007, 2006, and 2005, Guitar Center, Inc. accounted for approximately 16%, 19% and 17%, respectively, of our net sales. We anticipate that this customer will continue to represent a significant portion of our sales, however Guitar Center, Inc. is not under any obligation, by contract or otherwise, to continue purchasing products from us. If the relationship with Guitar Center, Inc. were to deteriorate for any reason we could lose a portion of our net sales revenues, which would have an adverse impact on our results of operations, liquidity and financial condition.

 

Acquisition Matters.  We have entered, and may in the future enter, into strategic transactions, including strategic supply and service agreements and acquisitions of other assets and businesses. Any such transactions

can be risky, may require a disproportionate amount of our management and financial resources and may create unforeseen operating difficulties or expenditures, including:

 

 

Some of our business acquisitions have increased, or in the future may increase, our level of difficulty in maintaining our financial reporting controls. In addition, acquisitions of, and investments in, businesses organized outside the United States often can involve additional risks, including:

 

 

The anticipated benefit of any of our strategic transactions may never materialize. Future investments, acquisitions or dispositions, or similar arrangements could result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities or amortization expenses, or write-offs of goodwill, any of which could harm our financial condition. Any such transactions may require us to obtain additional equity or debt financing, which may not be available on favorable terms, or at all. We have experienced certain of these risks in connection with our acquisitions and investments in the past, and the occurrence of any of these risks in the future may have a material effect on our business.

 

Competition.  Our industry is highly competitive, and we face competition from a number of well-known brands including Electro-Voice, Fender, Harman and Yamaha. Some of our competitors are substantially better capitalized and have substantially stronger market presence than we have. We also expect increasing

competition from both established and emerging companies. Competition may have the effects of reducing the prices we can charge for our products, increasing our marketing costs associated with developing and maintaining our market niche, or reducing the demand for our products. If we fail to compete successfully against current and future sources of competition, our profitability and financial performance will be adversely affected, and those effects may be material.

 

Variability in Quarterly Operating Results.  Our operating results will vary from quarter to quarter. Sales in each quarter is substantially dependent on orders received within that quarter as well as product availability. Our expenditures in each quarter are based on investment plans and our best estimates of future sales. We may, therefore, be unable to reduce spending if sales decline in a given quarter quickly enough to prevent adverse impacts on our operating results for such quarters. Moreover, results of operations for any one quarter are not necessarily indicative of results for any future period.

 

Other factors which could cause fluctuations in quarterly results to occur include:

 

 

It is likely that in some quarters our operating results will be adversely affected by these factors.

 

Rapid Technological Change.  Product technology in the professional audio and music products market evolves rapidly, making timely product innovation essential to success in the marketplace. The introduction of products with improved technologies or features may render our existing products obsolete and unmarketable. If we cannot develop products in a timely manner in response to industry changes, or if our products do not perform well, our business and financial condition may be adversely affected. In addition, new products may contain defects or errors, which may negatively impact the product’s acceptance in the market.

 

Product Liability.  Some of our products are electronically powered and may pose a risk of electrical shock or fire. These products, such as amplifiers, speakers and sound mixers, create a risk that our customers or third parties may bring claims that our products have caused property damage, physical injury or death. In extreme cases these claims may be asserted as class actions on behalf of large numbers of people. These types of litigation, if threatened or brought, can be costly to defend and may distract management’s attention from operating our business, whether or not we ultimately are adjudged to be liable and whether or not we settle such an action.

 

Use of Contract Distribution Centers.  We store and ship the majority of our products from our Woodinville, Washington and St. Louis, Missouri locations. In addition, we utilize contract distribution centers in Europe, Asia and Canada. These distribution centers may encounter personnel issues, business disruptions, information systems outages or other disruptions, which may not be remedied quickly, resulting in delays in shipments of our products. Failure to maintain adequate systems and internal controls at these facilities could result in customer shipments being delayed or otherwise improperly transacted, potentially resulting in lost revenue, products or customers.

 

Use of Contract Manufacturers.  The majority of our products are manufactured by contract manufacturers. Contract manufacturing creates additional risks including:

 

 

Manufacturing in China.  Our ability to import products from China at current tariff levels could be materially and adversely affected if the United States terminates the “normal trade relations” (“NTR”, formerly “most favored nation”) status granted to China for trade and tariff purposes. As a result of its NTR status, China receives the same favorable tariff treatment that the United States extends to its other “normal” trading partners. China’s NTR status, coupled with its membership in the World Trade Organization, could eventually reduce barriers to manufacturing products in and exporting products from China. However, we cannot provide any assurance that China’s WTO membership or NTR status will not change.

 

International Operations.  We have significant net sales to customers outside the United States and believe that international sales will continue to represent a significant portion of our revenue. International sales may fluctuate due to various factors, including:

 

 

Consumer Products Regulations.  In the United States, our products must comply with various regulations and standards defined by the Federal Communications Commission, the Consumer Products Safety Commission and Underwriters’ Laboratories. Internationally, our products may be required to comply with regulations or standards established by consumer protection or telecommunications authorities in the countries into which we sell our products, as well as standards established by various multinational or extranational bodies. These regulations are becoming more common and the trend is to impose greater restrictions upon products such as ours. For example, the European Union recently adopted a directive on the restriction of certain hazardous substances in electronic and electrical equipment, known as RoHs, and has enacted the Waste Electrical and Electronic Equipment, or WEEE, directive applicable to persons who import electrical or electronic equipment into Europe. Similarly, California has a consumer protection measure that requires us to identify or eliminate potential hazardous components used in our products.

 

We believe we are in material compliance with all applicable regulations; however, the regulations may expose us to various civil penalties in cases of noncompliance. Moreover, as these regulations are constantly evolving and generally are becoming more, rather than less, restrictive upon our business, we can offer no assurances that our existing and future product offerings will remain compliant with evolving standards and regulations. If we fail to obtain timely domestic or foreign regulatory approvals or certification, we may be unable to sell our products into jurisdictions to which these standards apply, which may prevent us from sustaining our revenues or maintaining profitability. Finally, noncompliance with applicable regulations may

increase our exposure to potential tort liability to persons claiming to have been harmed as a result of our actions or omissions.

 

Protection of Intellectual Property.  We have a strong interest in protecting the intellectual property that reflects our original research, creative development, and product development. As such, we have sought protection through patents, copyrights, trademarks, and trade secrets. Along with extensive trademark and patent registration and filings, we have claimed copyright protection for works of original authorship, including product brochures, literature, advertisement, and web pages. While certain legal rights of enforceability are available to us, there can be no assurance as to the ability to successfully prevent others from infringing upon our intellectual property.

 

We have never conducted a comprehensive patent search relating to the technology used in our products, however, we believe that our products do not infringe upon the proprietary rights of others. There can be no assurance, however, that others will not assert infringement claims against us in the future or that those claims, if brought, will not be successful.

 

While we pursue patent, trademark and copyright protection for products and various marks, we also rely on the use of confidentiality agreements with our employees, consultants, development partners and contract manufacturers to protect our trade secrets, proprietary information and other intellectual property. There can be no assurance, however, that these confidentiality agreements will be honored or will be effective in protecting our trade secrets, proprietary information and other intellectual property. Moreover, there can be no assurance that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.

 

Dependence on Key Personnel.  Our future success will depend in a large part on the continued service of many of our technical, marketing, sales and management personnel and on our ability to attract, train, motivate and retain highly qualified employees. Our employees may voluntarily terminate their employment at any time. The loss of the services of key personnel or the inability to attract new personnel could have a material adverse effect upon our results of operations.

 

Sarbanes-Oxley Compliance.  Section 404 of the Sarbanes-Oxley Act of 2002 requires us, like all other publicly traded companies, to perform an evaluation of our internal control over financial reporting and have our auditors attest to such evaluation. However, the SEC has currently delayed the effectiveness of the regulations that would require us to file these reports. Currently, the SEC has postponed the requirement for non-accelerated filers to provide management’s report on internal control until after its annual report for the period ended December 31, 2008, and the auditor’s attestation report after it files its annual report for the fiscal year ended December 31, 2009. However, it is possible that the SEC will further postpone the requirements to later dates. When such requirement is implemented, we will have to establish an ongoing program to perform the system and process evaluation and testing necessary for compliance. If we do not establish and maintain an effective system of internal control and address and remediate any material weaknesses and other significant deficiencies, the reliability of our periodic reports on Form 10-Q and annual report on Form 10-K may be compromised. In addition, reporting any material weakness may negatively impact investors’ perception of us. Finally, if we fail to complete our evaluation on a timely basis and in a satisfactory manner or if management or our auditors are unable to attest on a timely basis to the adequacy of our internal controls, we may be subject to additional regulatory scrutiny and to a loss of public confidence in our internal controls over financial reporting.

 

 

None.

 

 

We owned one building, a 63,250 square foot building located on 7.66 acres in Yellville, Arkansas, which was used primarily for manufacturing. The sale of the Yellville, Arkansas facility closed on March 30, 2007 and we turned over possession to the new owner on April 30, 2007.

The remainder of our facilities are leased. We lease additional smaller facilities in the United States, Canada, Europe and Asia for our regional sales and support offices. We believe these properties are adequate for our current anticipated needs.

 

 

 

In November 2005, LOUD Technologies Inc. and its subsidiary, St. Louis Music, Inc., were named as defendants in a lawsuit in the United States District Court, Southern District of Florida. The plaintiff, Ace Pro Sound and Recordings, claims that a leading United States retailer of musical products gave notice to us and six other defendants that it would no longer trade with the plaintiff and that the seven defendants then refused to trade with plaintiff in violation of federal antitrust laws. As of the end of the year ended December 31, 2007, this matter has been resolved.

 

 

There were no matters submitted to a vote of our security holders during the fourth quarter of the fiscal year ended December 31, 2007.

 

 

The Company voluntarily delisted from the Nasdaq Small Cap Market^tm on February 7, 2003 because of ongoing difficulties in satisfying certain of the Nasdaq continuing listing requirements. The Company’s stock began trading on the OTC Bulletin Board on February 11, 2003. We applied for reinstatement to the Nasdaq Capital Market^tm on November 23, 2005. Our stock began trading on the Nasdaq Capital Market^tm under the symbol “LTEC” on March 1, 2006.

 

As of December 31, 2007, there were 4,618,942 common stock shares of LOUD Technologies Inc. issued and outstanding and approximately 55 shareholders of record. The following table shows the high and low sales prices for our common stock for the periods indicated.

 

 

We have not paid dividends on our common stock in the past, and it is not anticipated that cash dividends will be paid on shares of our common stock in the foreseeable future. Any future dividends will be dependent upon our financial condition, results of operations, current and anticipated cash requirements, acquisition plans and plans for expansion, and any other factors that our Board of Directors deems relevant. Under our current loan and security agreement, we are prohibited from paying any dividends.

 

Sales of Unregistered Securities

 

In connection with the acquisition of St. Louis Music and pursuant to the Acquisition Agreement dated March 4, 2005 by and among LOUD Technologies Inc., SLM Holding Corp., SLM Merger Corp. and St. Louis Music, we issued 79,358 shares of common stock to Edward Kornblum, one of the shareholders of St. Louis Music. The shares were issued in an unregistered private placement in reliance upon an exemption from registration set forth in Section 4(2) of the Securities Act of 1933, as amended.

 

On August 29, 2005 we issued 51,547 shares of common stock, par value $14.55 per share, to certain institutional and accredited investors in accordance with Rule 506 of Regulation D promulgated under the Securities Act of 1933, as amended. The consideration for these shares was cash in the amount of $750,000 and the proceeds of such sale were used for debt retirement and working capital.

Equity Compensation Plan Information

 

The Company has a shareholder-approved equity plan that enables the compensation committee of the board of directors to make stock option awards.

 

The table below provides information, as of December 31, 2007, concerning securities under current and former equity compensation plans.

 

 

During 2003, our board of directors adopted the 2003 Stock Option Plan (the “2003 Plan”), authorizing options to purchase 345,600 shares of common stock. The 2003 Plan calls for options to be non-qualified stock options with exercise prices equal to the fair value of the stock on the date granted. Options generally vest over a five-year period and expire on the earlier of ten years from grant date or three months from termination. If an option holder is terminated for cause, as defined in the 2003 Plan, the options would terminate a day prior to termination. At December 31, 2007, 178,000 shares of common stock were available for future grants under the 2003 Plan.

 

The Company also has a 1995 Stock Option Plan (the “1995 Plan”), which authorized 1.3 million shares of common stock for grants. The exercise price of incentive stock options granted under the 1995 Plan may not be less than the fair value of the common stock on the date of grant. The exercise price of nonqualified stock options granted under the plan may be greater or less than the fair value of the common stock on the date of grant, as determined by the stock option committee of the board of directors at its discretion. Options generally vest over a four- to five-year period and expire no later than ten years after the date of grant or three months from termination. At December 31, 2007, 902,000 shares of common stock were available for future grants under the 1995 Plan.

Stock Performance Graph

 

The following graph compares the cumulative total shareholder return for the Company’s stock at December 31, 2007 since December 31, 2002 to the cumulative return over such period of (1) the Total Return Index of the NASDAQ Composite and (2) the Total Return Index of the NASDAQ Electronic Components. The graph assumes that on December 31, 2002, $100 was invested in the common stock of the Company and in each of the comparative indices. The stock price performance on the following graph is not necessarily indicative of future stock price performance.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

Among LOUD Technologies, The NASDAQ Composite Index

And The NASDAQ Electronic Components Index

 

 

 

The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements of the Company, including the notes thereto, included elsewhere in this Form 10-K.

 

 

 

 

 

 

The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data” and the Consolidated Financial Statements and Notes thereto included elsewhere in this Annual Report. This discussion contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Actual results could differ materially from those discussed here.

The cautionary statements made in this Annual Report should be read as being applicable to all forward-looking statements wherever they appear. Factors that could cause or contribute to such differences include those discussed in “Risk Factors,” as well as those discussed elsewhere herein. We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be required to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

 

General

 

Our product lines include sound reinforcement speakers, analog mixers, guitar and bass amplifiers, professional loudspeaker systems, and branded musical instruments. These products can be found in professional and project recording studios, video and broadcast suites, post-production facilities, sound reinforcement applications including churches and nightclubs, retail locations, and on major musical concert tours. We distribute our products primarily through retail dealers, mail order outlets and installed sound contractors. We have our primary operations in the United States with other operations in the United Kingdom, Canada, China and Japan.

 

Operating results for 2007 were substantially impacted by restructuring costs incurred during the manufacturing transition to Asia and the general softening in the demand for most of our product lines. Although this softening was partially offset by the inclusion of results of Martin Audio of $1.3 million for the period April 11, 2007 through December 31, 2007, our operating results decreased $8.1 million when compared to 2006. For the twelve months ended December 31, 2007, net sales decreased 3.2% to $208.3 million from $215.0 million for 2006. The decrease in net sales is primarily related to the softening in the demand for our products. The decrease is partially offset by the inclusion of the results of Martin Audio of $20.9 million for the period April 11, 2007 through December 31, 2007. Our operating income for 2007 decreased by 92.2% to $0.7 million, representing 0.3% of sales, compared to the operating income for 2006, which was $8.8 million, representing 4.1% of net sales. Net loss declined to $12.6 million, or $2.60 per diluted share, compared to net income of $0.6 million, or $0.13 per diluted share, for 2006.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses, and related disclosure of contingent assets and liabilities.

 

We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. Because of the uncertainty inherent in these matters, actual results could differ from the estimates we use in applying the critical accounting policies. Certain of these critical accounting policies affect working capital account balances, including the policies for revenue recognition, allowance for doubtful accounts, inventory valuation and income taxes. These policies require that we make estimates in the preparation of our financial statements as of a given date. However, since our business cycle is relatively short, actual results related to these estimates are generally known within the six-month period following the financial statement date. Thus, these policies generally affect only the timing of reported amounts.

 

Inventory Valuation.  LOUD inventories are reported at the lower of standard cost, which approximates actual cost on a first-in, first-out method, or market. Demonstration products used by our sales representatives and marketing department (including finished goods that have been shipped to customers for evaluation) are included in our inventories. Market value adjustments are recorded for excess and obsolete material, slow-moving product, service and demonstration products. We base judgments regarding the carrying value of our inventory upon current market conditions. Current market conditions depend upon competitive product introductions, customer demand and other factors. In the event that the market changes related to products that have been previously released, we may be required to write down the cost of our inventory to reflect this change in the market.

Allowance for Doubtful Accounts.  Estimates relating to the collectibility of our accounts receivable are ongoing and we maintain an allowance for estimated losses resulting from the inability of our customers to meet their financial obligations to us. We consider our historical level of credit losses to determine the amount of the allowance and we make judgments about the creditworthiness of significant customers based on ongoing credit evaluations of those customers. Since unforeseen changes in the financial stability of our customers cannot be predicted, actual future losses from uncollectible accounts may differ from our estimates. If the financial condition of a customer were to deteriorate and it was unable to make payments when due, a larger allowance may be required. In the event we determine that a smaller or larger allowance for estimated losses is appropriate, we would record a credit or a charge to the selling, general, and administrative expense in the period in which the adjustment to the allowance for estimated losses was made.

 

Long-lived Assets.  We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Significant business judgment is used to assess events and factors which might trigger impairment of long-lived assets, including significant underperformance relative to expected operating results, significant changes in the use of the assets or the strategy for our overall business, and/or significant negative industry or economic trends. As we continue to review our distribution methods and transition our manufacturing to third parties, this may result in circumstances where the carrying value of certain long-lived assets may not be recoverable.

 

Goodwill and Other Intangible Assets.  We assess the impairment of goodwill on an annual basis during our fourth fiscal quarter, or upon the occurrence of events or changes in circumstances that indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. A reporting unit is considered to be a brand or group of brands. Factors we consider important which could trigger an impairment review include the following:

 

 

If we were to determine that the fair value of the reporting unit was less than its carrying value (including the value of goodwill) based upon the annual test or the existence of one or more of the above indicators of impairment, we would measure impairment based on a comparison of the implied fair value of the reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value following this allocation is the implied fair value of the goodwill of the reporting unit. To the extent the carrying amount of the reporting unit goodwill is greater than the implied fair value of the reporting unit goodwill, we would record an impairment charge of the difference. There were no impairments related to goodwill for the Fiscal Year ended December 31, 2007.

 

Revenue Recognition.  Revenues from sales of products, net of sales discounts, returns and allowances, are generally recognized upon shipment under a customer agreement when the following have occurred: the risk of loss has passed to the customer; all significant contractual obligations have been satisfied; the fee is fixed or determinable; and collection of the resulting receivable is considered probable. Products are generally shipped “FOB shipping point” with no right of return. We do provide products to some dealers who finance their purchases through finance companies. We have a manufacturer’s repurchase agreement with the finance companies. We defer the revenue and related cost of goods sold of these sales at the time of the sale and recognize the revenue and related cost of goods sold of these sales when the right of return no longer exists. Sales with contingencies (such as rights of return, rotation rights, conditional acceptance provisions and price protection) are rare and not material. We generally warrant our products against defects in materials and workmanship for periods of between one and six years, with the exception of Alvarez Yairi guitars, which have a limited lifetime warranty. The estimated cost of warranty obligations, sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience.

Income Taxes.  In connection with preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or change this allowance in a period, it may materially impact the tax provision in the Statement of Operations.

 

Accounting for Acquisitions.  Significant business judgment is required to estimate the fair value of purchased assets and liabilities at the date of acquisition, including estimating future cash flows from the acquired business, determining appropriate discount rates, asset lives and other assumptions. Our process to determine the fair value of trademarks, customer relationships, and developed technology includes the use of estimates such as:

 

 

Our process to determine the fair value of inventories acquired was to estimate the selling price of the inventories less the sum of costs to sell and a reasonable selling profit allowance.

 

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

 

Net Sales

 

Net sales decreased by 3.2% to $208.3 million in 2007 from $215.0 million in 2006. We have experienced general softening in the demand for most of our product lines over the last 18 months. These trends are reflective of challenges facing our major customers and the industry as a whole. These trends were partially offset by the inclusion of sales of Martin Audio products from April 11, 2007 through December 31, 2007 of $20.9 million. We have one significant customer who represented approximately 16% and 19% of our total net sales in 2007 and 2006, respectively. U.S. sales represented approximately 53% of our net sales in 2007, compared to approximately 66% in 2006.

 

Gross Profit

 

Gross profit decreased by 16.0% to $60.0 million, or 28.8% of net sales, in 2007 from $71.5 million, or 33.2% of net sales, in 2006. Included in gross profit was $1.3 million related to Martin Audio for the period April 11, 2007 through December 31, 2007 which was negatively affected by $1.6 million due to recording Martin Audio’s inventories at fair value as a result of the purchase price allocation of Martin Audio. Gross profit was also reduced by the costs associated with the domestic factory shutdowns and additional sales discounting done in the first quarter of 2007 to reduce the carrying balances of our inventories at December 31, 2006. Excluding the $1.6 million fair value adjustment for Martin Audio’s inventory, gross profit percent for 2007 was 29.6%.

 

Selling, General and Administrative

 

Selling, general and administrative expenses decreased by 7.2% to $45.8 million, or 22.0% of net sales in 2007, from $49.3 million, or 22.9% of net sales in 2006. The decrease was primarily attributable to the effect of cost-cutting programs implemented in 2006 partially offset by costs related to Martin Audio of $4.2 million for the period April 11, 2007 through December 31, 2007.

Research and Development

 

Research and development expenses decreased by 1.7% to $11.6 million, or 5.6% of net sales in 2007, from $11.8 million, or 5.5% of net sales in 2006. The decrease was primarily attributable to the effect of cost-cutting programs implemented in late 2006 and continuing into 2007 partially offset by costs related to Martin Audio of $1.2 million for the period April 11, 2007 through December 31, 2007.

 

Other Expense

 

Net other expense increased by 77.4% to $13.7 million in 2007, from $7.7 million in 2006. This increase was attributable primarily to an increase to interest expense of $3.9 million and the write-off of $2.5 million of unamortized fees related to the prior debt facility as a result of the refinancing of our debt facilities in March 2007. The increase in interest expense is primarily attributable to increasing variable interest rates and increased debt as a result of the $112 million senior secured credit facility.

 

Management fees are paid quarterly to Sun Capital Partners Management, LLC, an affiliate of our principal shareholder, and are calculated as the greater of $0.4 million annually or 6% of EBITDA, not to exceed $1.0 million per year. Of the $0.9 million of management fees expensed during 2007, $0.8 million relates to the 2007 EBITDA calculation and $0.1 million is miscellaneous expenses incurred by Sun Capital Partners Management, LLC, for which they are entitled to reimbursement pursuant to our Management Services Agreement dated February 21, 2003. Of the $1.1 million of management fees expensed during 2006, $1.0 million relates to the 2006 EBITDA calculation and $0.1 million is miscellaneous expense incurred by Sun Capital Partners Management, LLC.

 

Income Tax Expense

 

The income tax benefit was $436,000 in 2007 compared to income tax expense of $431,000 in 2006. The primary components of the 2007 benefit is the deferred tax benefit recorded as a result of the partial amortization of the deferred tax liability recorded as a result of the acquisition of Martin Audio. This deferred tax benefit was further impacted by the enactment of a U.K. tax law during 2007, which reduced the statutory tax rate. This deferred tax benefit was partially offset by current taxes due from our foreign subsidiaries and an increase to our income tax reserve. The primary components of the 2006 taxes are the Alternative Minimum Tax, changes in our income tax reserve, deferred tax expense recorded as a result of the goodwill that is amortized for tax purposes only from the St. Louis Music, Inc. acquisition, and foreign subsidiary tax expense.

 

As of December 31, 2007, we had net operating loss carryforwards for federal income tax purposes of approximately $32.6 million, which if not utilized would begin to expire in 2024. Approximately $31.0 million of these loss carryforwards relate to the United States and United Kingdom. Approximately $1.6 million of these loss carryforwards relate to our discontinued operation in France, which we believe we will not be able to realize. We have recorded a valuation allowance for all of the net deferred tax assets related to the United States as a result of uncertainties of future taxable income necessary for the realization of these net assets.

 

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005

 

Net Sales

 

Net sales from continuing operations increased by 5.2% to $215.0 million in 2006, from $204.3 million in 2005, due to the inclusion of a full year of sales from historical St. Louis Music brands in 2006, which we acquired on March 4, 2005. We have one significant customer who represented approximately 19% and 17% of our total net sales in 2006 and 2005, respectively. U.S. sales represented approximately 66% of our net sales in 2006, compared to approximately 63% in 2005.

Gross Profit

 

Gross profit increased by 9.4% to $71.5 million, or 33.2% of net sales, in 2006 from $65.3 million, or 32.0% of net sales, in 2005. The increase in gross profit is primarily attributable to the increase in sales volume in 2006. The 2005 gross profit was impacted by the $2.4 million fair value adjustment for recording of St. Louis Music’s inventories at fair value as a result of the purchase price allocation of St. Louis Music. The remaining increase is due to the continuing benefit of outsourcing our production overseas, which is partially offset by a larger percentage of lower margin historical St. Louis Music brand sales.

 

Selling, General and Administrative

 

Selling, general and administrative expenses increased by 5.9% to $49.3 million in 2006, from $46.6 million in 2005. This increase is partially attributable to having a full twelve months of St. Louis Music expenses. The remaining increase is due to one-time costs associated with the shift to direct sales distribution of Mackie products in North America. These increases were partially offset by the consolidation of the St. Louis Music operations, the ongoing cost benefits of our direct sales program, and the cost-cutting programs implemented in June 2006.

 

Research and Development

 

Research and development expenses increased by 14.6% to $11.8 million in 2006, from $10.3 million in 2005. The increase was primarily attributable to a full year of St. Louis Music costs, an increase in new product development in 2006 when compared to 2005, and additional engineering resources required to transition our domestic manufacturing to our contract manufacturers.

 

Other Expense

 

Net other expense increased $0.2 million, or 2.6% from $7.5 million in 2005 to $7.7 million in 2006. This increase was related primarily to an increase in interest expense partially offset by decreases to management fees and other expenses.

 

Of the $1.1 million of management fees expensed during 2006, $1.0 million is attributable to the 2006 EBITDA calculation and $0.1 million is miscellaneous expenses incurred by Sun Capital Partners Management, LLC. Of the $1.2 million of management fees expensed during 2005, $1.0 million is attributable to the 2005 EBITDA calculation, $0.1 million is a correction to the management fee owed for the 2004 EBITDA calculation, and the remaining amount is miscellaneous expenses incurred by Sun Capital Partners Management, LLC.

 

Income Tax Expense

 

Income tax expense was $431,000 in 2006 compared to $47,000 in 2005. The primary components of the 2006 and the 2005 taxes are the Alternative Minimum Tax, changes in our income tax reserve, deferred tax expense recorded as a result of the goodwill that is amortized for tax purposes only from the St. Louis Music, Inc. acquisition, and foreign subsidiary tax expense.

 

As of December 31, 2006, we had net operating loss carryforwards for federal income tax purposes of approximately $22.1 million, which if not utilized would begin to expire in 2024. Approximately $20.7 million of these loss carryforwards relate to the United States and United Kingdom. Approximately $1.4 million of these loss carryforwards relate to our discontinued operation in France, which we believe we will not be able to realize. We have recorded a valuation allowance for all of the net deferred tax assets as a result of uncertainties of future taxable income necessary for the realization of these net assets.

 

Gain on Discontinued Operations

 

In March 2005, we recognized a $2.8 million gain from the discontinued operations of our former Italian subsidiary, net of tax of $58,000. This gain was a result of an agreement with Mackie Italy to settle the net outstanding amounts owed by the Company.

Liquidity and Capital Resources

 

As of December 31, 2007, we had cash and cash equivalents of $3.6 million and total debt and short-term borrowings of $101.7 million. At December 31, 2007 we had availability of $8.7 million on our revolving line of credit.

 

The following paragraphs describe transactions that affected our liquidity and capital resources.

 

On August 29, 2005, a credit facility was completed providing a $69.5 million senior secured loan facility and a $14.8 million senior subordinated note. The senior secured loan facility consists of a $40.0 million revolving loan (of which $14.2 million was outstanding as of December 31, 2006), a $15.0 million Term Loan A, and a $14.5 million Term Loan B. In connection with the senior subordinated note, the Company issued 51,547 shares of common stock to the subordinated lender at a per share price of $14.55.

 

LOUD was not in compliance with the Credit Agreement at February 14, 2007, because it did not meet the financial covenants set forth in the Credit Agreement for the period ending December 31, 2006. On March 5, 2007, the Company entered into a Forbearance and Consent Agreement, whereby the Lenders agreed to forbear from exercising certain of their rights and remedies with respect to certain events of default under the previous Credit Agreement dated August 29, 2005 and consented to the Martin Audio, Ltd. acquisition. The Forbearance Agreement covered the period commencing on March 5, 2007 and ending on March 30, 2007, when we closed on a new $112 million senior secured credit facility. The proceeds from this new credit facility were used to retire all amounts outstanding on the previous credit facility dated August 29, 2005, to fund the acquisition of Martin Audio, Ltd., and to provide for our future working capital needs. The $112 million senior secured credit facility consists of a $10.0 million revolving loan, a $20.0 million Term Loan A, a $40.0 million US Term Loan B, a $30.0 million UK Term Loan B, and a $12.0 million Term Loan C.

 

The $102.0 million term loans under the $112 million senior secured credit facility require quarterly principal payments. The term loans bear interest at the Chase Manhattan Bank’s prime rate or LIBOR, plus a specified margin. Interest is due quarterly on each term loan. Under the revolving line of credit, the Company can borrow up to $10.0 million, subject to certain restrictions. Interest is due quarterly and is based on Chase Manhattan Bank’s prime rate or LIBOR, plus a specified margin. The $112 million senior secured credit facility is secured by substantially all of the assets of the Company and its subsidiaries.

 

As of September 30, 2007 and December 31, 2007, we failed to meet our EBITDA targets, fixed charge coverage ratios, and consolidated leverage ratios. On October 17, 2007 we entered into a waiver agreement with the lenders effective as of September 30, 2007 with respect to the September 30, 2007 defaults. We paid the lenders a fee of $225,000 upon execution of the waiver and the interest rates on Term Loan A increased to Chase Manhattan Bank’s prime rate plus 0.85% or LIBOR plus 3.35% and the interest rate on Term Loans B increased to Chase Manhattan Bank’s prime rate plus 2.95% or LIBOR plus 5.2%. With respect to the December 31, 2007 default, we entered into a waiver agreement on March 6, 2008 with the lenders effective as of December 31, 2007. We paid the lenders a fee of $100,000 upon execution of the waiver.

 

On March 6, 2008, we entered into an Amendment related to the Ableco credit facility. The Amendment modifies certain definitions used in the Financing Agreement and requires us to reduce the balance outstanding under the Financing Agreement by $7.5 million. The Amendment modifies the definition of “Consolidated EBITDA” and “Consolidated Funded Indebtedness” to change the calculations pursuant to these terms, as well as other terms used in the Financing Agreement.

 

As a condition to entering into the Amendment, our lender has requested that we seek $7.5 million of subordinated financing. On March 18, 2008, we issued to our controlling stockholder, Sun Mackie a $7.5 million Convertible Senior Subordinated Secured Promissory Note due 2012 (the “Note”) that is secured by all of the assets of the Company now owned and thereafter acquired. The Note bears interest at a rate of 15.25% per annum, payable in kind until maturity, and is convertible into common stock at a conversion price of $5.00. We paid Sun Mackie a fee of $150,000 upon issuance of the Note.

In April 2007 we acquired all of the outstanding capital stock of Martin Audio, a UK based manufacturer of loudspeakers and related equipment for total cash consideration including transaction costs of $35.7 million and the assumption of certain liabilities of $15.3 million.

 

In March 2005, we acquired all of the shares of St. Louis Music, Inc., a Missouri-based manufacturer, distributor and importer of branded musical instruments and professional audio products for total cash consideration including transaction costs of $35.3 million and the assumption of certain liabilities of $7.2 million.

 

In February 2005, we made an offer to Mackie Italy to settle any outstanding amounts owed by the Company to Mackie Italy for $4.7 million. This proposal was accepted by the Italian court appointed trustee on behalf of Mackie Italy in May 2005. Under the terms of the settlement agreement, we made payments of $2.5 million in 2005. Additionally, we committed to pay $2.2 million in 2006, of which $1.5 million was paid in 2006 and the remaining $0.7 million was paid in January 2007. We recognized a gain on discontinued operations of $2.9 million in 2005 related to this settlement.

 

Net Cash Provided by Operating Activities

 

Cash provided by operations was $0.3 million in 2007, $0.3 million in 2006 and $10.0 million in 2005. The net loss for 2007 was $12.6 million that included $5.0 million in depreciation and amortization, $3.1 million in amortization and write off of deferred financing fees, a gain on asset dispositions of $0.5 million, stock based compensation expense of $0.3 million and $0.3 million of non-cash interest expense. In 2007 decreases to accounts receivable and inventories provided cash of $5.6 million and $4.1 million, respectively, while decreases to accounts payable, accrued liabilities, and payable to our former Italian subsidiary, and taxes payable used cash of $3.9 million and $1.4 million, respectively. Net income for 2006 was $0.6 million that included $4.6 million in depreciation and amortization, $0.7 million in amortization of deferred financing fees and $0.4 million in stock based compensation expense. In 2006, a decrease of our accounts receivable and prepaid expenses and an increase to accounts payable, accrued liabilities and payable to our former Italian subsidiary of $2.3 million and $6.6 million, respectively, provided cash, while an increase of our inventory levels used $15.6 million of cash. Net income for 2005 was $3.8 million which included $4.5 million in depreciation and amortization, $1.1 million in amortization and write off of deferred financing costs, a gain on discontinued operations of $2.9 million, stock based compensation expense of $0.1 million and non cash interest expense of $0.1 million. In 2005 decreases to our accounts receivable, inventories, and prepaid expenses and other current assets provided cash of $8.8 million while a decrease to our accounts payable, accrued liabilities and payable to our former Italian subsidiary used cash of $5.4 million.

 

Net Cash Used in Investing Activities

 

Cash used in investing activities was $36.3 million in 2007, $2.4 million in 2006 and $37.0 million in 2005. Cash used in investing activities during 2007 was primarily related to the acquisition of Martin Audio of $32.0 million, payment of $3.2 million related to our commitment to pay the former shareholders of St. Louis Music and purchases of $2.4 million of property, plant and equipment. Investing activities were partially offset by proceeds of $1.2 million from sales of property, plant and equipment. Cash used in investing activities of $2.4 million in 2006 related to purchases of property, plant and equipment. The cash used in investing activities in 2005 was primarily related to the acquisition of St. Louis Music, Inc. for $35.3 million, in addition to cash used of $1.7 million related to the purchase of property, plant and equipment.

 

Net Cash Provided by Financing Activities

 

Cash provided by financing activities was $39.7 million in 2007, $2.0 million in 2006, and $27.0 million in 2005. Cash provided by financing activities during 2007 related primarily to a new credit facility of $112.0 million consisting of a revolving loan facility of $10.0 million, of which $1.3 million was outstanding at December 31, 2007, a Term Loan A of $20.0 million, Term Loans B of $70.0 million and a Term Loan C of $12.0 million. Along with this refinancing, we paid $26.2 million of our existing Term Loans A and B, subordinated debt of $14.8 million, a revolving loan facility of $26.2 million, a debt and credit facility

acquired in the acquisition of Martin Audio of $3.0 million, and we incurred $3.0 million in deferred financing costs. Cash provided by financing activities during 2006 was primarily attributable to an increase in our borrowings from our bank line of credit of $4.6 million, which was partially offset by payments made on our long-term debt of $2.6 million. Cash provided by financing activities during 2005 related primarily to the Company issuing a new senior credit facility of $69.5 million, which consisted of a revolving loan facility of $40.0 million, of which $9.6 million was outstanding at December 31, 2005, a Term Loan A of $15.0 million and a Term Loan B of $14.5 million. Also issued in 2005 was new subordinated debt of $14.8 million. Along with this refinancing, we paid off our existing $11.4 million note, a term loan of $0.6 million, a credit facility of $11.8 million, and we incurred $3.6 million in deferred financing costs.

 

Payments and Proceeds from Long-term Debt, Line of Credit and Other Short-term Borrowings

 

Under the terms of the Company’s senior secured credit facility, we are required to maintain certain financial ratios, such as a fixed charge coverage ratio and a consolidated leverage ratio. We are also required to meet certain EBITDA targets and adhere to certain capital expenditure limits.

 

Our continued liquidity is dependent upon the following key factors:

 

Ability to stay in compliance with debt covenants

 

Under the terms of the Company’s senior secured credit facility, we are required to maintain certain financial ratios, such as a fixed charge coverage ratio and a consolidated leverage ratio. We are also required to meet certain EBITDA targets and adhere to certain expenditure limits. As of December 31, 2007, we failed to meet our EBITDA target, fixed charge coverage ratio, and consolidated leverage ratio. On March 6, 2008, we entered into a waiver agreement with the lenders effective as of December 31, 2007 with respect to the defaults. We paid a fee to the lenders of $100,000 upon execution of the waiver agreement.

 

On March 6, 2008, the Company entered into an Amendment related to the senior secured credit facility. The Amendment modifies certain definitions used in the Financing Agreement and requires the Company to reduce the balance outstanding on the senior secured credit facility by $7.5 million. The Amendment modifies the definition of “Consolidated EBITDA” and “Consolidated Funded Indebtedness” to change the calculations pursuant to these terms, as well as other terms used in the Financing Agreement. These transactions and the impact to our liquidity are explained in more detail in Notes 10 and 18 of the accompanying consolidated financial statements.

 

Commitments

 

We had significant contractual commitments related to operating leases for equipment facilities as of December 31, 2007. In addition, we had significant obligations related to short-term and long-term debt arrangements, excluding our accounts payable, accrued liabilities and taxes payable of $38.7 million at December 31, 2007 (in thousands):

 

 

Included in the debt line above is expected future interest expense relating to our $112 million senior secured credit facility.

 

We also have purchase commitments that range between $47 million to $52 million that are primarily due to our contract manufacturers.

Recent Accounting Pronouncements

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently assessing the impact of SFAS No. 157 on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS No. 159 is to reduce both the complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact of SFAS No. 159 on our consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 141R, Business Combinations (“SFAS 141R”), which establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in an acquiree, including the recognition and measurement of goodwill acquired in a business combination. The requirements of SFAS 141R are effective for periods beginning after December 15, 2008. We are currently assessing the impact of SFAS No. 141R on our consolidated financial statements.

 

We are exposed to various market risks, including fluctuations in foreign currency rates and interest rates. We may enter into various derivative transactions to manage certain of these exposures; however, we did not have any derivative financial instruments as of December 31, 2007.

 

Interest Rate Risk

 

Our $112.0 million senior secured credit facility is subject to variable interest rates. As such, changes in U.S. interest rates affect interest we pay on our debt. For the year ended December 31, 2007, an increase in the average interest rate of 10%, i.e. from 10.44% to 11.49%, would have resulted in an approximately $921,000 increase in net loss before income taxes. The fair value of such debt approximates the carrying amount on the consolidated balance sheet as of December 31, 2007.

 

Foreign Currency Risk

 

A majority of our sales are denominated in U.S. Dollars, and during the year ended December 31, 2007 approximately 23.4% of our sales were denominated in foreign currencies. We ordinarily do not engage in hedging, rate swaps, or other derivatives as a means to minimize our foreign currency risk and, instead, mitigate that exposure by limiting the portion of our sales that are denominated in other than U.S. Dollars. Assuming the same level of foreign currency denominated sales as in the year ended December 31, 2007, a 10% decline in the average exchange rates for all these currencies would have caused a decline of approximately $4.4 million, or 8.7%, of our sales.

The majority of our products are manufactured by foreign third-party contract manufacturers with the majority of the contracts denominated in U.S. Dollars. The exchange rate for these contracts is adjusted quarterly based on the Chinese Yuan Renminbi. Foreign third-party manufacturing creates risks that include fluctuations in currency exchange rates that could affect the price we pay for our product. Our two largest foreign contract manufacturers’ products represented 53% of our net sales for the year ended December 31, 2007. A 10% increase to the cost of the product sold that was manufactured by these two manufacturers would have resulted in an increase to cost of sales for the year ended December 31, 2007 of approximately $5.2 million.

 

We are exposed to foreign exchange rate fluctuations as the financial results of our foreign subsidiary, Martin Audio, are translated into U.S. Dollars in consolidation. Our exposure to foreign exchange rate fluctuations also arises from intercompany payables and receivables to and from our foreign subsidiary. Foreign exchange rate fluctuations did not have a material impact on our financial results in 2007.

 

 

The following consolidated financial statements and supplementary data are included beginning on page 28 of this report.

 

The Board of Directors and Shareholders

LOUD Technologies Inc.:

 

We have audited the accompanying consolidated balance sheets of LOUD Technologies Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of LOUD Technologies Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 2 to the consolidated financial statements, effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment.

 

/s/ KPMG LLP

 

Seattle, Washington
March 28, 2008

LOUD TECHNOLOGIES INC.
AND SUBSIDIARIES

 

 

See accompanying notes to consolidated financial statements.

LOUD TECHNOLOGIES INC.
AND SUBSIDIARIES

Consolidated Statements of Operations and Comprehensive Income (Loss)
Years ended December 31, 2007, 2006, and 2005

 

 

See accompanying notes to consolidated financial statements.

LOUD TECHNOLOGIES INC.
AND SUBSIDIARIES

Consolidated Statements of Shareholders’ Equity (Deficit)
Years ended December 31, 2007, 2006, and 2005

 

 

See accompanying notes to consolidated financial statements.

LOUD TECHNOLOGIES INC.
AND SUBSIDIARIES

Consolidated Statements of Cash Flows
Years ended December 31, 2007, 2006, and 2005

 

 

See accompanying notes to consolidated financial statements.

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2007

 

 

LOUD Technologies Inc. (“LOUD” or the “Company”) develops, manufactures, and sells digital and analog audio mixers, speakers, guitar and bass amplifiers, branded musical instruments and related accessories, and other professional audio equipment. Our products are used by professional and amateur musicians; school music programs; sound installation contractors and broadcast professionals in sound recordings, live presentations systems and installed sound systems. LOUD distributes its products primarily through retail dealers, mail order outlets and installed sound contractors. The Company has its primary operations in the United States with other operations in the United Kingdom, Canada, China and Japan.

 

 

 

The financial statements consolidate the accounts of LOUD Technologies Inc. and our wholly owned subsidiaries. The companies are collectively hereinafter referred to as “the Company,” “LOUD”, “we,” “our” and “us.” All significant intercompany accounts and transactions have been eliminated. Financial information for the year 2007 includes Martin Audio, Ltd (“Martin Audio”) for the period April 11, 2007 through December 31, 2007 and for the year 2005 includes St. Louis Music, Inc. (“St. Louis Music”) for the period March 5, 2005 through December 31, 2005.

 

 

The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include the allocation of purchase cost to assets acquired and liabilities assumed, the carrying amount of property and equipment and intangibles; valuation allowances for receivables, inventories, and deferred income tax assets and liabilities. Actual results may differ from those estimates.

 

 

Revenues from sales of products, net of sales discounts, returns and allowances, are generally recognized upon shipment under an agreement with a customer when risk of loss has passed to the customer, all significant contractual obligations have been satisfied, the fee is fixed or determinable and collection of the resulting receivable is considered probable. Products are generally shipped “FOB shipping point” with no right of return. We do have some dealers who finance their purchases through finance companies. We have manufacturer’s repurchase agreements with the finance companies and defer the revenue and related cost of goods sold of these sales at the time of the sale. We then recognize the revenue and related cost of goods sold from these sales when the repurchase obligation no longer exists. Sales with contingencies, such as rights of return, rotation rights, conditional acceptance provisions and price protection, are deferred until the contingencies have been satisfied or the contingent period has lapsed. We generally warrant our products against defects in materials and workmanship for periods of between one and six years, with the exception of Alvarez Yairi guitars, which have a limited lifetime warranty. The estimated cost of warranty obligations, sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience.

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The cost of advertising included in selling, general and administrative expense is expensed as incurred. For 2007, 2006, and 2005 these expenses totaled $4.1 million, $6.1 million, and $7.1 million, respectively.

 

 

Expenditures relating to the development of new products and processes, including significant improvements and refinements to existing products, are expensed as incurred. Under our current practice of developing new products and enhancements, the technological feasibility of the underlying products is not established until the completion of a working model at which time all product development is substantially complete. Accordingly no such costs have been capitalized because the impact would not be material.

 

 

The financial statements of one of our non-U.S. subsidiaries, Martin Audio, have been translated into U.S. Dollars. The functional currency of this subsidiary is the British Pound. All assets and liabilities in the balance sheet of this subsidiary are translated at period-end exchange rates. Net sales, costs and expenses are translated at average rates of exchange prevailing during the period. Translation gains and losses are accumulated in a separate component of shareholders’ equity.

 

The functional currency of the Company’s other international subsidiaries is the U.S. Dollar. Assets and liabilities recorded in foreign currencies are translated into U.S. Dollars at the exchange rate on the balance sheet date. Net sales, costs and expenses and cash flows are translated at average rates of exchange prevailing during the period. Foreign currency transaction gains and losses are included in other income (expense). For the years 2007, 2006 and 2005 the amount related to transaction losses was approximately $295,000, $85,000 and $466,000, respectively.

 

 

Accounts receivable are recorded at the invoice amount and typically do not bear interest. Included in the accounts receivable allowance are allowances for doubtful accounts, sales returns, sales credits, sales rebates and quick pay discounts. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We determine the allowance for doubtful accounts based upon our historical write-off experience, the current aging of accounts receivable, and customer specific credit risk factors. Accounts receivable balances are written off when we determine that it is unlikely we will receive future remittances. Sales returns, sales credits and quick pay discounts are determined based upon our historical experience and sales rebates are determined based on actual sales volume of our customers.

 

Allowances deducted from accounts receivable for the years ended December 31, 2007, 2006, and 2005 are as follows (in thousands):

 

 

 

LOUD inventories are stated at the lower of standard cost, which approximates actual cost on a first-in, first-out method, or market. Market value adjustments are recorded for excess and obsolete material, slow-

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

moving product, service and demonstration products. We make judgments regarding the carrying value of our inventory based upon current market conditions.

 

 

Property, plant and equipment are stated at cost, (fair value as of the acquisition date in the case of Martin Audio and St. Louis Music acquired property, plant and equipment), less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets as follows: buildings, 20 years; machinery and equipment, 5 to 7 years; and furniture and fixtures, 3 to 5 years. Leasehold improvements are amortized over the shorter of their useful lives or the term of the lease. Maintenance and repairs are expensed as incurred.

 

 

Financing costs associated with debt financing are deferred and amortized over the term of the debt. The amortization periods are five years for both the revolving loan and term loans. The amortization method for the revolving loan is straight line, whereas the term loans are amortized using the effective interest rate method. As of December 31, 2007, approximately $392,000 of amortization has been incurred.

 

Expected future amortization expense related to deferred financing costs is as follows (in thousands):

 

 

 

Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill is tested for impairment at least annually, or when events indicate that impairment exists.

 

Impairment testing of goodwill involves a two-phase process and the timing of transitional impairment steps. The first phase identifies indications of impairment; while the second phase (if necessary), measures the impairment. During the fourth quarter of 2007, the Company performed an impairment test on the goodwill acquired at the reporting unit level and determined no impairment was necessary.

 

 

The recoverability of long-lived assets including property, plant and equipment is reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Intangible assets that are determined to have definite lives are amortized using the straight-line method over their estimated useful lives. Developed technology and the trademark of EAW are amortized over 20 years. Trademarks, customer relationships and developed technology due to the acquisition of St. Louis Music are amortized over 20, 15 and 5 years, respectively. Trademarks, customer and distributor relationships, developed technology and non compete agreements due to the acquisition of Martin Audio are amortized over 20, 15, 5 and 2 years, respectively. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or the fair value less cost to sell. Factors that may trigger

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

impairment include significant underperformance relative to expected operating results, significant changes in our use of the assets or the strategy for our overall business, and significant negative industry or economic trends.

 

 

The carrying amounts of cash, accounts receivable, short-term borrowings, accounts payable, accrued liabilities and long-term debt approximate their fair value because they are of a short-term nature or have interest rates that approximate market rates.

 

 

During 2003, our board of directors adopted the 2003 Stock Option Plan (the “2003 Plan”), authorizing options to purchase 345,600 shares of common stock. The 2003 Plan calls for options to be non-qualified stock options with exercise prices equal to the fair value of the stock on the date granted. Options generally vest over a five-year period and expire on the earlier of ten years from grant date or three months from termination. If an option holder is terminated for Cause, as defined in the 2003 Plan, the options would terminate a day prior to termination. At December 31, 2007, 178,000 shares of common stock were available for future grants under the 2003 Plan.

 

The Company also has a 1995 Stock Option Plan (the “1995 Plan”), which authorized 1.3 million shares of common stock for grants. The exercise price of incentive stock options granted under the 1995 Plan may not be less than the fair value of the common stock on the date of grant. The exercise price of nonqualified stock options granted under the plan may be greater or less than the fair value of the common stock on the date of grant, as determined by the stock option committee of the board of directors at its discretion. Options generally vest over a four to five-year period and expire no later than ten years after the date of grant or three months from termination. At December 31, 2007, 902,000 shares of common stock were available for future grants under the 1995 Plan.

 

The Company’s policy is to issue new shares for stock option exercises. Shares issued under the 2003 Plan are also subject to a Shareholder’s Agreement governing restrictions on transfer and voting rights for shares issued under the plan. No share repurchases took place in 2007 or are planned in 2008.

 

The Company adopted SFAS 123R, Share Based Payment: An Amendment of SFAS No. 123, effective January 1, 2006, using the Modified Prospective Application Method whereby previously awarded but unvested equity awards are accounted for in accordance with SFAS No. 123R and prospective amounts are recognized in the income statement instead of simply being disclosed. Prior to the adoption of SFAS No. 123R, the Company followed the intrinsic-value method to account for its stock options granted under its employee option plans. Under this method, deferred compensation expense was recorded on the date of grant only to the extent the current market price of the underlying stock exceeded the exercise price and was recognized over the vesting period. The adoption of SFAS No. 123R primarily resulted in a change in the Company’s method of recognizing the fair value of share-based compensation for all unvested awards. Specifically, the adoption of SFAS No. 123R resulted in the Company recording compensation expense during 2007 and 2006 of approximately $305,000 and $438,000, respectively. The amounts are classified in the consolidated statements of operations as follows (in thousands):

 

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In February 2003, as part of a separation agreement with a former founder and director, we repriced options to purchase 66,000 shares with an average exercise price of $31.35 to a new exercise price of $5.10 in exchange for a non-compete agreement valued at $285,000. The value of the unvested portion of these options was amortized over a three year period. Approximately $10,000 related to this was expensed in 2006.

 

No stock-based compensation was capitalized as part of an asset as of December 31, 2007.

 

Had compensation expense for employee stock options granted under the Company’s stock incentive plans been determined based on SFAS No. 123R’s Modified Prospective Application Method, the Company’s Income from continuing operations, net income, and basic and diluted per share amounts would have been reduced to the pro forma amounts as indicated below (in thousands except per share data):

 

 

 

In the ordinary course of business, we are not subject to any significant obligations under guarantees except for standard indemnification and warranty provisions.

 

Indemnification and warranty provisions contained within our sales agreements are generally consistent with those prevalent in our industry. The duration of product warranties is generally one to six years following delivery of products, with the exception of Alvarez Yairi guitars, which have a limited lifetime warranty.

 

The warranty liability, which is included in accrued liabilities, is summarized as follows (in thousands):

 

 

 

Operating segments are defined as revenue-producing components of an enterprise for which discrete financial information is available and whose operating results are regularly reviewed by the Company’s chief operating decision maker. LOUD management and the chief operating decision maker review financial information on a consolidated basis and, therefore, the Company operated as a single segment for all periods presented.

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Income taxes are accounted for 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 and operating loss and tax credit carryforwards. 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. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company has recorded a valuation allowance due to the uncertainty surrounding the ultimate realization of such assets. Management evaluates, on a periodic basis, the recoverability of the net deferred tax assets and the amount of the valuation allowance. At such time as it is determined that it is more likely than not the deferred tax assets are realizable, the valuation allowance will be reduced.

 

The Company has recorded a deferred tax liability related to goodwill associated with the St. Louis Music acquisition, which is being amortized for tax purposes, but not for book purposes. As goodwill has an indeterminable life, the Company cannot reasonably estimate the amount, if any, of deferred tax liabilities related to goodwill which will reverse during the net operating loss carry forward period. Accordingly, the Company increases the valuation allowance with a corresponding deferred tax provision as the deferred tax liability related to goodwill increases due to continued amortization of goodwill for tax purposes.

 

The Company has also recorded a deferred tax liability related to the identifiable intangible assets and fair value adjustments to the assets purchased associated with the acquisition of Martin Audio. The Company recognizes a tax benefit as these assets are amortized for book purposes.

 

 

Basic net income (loss) per share is computed using the weighted average number of common stock outstanding for the year including warrants and options to purchase shares exercisable for little cash consideration. Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding during the year increased by the weighted average number of potential common shares outstanding during the period, using the treasury stock method. The following table sets forth the computation of basic and diluted net income (loss) per share. Stock options representing 365,000, 391,000, and 430,000 shares in 2007, 2006 and 2005, respectively, were excluded from the calculation of diluted net income (loss) per share because they were antidilutive in 2007, whereas in 2006 and 2005, they were excluded because they were out of the money.

 

The share count used to compute basic and diluted net income (loss) per share is calculated as follows (in thousands):

 

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

We sell products on a worldwide basis and a significant portion of our accounts receivable are due from customers outside of the United States. Where we are exposed to significant credit risk, we generally require letters of credit, advance payments, or carry foreign credit insurance. No individual country outside of the United States accounted for more than 10% of net sales in any of the periods presented. Sales to U.S. customers are generally on open credit terms. In the United States, we primarily sell our products through certain resellers and experience individually significant annual sales volumes with major resellers. In 2007, 2006 and 2005, we had sales to one customer of $33.2 million, $40.6 million and $34.3 million or 16%, 19% and 17%, respectively, of consolidated net sales from continuing operations.

 

Many of our products are being manufactured exclusively by contract manufacturers on our behalf. During 2007, sales of products manufactured by one manufacturer were $82.3 million, or approximately 40% of net sales, while sales of products manufactured by another manufacturer were $27.4 million or approximately 13% of net sales. No other contract manufacturer manufactured more than 10% of our products sold in 2007.

 

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is currently assessing the impact of SFAS No. 157 on its consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS No. 159 is to reduce both the complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact of SFAS No. 159 on its consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 141R, Business Combinations (“SFAS 141R”), which establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in an acquiree, including the recognition and measurement of goodwill acquired in a business combination. The requirements of SFAS 141R are effective for periods beginning after December 15, 2008. The Company is currently assessing the impact of SFAS No. 141R on its consolidated financial statements.

 

 

Certain prior year amounts have been reclassified to conform with the current year presentation.

 

 

In December 2003, we placed our indirect wholly owned Italian subsidiary, Mackie Designs (Italy) S.p.A. (“Mackie Italy”), into an Italian form of court-supervised liquidation and sold all of the shares of Mackie Italy to a third party. Mackie Italy was a manufacturer of many of our speaker products, which were purchased by the Company for subsequent sale outside of Italy. At the time of sale, the Company owed Mackie Italy approximately $9.2 million related to the purchase of goods in the normal course of business. During 2004, we made payments to Mackie Italy of approximately $1.6 million, lowering our liability to $7.6 million at

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

December 31, 2004. Additionally, Mackie Italy had a payable to a separate wholly-owned subsidiary of the Company for approximately $2.7 million, which was fully reserved at the date of sale in 2003.

 

In February 2005, we made an offer to Mackie Italy to settle any outstanding amounts owed by the Company to Mackie Italy for $4.7 million. This proposal was accepted by the Italian court appointed trustee on behalf of Mackie Italy in May 2005. Under the terms of the settlement agreement, we made payments of $2.5 million in 2005. Additionally, we committed to pay $2.2 million during 2006, of which $1.5 million was paid by December 31, 2006 and the remaining $0.7 million was paid in January 2007. We recognized a gain on discontinued operations of $2.9 million in 2005 related to this settlement.

 

 

During 2007 and 2006, management approved and implemented a restructuring plan primarily consisting of the consolidation of the St. Louis Music operations and a shift of our domestic manufacturing to overseas contract manufacturers. During 2007 and 2006, we incurred approximately $2.0 million and $1.6 million, respectively, of restructuring costs primarily representing employee severance and related costs for approximately 226 and 94 terminated employees, respectively. We had $462,000 of these restructuring amounts remaining in accrued liabilities at December 31, 2007. We expect to pay this amount during 2008. The restructuring liability is included in accrued liabilities on the consolidated balance sheet and is summarized as follows (in thousands):

 

 

 

Inventories consist of the following (in thousands):

 

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Intangible assets with finite lives consist of the following (in thousands):

 

 

The Company acquired Martin Audio on April 11, 2007. Certain identifiable intangible assets were recorded as a result of this acquisition. See Note 16 for further explanation of these intangible assets. Amortization expense for intangible assets was $1.7 million, $0.8 million and $0.8 million in 2007, 2006 and 2005, respectively.

 

Expected future amortization expense related to identifiable intangible assets for the next five years is as follows (in thousands):

 

 

 

Changes in goodwill are as follows (in thousands):

 

 

LOUD TECHNOLOGIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

As of December 31, 2007 and 2006, property, plant and equipment consisted of the following (in thousands):

 

 

 

Components of income (loss) before income taxes are as follows (in thousands):