Spy (XSPY) 10-Q 2007 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2007

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to            

Commission File Number: 000-51071

ORANGE 21 INC.

(Exact name of registrant as specified in its charter)

Delaware	33-0580186
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

2070 Las Palmas Drive, Carlsbad, CA 92009	(760) 804-8420
(Address of principal executive offices)	(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required 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  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerate filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

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

As of May 15, 2007, there were 8,100,564 shares of Common Stock, par value $0.0001 per share, issued and outstanding.

ORANGE 21 INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

PART I	FINANCIAL INFORMATION
	Item 1. Financial Statements	3
	Consolidated Balance Sheets as of March 31, 2007 (Unaudited) and December 31, 2006 and	3
	Consolidated Statements of Operations (Unaudited) for the three months ended March 31, 2007 and 2006	4
	Consolidated Statements of Cash Flows (Unaudited) for the three months ended March 31, 2007 and 2006	5
	Notes to Unaudited Consolidated Financial Statements	6
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
	Item 3. Quantitative and Qualitative Disclosures About Market Risk	18
	Item 4. Controls and Procedures	18
PART II	OTHER INFORMATION	19
	Item 1. Legal Procedures	19
	Item 1A. Risk Factors	19
	Item 6. Exhibits	26
Signatures		27

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ITEM 1. FINANCIAL STATEMENTS

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Thousands, except number of shares and per share amounts)

	March 31, 2007			December 31, 2006
	(Unaudited)
Assets
Current assets
Cash and cash equivalents	$	1,230		$	1,279
Restricted Cash		2,070			1,728
Short-term investments		—			500
Accounts receivable, net		8,033			10,014
Inventories, net		10,578			9,276
Prepaid expenses and other current assets		1,128			1,533
Income taxes receivable		598			606
Deferred income taxes		1,402			1,827
Total current assets		25,039			26,763
Property and equipment, net		7,873			8,042
Goodwill		8,814			8,727
Intangible assets, net of accumulated amortization of $430 and $376 at March 31, 2007 and December 31, 2006, respectively		518			530
Deferred income taxes		2,768			1,575
Other long-term assets		72			69
Total assets	$	45,084		$	45,706
Liabilities and Shareholders' Equity
Current liabilities
Lines of credit	$	2,670		$	2,976
Current portion of capital leases		382			410
Current portion of notes payable		1,023			251
Accounts payable		7,655			6,418
Accrued expenses and other liabilities		3,641			4,403
Deferred purchase price obligation		676			1,020
Total current liabilities		16,047			15,478
Notes payable, less current portion		1,142			593
Capitalized leases, less current portion		583			647
Deferred income taxes		316			300
Total liabilities		18,088			17,018
Stockholders' equity
Preferred stock: par value $0.0001; 5,000,000 authorized; none issued		—			—
Common stock: par value $0.0001; 100,000,000 shares authorized; 8,100,564 shares issued and outstanding at March 31, 2007 and December 31, 2006		1			1
Additional paid-in-capital		36,397			36,336
Accumulated other comprehensive income		1,521			1,505
Accumulated deficit		(10,923	)		(9,154	)
Total stockholders' equity		26,996			28,688
Total liabilities and stockholders' equity	$	45,084		$	45,706

The accompanying notes are an integral part of these consolidated financial statements.

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ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Thousands, except per share figures)

	Three Months Ended March 31,
	2007			2006
	(Unaudited)
Net sales	$	9,389		$	9,382
Cost of sales		4,480			4,867
Gross profit		4,909			4,515
Operating expenses
Sales and marketing		3,822			3,507
General and administrative		2,510			2,139
Shipping and warehousing		637			476
Research and development		193			266
Total operating expenses		7,162			6,388
Loss from operations		(2,253	)		(1,873	)
Other expense:
Interest expense		(67	)		(34	)
Foreign currency transaction loss		(51	)		(28	)
Other expense		(48	)		(6	)
Total other expense		(166	)		(68	)
Loss before benefit for income taxes		(2,419	)		(1,941	)
Income tax benefit		(651	)		(207	)
Net loss	$	(1,768	)	$	(1,734	)
Net loss per share of Common Stock
Basic	$	(0.22	)	$	(0.21	)
Diluted	$	(0.22	)	$	(0.21	)
Shares used in computing net loss per share of Common Stock
Basic		8,101			8,084
Diluted		8,101			8,084

The accompanying notes are an integral part of these consolidated financial statements.

4

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Thousands)

	Three Months Ended March 31,
	2007			2006
	(Unaudited)
Operating Activities
Net loss	$	(1,768	)	$	(1,734	)
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		1,044			721
Deferred income taxes		(754	)		(104	)
Stock-based compensation		62			22
Provision for bad debts		59			(21	)
Loss on sale of property and equipment		19			—
Change in operating assets and liabilities:
Accounts receivable		1,942			1,883
Inventories, net		(1,249	)		2,031
Prepaid expenses and other current assets		1,473			(151	)
Other assets		(3	)		10
Accounts payable		1,118			(489	)
Accrued expenses and other liabilities		(1,849	)		(606	)
Income tax payable/receivable		64			(154	)
Net cash provided by operating activities		158			1,408
Investing Activities
Purchase of property and equipment		(844	)		(707	)
Purchases of short-term investments		—			(501	)
Proceeds from maturities of short-term investments		500			4,500
Investment in restricted cash		(343	)		(847	)
Proceeds from sale of property and equipment		41			10
Acquisition of business, net of cash acquired		(345	)		(2,829	)
Purchase of intangibles		(40	)		—
Net cash used in investing activities		(1,031	)		(374	)
Financing Activities
Line of credit borrowings		253			743
Principal payments on notes payable		(39	)		(83	)
Proceeds from issuance of notes payable		772			—
Principal payments on capital leases		(100	)		(106	)
Net cash provided by financing activities		886			554
Effect of exchange rate changes on cash and cash equivalents		(62	)		135
Net increase (decrease) in cash and cash equivalents		(49	)		1,723
Cash and cash equivalents at beginning of period		1,279			2,669
Cash and cash equivalents at end of period	$	1,230		$	4,392
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	52		$	60
Income taxes	$	—		$	190

The accompanying notes are an integral part of these consolidated financial statements.

5

ORANGE 21 INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The accompanying unaudited consolidated financial statements of Orange 21 Inc. and its subsidiaries (the “Company”) have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by GAAP for complete financial statements.

In the opinion of management, the unaudited consolidated financial statements contain all adjustments, consisting of normal recurring items, considered necessary for a fair presentation of the Company’s financial position, results of operations and cash flows. Operating results for the three months ended March 31, 2007 are not necessarily indicative of the results of operations for the year ending December 31, 2007. The consolidated financial statements contained in this Form 10-Q should be read in conjunction with the consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

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

2. Recently Issued Accounting Pronouncements

On January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board Interpretation Number 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. There has been no material effect on the Company’s financial statements as a result of the adoption of FIN 48 as of March 31, 2007.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”(“SFAS No. 157”), 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. This statement is effective for us beginning January 1, 2008. We are currently assessing the potential impact that the adoption of SFAS No. 157 will have on our financial statements.

In February 2007, the FASB released FASB No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which is effective for fiscal years beginning after November 15, 2007. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The Company is currently assessing the impact the adoption of this pronouncement will have on the financial statements.

3. Cash, Cash Equivalents and Short-term Investments

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. The Company’s investments, which generally have maturities between three and twelve months at time of acquisition, are considered short-term and classified as available for sale. Cash, cash equivalents and short-term investments consist primarily of corporate obligations such as commercial paper and corporate bonds, but may also include government agency notes, certificates of deposit, bank time deposits and institutional money market funds.

At December 31, 2006, short-term investments consisted of auction rate securities of $500,000, which had no unrealized gains or losses at December 31, 2006. There were no short-term investments at March 31, 2007. Auction rate securities, for which the interest rate resets approximately every 7 to 28 days, have been allocated within the contractual maturities table based upon the set maturity date of the security. During the three months ended March 31, 2007 and 2006, the Company did not record any realized gains or losses on its short-term investments. At March 31, 2007 and December 31, 2006, the Company had no investments that have been in a continuous unrealized loss position for a period of 12 months.

At March 31, 2007 and December 31, 2006, the Company had $404,000 and $728,000, respectively of restricted cash which was held in an escrow account as required in accordance with the purchase agreement pursuant to which the Company acquired LEM S.r.l. (“LEM”), its manufacturing subsidiary. The escrow account relates to the earn-out provision of the purchase agreement. The escrow account must be maintained at a minimum level of 300,000 Euro through June 30, 2007. At March 31, 2007 and December 31, 2006, the Company also had $1.7 million and $1.0 million, respectively, on deposit with Comerica Bank to be used as collateral to secure the line of credit facility. See Note 9.

4. Derivatives and Hedging

The Company is exposed to gains and losses resulting from fluctuations in foreign currency exchange rates relating to forecasted product purchases denominated in foreign currencies and transactions of its foreign subsidiaries. As part of its overall strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, the Company uses foreign exchange contracts in the form of forward contracts.

A majority of the Company’s derivatives are designated as cash flow hedges and qualify for hedge accounting under Statement of Financial Accounting Standards (“SFAS”) No. 133 “Accounting for Derivative Instruments and Hedges” (“SFAS No. 133”). The Company uses forward contracts designated as cash flow hedges primarily to protect against the foreign exchange risks inherent in its forecasted purchase of products at prices denominated in currencies other than the U.S. dollar. For derivative instruments that are designated and qualify as cash flow hedges, the Company records the effective portion of the gain or loss on the derivative in accumulated other comprehensive income as a separate component of stockholders’ equity and subsequently reclassifies these amounts into earnings in the period during which the hedged transaction is recognized in earnings. The Company reports the effective portion of cash flow hedges in the same financial statement line as the changes in the value of the hedged item. As of March 31, 2007 and December 31, 2006, the notional amounts of the Company’s foreign exchange contracts designated as cash flow hedges were approximately $2,465,000 and $5,023,000, respectively. As of March 31, 2007 and December 31, 2006, a net gain of approximately $265,000 and $355,000, respectively, related to derivative instruments designated as cash flow hedges was recorded in accumulated other comprehensive loss. It is expected that $265,000 will be reclassified into earnings in the next 12 months along with the earnings effects of the related forecasted transactions. Existing cash flow hedge transactions are expected to occur over the next year.

During the three months ended March 31, 2007 and 2006, the Company did not discontinue any cash flow hedges for which it was probable that a forecasted transaction would not occur.

For foreign currency contracts designated as cash flow hedges, hedge effectiveness is measured using the spot rate. Changes in the spot-forward differential are excluded from the test of hedge effectiveness and are recorded currently in earnings in the foreign currency transaction gain. The Company measures effectiveness by comparing the cumulative change in the hedge contract with the cumulative change in the hedged item.

Other derivatives not designated as hedging instruments under SFAS No. 133 consist primarily of forward contracts the Company uses to hedge foreign currency balance sheet exposures and interest rate swaps. For derivative instruments not designated

6

as hedging instruments under SFAS No. 133, the Company recognizes changes in fair value in earnings in the period of change. The Company recognizes the gains or losses on foreign currency forward contracts used to hedge balance sheet exposures in the foreign currency transaction gain.

As of March 31, 2007 and December 31, 2006, the notional amounts of the Company’s foreign exchange contracts not designated as hedging instruments were approximately $338,000 and $647,000, respectively.

As part of the acquisition of LEM in January 2006, the Company acquired an interest rate swap with a notional amount of 1.0 million Euros as of December 31, 2006. The interest rate swap was closed in February 2007 at a loss of approximately 10,000 Euro or $13,000.

Foreign currency derivatives are used only to meet the Company’s objectives of minimizing variability in the Company’s operating results arising from foreign exchange rate movements which may include derivatives that do not meet the criteria for hedge accounting. The Company does not enter into foreign exchange contracts for speculative purposes.

5. Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing net income or loss by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share is calculated by including the additional shares of common stock issuable upon exercise of outstanding options and warrants and upon vesting of restricted stock, using the treasury stock method. For the three months ended March 31, 2007 and 2006, the Company has excluded all stock options, warrants, convertible notes and restricted stock awards since the effect of those securities would be anti-dilutive for these periods. The total potential common shares excluded from the calculation of diluted loss per share was 995,000 and 1,109,000 for the three months ended March 31, 2007 and 2006, respectively.

6. Comprehensive Income

Comprehensive income represents the results of operations adjusted to reflect all items recognized under accounting standards as components of comprehensive income.

The components of accumulated other comprehensive income, net of tax, are as follows:

	March 31, 2007		December 31, 2006
	(Thousands)
Unrealized gain on cash flow hedges, net of tax	$	265	$	355
Equity adjustment from foreign currency translation		1,102		1,041
Unrealized gain on foreign currency exposure of net investment in foreign operations		154		109
Comprehensive income	$	1,521	$	1,505

7. Accounts Receivable

Accounts receivable consisted of the following:

	March 31, 2007			December 31, 2006
	(Thousands)
Trade receivables	$	10,608		$	12,893
Less allowance for doubtful accounts		(793	)		(847	)
Less allowance for returns		(1,782	)		(2,032	)
Accounts receivable, net	$	8,033		$	10,014

8. Inventories

Inventories consisted of the following:

	March 31, 2007		December 31, 2006
	(Thousands)
Raw materials	$	2,316	$	2,301
Work in process		1,085		1,024
Finished goods		7,177		5,951
Inventories, net	$	10,578	$	9,276

The Company’s balances are net of an allowance for obsolescence of approximately $3,420,000 and $3,611,000 at March 31, 2007 and December 31, 2006, respectively.

7

9. Financing Arrangements

Credit Facilities

At December 31, 2006, the Company had financing arrangements with Comerica Bank consisting of a line of credit facility with a $5.0 million limit, a foreign exchange facility and letter of credit accommodations. These arrangements were secured by all of the Company’s assets, excluding its intellectual property, and a $1.0 million collateral cash deposit with Comerica, and were subject to certain covenants, including several liquidity, debt coverage and minimum equity ratios. The $5.0 million available line of credit was reduced by the amount of outstanding letters of credit (sub limit of $4.1 million) and 10% of outstanding foreign exchange forward contracts ($0.9 million sub limit). Borrowings were limited to cover any outstanding letters of credit issued to San Paolo IMI on behalf of LEM (3.0 million Euros or $3.9 million at December 31, 2006).

The Company’s foreign exchange facility allowed for the purchase of currency contracts which were used primarily to hedge foreign currency exposure. The amount of allowable purchases of such contracts was $9.0 million. At December 31, 2006, net foreign exchange forward contracts outstanding amounted to $5.7 million, which reduced the amount available under the line of credit by $570,000. As a result, at December 31, 2006, the unused line of credit was approximately $0.5 million with Comerica Bank.

At December 31, 2006, the Company was not in compliance with two financial covenants under the financing arrangement with Comerica related to maintaining a minimum tangible net worth and not incurring more than two consecutive quarterly net losses. On February 22, 2007, the Company amended its financing arrangements with Comerica, which decreased its letter of credit sub limit to $1.8 million, decreased its foreign exchange facility limit from $9.0 million to $7.2 million and extended the expiration date to May 15, 2007.

On February 26, 2007, Spy Optic, Inc. entered into a Loan and Security Agreement (“Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5,000,000. Actual borrowing availability under the Loan Agreement is based on eligible trade receivable and inventory levels of Spy Optic Inc. Loans extended pursuant to the Loan Agreement will bear interest at a rate per annum of 2.5% above the higher of (i) the prime rate as reported in the western edition of the Wall Street Journal from time to time or (ii) 8% with a minimum monthly interest charge of $2,000. The Company granted BFI a security interest in all of Spy Optic, Inc.’s assets as security for its obligations under the Agreement, except for its copyrights, patents, trademarks, servicemarks and related applications. Additionally, the obligations under the Loan Agreement are guaranteed by Orange 21, Inc.

The Loan Agreement imposes certain covenants on Spy Optic, Inc., including, but not limited to, covenants requiring the Company to provide certain periodic reports to BFI, inform BFI of certain changes in the business, refrain from incurring additional debt in excess of $100,000 and refrain from paying dividends. Spy Optic, Inc. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy Optic, Inc. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy Optic, Inc. any amounts remaining after payment of all amounts due under the Loan Agreement. To secure its obligations under the guaranty, Orange 21 Inc. granted BFI a blanket security interest in all of its assets, except for its stock in Spy Optic, Inc., which it has covenanted not to pledge to any other person or entity.

The Company received a loan in the amount of $650,000 upon the execution of the Loan Agreement. These proceeds were used to fully collateralize Comerica Bank for the letter of credit issued by Comerica on behalf of Orange 21 Inc. and LEM to San Paolo IMI in the amount of 1.2 million Euros. At March 31, 2007, there were outstanding borrowings of $1.2 million under this line, bearing an interest rate of 10.88% and availability under this line of $3.8 million, subject to eligible accounts receivable and inventory levels.

At March 31, 2007 and December 31, 2006, the Company also had a 2.2 million Euro line of credit in Italy with San Paolo IMI for LEM, which expires on September 31, 2007. This debt is normally negotiated on a yearly basis. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At March 31, 2007, there was approximately 1.1 million Euro available under this line of credit. At March 31, 2007 and December 31, 2006, lines of credit amounted to $1.4 million and $3.0 million, respectively, and bear interest at rates ranging from 4.0% to 4.85%.

10. Notes Payable

Notes payables at March 31, 2007 consist of the following:

	(Thousands)
Unsecured San Paolo IMI long-term debt, EURIBOR 6 months interest rate plus 1.0% spread, payable in half year installments due from March 2007 to February 2011	$	783
Unsecured San Paolo IMI debt (“bridge loan”), EURIBOR 6 months interest rate plus 1% spread, due on June 2007		574
Unsecured long-term debt, EURIBOR 6 months interest rate plus 1% spread, payable in half year installments due from December 2005 to December 2010		191
Unsecured long-term debt, fixed interest rate at 0.5%, payable in half year installments due from December 2005 to December 2010		80
Secured notes payable for software purchases, 4.55% interest rate with monthly payments of $15,000 due through August 2009 and 7.45% interest rate with monthly payments of $4,200 due through March 2010. Both secured by software.		537
		2,165
Less current portion		(1,023	)
Notes payable, less current portion	$	1,142

11. Share-Based Compensation

On January 1, 2006, the Company adopted SFAS No. 123(R) “Share-Based Payments” (“SFAS No. 123(R)”), which requires the Company to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the consolidated statement of operations over the period during which the employee is required to provide service in exchange for the award—the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The grant-date fair value of employee share options and similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments.

8

In December 2004, the Board of Directors of the Company adopted, and the stockholders of the Company approved, the 2004 Stock Incentive Plan (the “Plan”). The Plan provides for the grant of incentive stock options to employees only, and restricted stock, stock units, nonqualified options or SARS to employees, consultants and outside directors. The Plan is administered by the Compensation Committee who determines the vesting period, exercise price and other details for each award.

Prior to the adoption of the 2004 Stock Incentive Plan, the Company had periodically granted nonqualified common stock options to certain employees and officers of the Company. These stock options generally vest ratably over a five-year period and expire ratably five years after each vesting date. Generally, the exercise price of all stock options granted equaled the fair value of the Company’s common stock on the date of grant, which resulted in no compensation expense when the stock options were issued.

Stock Option Activity

	Shares		Weighted- Average Exercise Price		Weight-Average Remaining Contractual Term (years)	Aggregate Intrinsic Value
						(thousands)
Options outstanding at December 31, 2006	804,688			6.64
Forfeited	(66,563	)		6.17
Options outstanding at March 31, 2007	738,125			6.68	6.69	$	309
Options exercisable at March 31, 2007	653,161		$	6.90	6.57	$	270

Intrinsic value is defined as the difference between the relevant current market value of the common stock and the grant price for options with exercise prices less than the market values on such dates. During the three months ended March 31, 2007 and 2006, the Company received approximately $0 in cash proceeds from the exercise of stock options.

Information regarding stock options outstanding as of March 31, 2007 is as follows:

	Options Outstanding				Options Exercisable
Price Range	Shares	Weighted- Average Exercise Price		Weight- Average Remaining Contractual Term (years)	Shares	Weighted- Average Exercise Price
$        1.60	31,250	$	1.60	4.8	31,250	$	1.60
$        3.20	40,625	$	3.20	4.4	40,625	$	3.20
$4.80 - $4.99	156,250	$	4.83	3.4	101,286	$	4.81
$        5.11	30,000	$	5.11	9.2	—	$	5.11
$5.95 - $6.12	135,000	$	6.09	0.4	135,000	$	6.09
$        8.75	345,000	$	8.75	7.8	345,000	$	8.75
Total	738,125	$	6.68	6.69	653,161	$	6.90

Restricted Stock Awards

The Company periodically issues restricted stock awards to certain key employees subject to certain vesting requirements based on future service. During June 2006, the Company issued awards for an aggregate of 97,500 shares of restricted common stock, of which 24,375 shares vest after one year and the remaining 73,125 shares vest monthly over the following three years in equal increments. During October 2006, the Company issued one award of 20,000 shares of restricted common stock, of which 5,000 shares vest after one year and the remaining 15,000 shares vest monthly over the following three years.

During the three months ended March 31, 2007 there were no issuances or vesting of restricted stock awards. At March 31, 2007 and December 31, 2006, the Company had 110,000 restricted stock awards outstanding with a weighted average grant date fair value of $4.99 per share.

9

The Company recognized the following share-based compensation expense during the three months ended March 31, 2007 and 2006:

	Three Months Ended March 31,
	2007			2006
	(Thousands, except per share figures)
Stock options
General and administrative expense	$	32		$	22
Restricted stock
General and administrative expense		20			—
Selling and marketing		7			—
Research and development		2			—
Stock award grants to board of directors
General and administrative expense		—			—
Total		61			22
Income tax benefit		(21	)		(7	)
Stock-based compensation expense, net of taxes		40			15
Effect of stock-based compensation on net income per share:
Basic		(0.00	)		(0.00	)
Diluted		(0.00	)		(0.00	)

The following table summarizes the approximate unrecognized compensation cost for the share-based compensation awards and the weighted average remaining years over which the cost will be recognized:

	Total Unrecognized Compensation Expense		Weighted Average Remaining Years
	(Thousands)
Stock options	$	101	2.7
Restricted stock		461	2.6
Total	$	562

12. Related Party Transactions

Customer Sales

No Fear, Inc. (“No Fear”), a stockholder, owns retail stores that purchase products from the Company. Aggregated sales to these stores during the three months ended March 31, 2007 and 2006 were approximately $183,000 and $248,000, respectively. Accounts receivable due from these stores amounted to $303,000 and $222,000 at March 31, 2007 and December 31, 2006, respectively.

Stockholders of the Company, other than No Fear, own retail stores and distribution companies that purchase products from the Company. Aggregated sales to these stores during the three months ended March 31, 2007 and 2006 were approximately $491,000 and $231,000, respectively. Accounts receivable due from these entities amounted to approximately $596,000 and $440,000 at March 31, 2007 and December 31, 2006, respectively.

Polinelli S.r.l., a stockholder of which is a member of the Board of Directors and a former shareholder of the Company’s wholly owned subsidiary LEM, purchases products from the Company. Aggregated sales to Polinelli S.r.l., during the three months ended March 31, 2007 and 2006 were $194,000 and $407,000, respectively. Accounts receivable due from Polinelli S.r.l., amounted to $382,000 and $341,000 at March 31, 2007 and December 31, 2006, respectively.

Design Services

The Company has a product design services agreement with Jerome Mage, through his business Mage Design LLC, for the design and development of eyewear, apparel and accessory product lines. Mage Design LLC is also a stockholder. The total amounts expensed related to these services during the three months ended March 31, 2007 and 2006 were approximately $115,000 and $125,000, respectively

13. Commitments and Contingencies

Operating Leases

The Company leases its principal administrative and distribution facilities in Carlsbad, California and a warehouse facility in Varese, Italy, which is used primarily for international sales and distribution. LEM leases four buildings in Italy that are used for office space, warehousing and manufacturing. In addition, the Company utilizes some third party warehousing in both the United States and Europe. The Company also leases certain computer equipment, vehicles and temporary housing in Italy. Rent expense was approximately $161,000 and $172,000 for the three months ended March 31, 2007 and 2006, respectively.

Athlete Contracts

The Company has entered into endorsement contracts with athletes to actively wear and endorse the Company’s products. These contracts are based on minimum annual payments and may include additional performance-based incentives and/or product-specific sales incentives.

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Product Design

The Company has entered into an agreement with its primary product designer, Jerome Mage, through his business Mage Design LLC, for the design and development of its eyewear, apparel and accessory product lines. Mr. Mage has agreed to provide his services to the Company as an independent consultant through December 31, 2008, and to be bound by confidentiality obligations. Mr. Mage has also agreed not to provide design services to any entity that is engaged principally in the business of designing, manufacturing or selling sunglasses, goggles or other optical products during the term of the agreement. Mr. Mage has developed products primarily for the Spy Optic brand. Under the agreement, Mr. Mage assigns all ideas, inventions and other intellectual property rights created or developed on the Company’s behalf during the term of the agreement to the Company. The agreement may be terminated by either party if the other party defaults or breaches a material provision of the agreement and has monthly minimum payments due.

Litigation

Oakley

On March 7, 2005, Oakley, Inc., a major competitor of the Company, filed a lawsuit alleging patent, trade dress and trademark infringement, unfair competition, and false designation of origin. The lawsuit specifically identified three of the Company’s product styles which accounted for 4% and 5% of the Company’s total sales, excluding sales related to LEM, for the years ended December 31, 2006 and 2005, respectively. On February 26, 2007, the Company entered into a Settlement Agreement and Release with Oakley with respect to this action. Pursuant to the terms of the Settlement Agreement, in exchange for Oakley’s agreement to release all claims, known or unknown, related to or arising out of this action and to dismiss this action, the Company and Spy Optic, Inc. agreed to release all of their claims, known or unknown, related to or arising out of this action and (i) sell all of their remaining inventory of e Eyewear product to Oakley for $1.00; (ii) cease all further manufacture and sale of e Eyewear products; (iii) refrain from making, offering or selling any eyeglasses bearing any marks having the letter “e” or “E” itself or as a commercially discrete component of the mark or having the mark “E Eyewear” or any confusingly similar variation thereof; (iv) abandon all existing trademark applications worldwide for marks related to sunglasses, eyeglasses or related products having the letter “e” or “E” itself or as a commercially discrete component of the mark or having the mark “E Eyewear” or any confusingly similar variation thereof; (v) cease all manufacturing of their Espada and Meteor sunglasses, provided that the Company and Spy Optic, Inc. have 180 days from the date of the Settlement Agreement to sell any remaining inventory of Espada and Meteor products; and (vi) refrain from opposing certain of Oakley’s trademark applications. Under the Settlement Agreement, this action was dismissed in March 2007.

Securities Class Action

The Company, its directors and certain of its officers were named as defendants in two stockholder lawsuits filed in the United States District Court for the Southern District of California. A consolidated complaint, filed October 11, 2005, sought unspecified damages on behalf of an alleged class of persons who purchased the Company’s common stock pursuant to the registration statement filed in connection with the Company’s initial public offering of stock on December 14, 2004. The complaint alleged that the Company and its officers and directors violated federal securities laws by failing to disclose in the registration statement material information about plans to make a distribution change in its European operations, the Company’s dealings with one of its customers and whether certain of the Company’s products infringe on the intellectual property rights of Oakley, Inc. The Company filed a motion to dismiss the complaint which the court granted on March 29, 2006. The court allowed plaintiffs to file an amended complaint only with respect to their claim about the European distribution change only. The plaintiffs filed an amended complaint on April 7, 2006. On May 7, 2006, the Company filed a motion to dismiss that amended complaint. On January 16, 2007, the Company announced that it had reached an agreement to settle this action, subject to court approval. Under the proposed settlement, $1.4 million was paid to the class of plaintiffs and for plaintiffs’ attorneys’ fees from proceeds of the Company’s directors’ and officers’ insurance. No amounts will be paid by the Company. The settlement received court approval on May 1, 2007.

Derivative Action

In December 2005, two stockholders filed derivative lawsuits in state court in San Diego, purportedly on the Company’s behalf, against eight of the Company’s current or former directors and officers and against one of the Company’s stockholders, No Fear. A consolidated amended complaint was filed in March 2006 alleging that the defendants breached their fiduciary duties and injured the Company by allowing the Company to issue a misleading registration statement and prospectus in connection with the Company’s December 2004 initial public offering and alleging that No Fear sold the Company’s stock while having knowledge of material, non-public information. The derivative plaintiffs sought compensatory damages, disgorgement of profits, treble damages and other relief. On May 4, 2006, the Court granted the defendants’ demurrer and dismissed the consolidated complaint, with leave to file an amended complaint. An amended complaint was filed on May 25, 2006, and on June 29, 2006 the defendants filed their demurrer to that amended complaint. On January 16, 2007, the Company announced that it had reached an agreement to settle this action, subject to court approval. Under the proposed settlement, No Fear and the insurer for the officer and director defendants have agreed to pay plaintiffs’ attorneys’ fees. In addition, the Company has agreed to continue adherence to a set of corporate governance guidelines. No amounts will be paid by the Company. The proposed settlement was approved by court in March 2007.

14. Operating Segments and Geographic Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company’s management in deciding how to allocate resources and in assessing performance. The Company designs, produces and distributes sunglasses, snow and motocross goggles, and branded apparel and accessories for the action sports and lifestyle markets. In January 2006, the Company acquired its primary manufacturer LEM located in Italy. LEM continues to manufacture products for non-competing brands in addition to most of the Company’s sunglass products. Results for LEM reflect operations of this manufacturer after elimination of intercompany transactions. Since the acquisition of LEM, the Company has operated in two business segments: distribution and manufacturing.

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Information related to the Company’s operating segments is as follows:

	Three Months Ended March 31,
	2007			2006
	(Thousands)
Net sales:
Distribution	$	8,379		$	8,708
Manufacturing		1,010			674
Intersegment		3,625			783
Eliminations		(3,625	)		(783	)
Total	$	9,389		$	9,382
Operating loss:
Distribution	$	(2,182	)	$	(1,374	)
Manufacturing		(71	)		(499	)
Total	$	(2,253	)	$	(1,873	)
Net loss:
Distribution	$	(1,597	)	$	(1,130	)
Manufacturing		(171	)		(604	)
Total	$	(1,768	)	$	(1,734	)
Identifiable assets:
Distribution	$	27,507		$	31,895
Manufacturing		17,577			15,138
Total	$	45,084		$	47,033

The Company markets its products domestically and internationally, with its principal international market being Europe. Revenue is attributed to the location from which the product was shipped. Identifiable assets are based on location of domicile.

	Three Months Ended March 31, 2007
	U.S. and Canada		Europe and Asia Pacific		Consolidated		Intersegment
			(Thousands)				(Thousands)
	2007						2007
Net sales	$	7,225	$	2,164	$	9,389	$	3,625
Identifiable assets		23,350		21,734		45,084
	2006
Net sales	$	7,951	$	1,431	$	9,382	$	783
Identifiable assets		27,290		19,743		47,033

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report (including the following section regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations) contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Quarterly Report. Additionally, statements concerning future matters such as the development of new products, our ability to increase manufacturing capacity, sales levels, expense levels and other statements regarding matters that are not historical are forward-looking statements.

Although forward-looking statements in this Quarterly Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include but are not limited to: risks related our ability to manage growth; risks related to the limited visibility of future orders; the ability to identify and work with qualified manufacturing partners and consultants; the ability to expand distribution channels and retail operations in a timely manner; unanticipated changes in general market conditions or other factors, which may result in cancellations of advance orders or a reduction in the rate of reorders placed by retailers; the ability to continue to develop, produce, and introduce innovative new products in a timely manner; the ability to source raw materials and finished products at favorable prices; the ability to identify and execute successfully cost control initiatives; uncertainties associated with our ability to maintain a sufficient supply of products and to manufacture successfully our products; the integration of the LEM acquisition; the performance of new products and continued acceptance of current products; the execution of strategic initiatives and alliances; uncertainties associated with intellectual property protection for our products; matters generally affecting the domestic and global economy, such as changes in interest and currency rates; and other factors described in Item 1A of Part II of this Quarterly Report under the caption “Risk Factors,” as well as those discussed elsewhere in this Quarterly Report. Readers are urged not to place undue reliance on forward-looking statements, which speak only as of the date of this Quarterly Report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Quarterly Report. Readers are urged to carefully review and consider the various disclosures made in this Quarterly Report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Quarterly Report. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in Item 1A of Part II of this Quarterly Report under the caption “Risk Factors,” and in the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2006, previously filed with the Securities and Exchange Commission.

Overview

The following discussion includes the operations of Orange 21 Inc. and its subsidiaries for each of the periods discussed.

We design, develop and market premium products for the action sports, motorsports and youth lifestyle markets. Our principal products, sunglasses and goggles, are marketed primarily under the brand, Spy Optic™. These products target the action sports market, including surfing, skateboarding and snowboarding, motocross, and the youth lifestyle market within fashion, music and entertainment. We have built our Spy^® brand by developing innovative, proprietary products that utilize high-quality materials and optical lens technology to convey performance, style, quality and value. We sell our products in approximately 5,000 retail locations in the United States and internationally through approximately 3,500 retail locations serviced by us and our international distributors. We have developed strong relationships with key multi-store action sport and youth lifestyle retailers in the United States, such as Cycle Gear, Inc., No Fear, Inc., Pacific Sunwear of California, Inc., Tilly’s Clothing, Shoes & Accessories and Zumiez, Inc., and a strategically selective collection of specialized surf, skate, snow, BMX, mountain bike and motocross stores.

We focus our marketing and sales efforts on the action sports, motorsports, and youth lifestyle markets, and specifically, persons ranging in age from 12 to 29. We separate our eyewear products into two groups: sunglasses, which includes fashion, performance sport and women-specific sunglasses, and goggles, which includes snowsport and motocross goggles. In addition, we sell branded apparel and accessories. In managing our business, we are particularly focused on ensuring that our product designs are keyed to current trends in the fashion industry, incorporate the most advanced technologies to enhance performance and provide value to our target market.

We began as a grassroots brand in Southern California and entered the action sports and youth lifestyle markets with innovative and performance-driven products and an authentic connection to the action sports and youth lifestyle markets under the Spy Optic™ brand. We have two wholly owned subsidiaries incorporated in Italy, Spy Optic, S.r.l. and LEM (our primary manufacturer which we acquired on January 16, 2006), and a wholly owned subsidiary incorporated in California, Spy Optic, Inc., which we consolidate in our financial statements. We were incorporated as Sports Colors, Inc. in California in August 1992. From August 1992 to April 1994, we had no operations. In April 1994, we changed our name to Spy Optic, Inc. In November 2004, we reincorporated in Delaware and changed our name to Orange 21 Inc.

Results of Operations

Three Months Ended March 31, 2007 and 2006

Net Sales

Our net sales are derived primarily from the sale of sunglasses, snow and motocross goggles, and apparel and accessories. Net sales are also derived from sales of eyewear products manufactured by our Italian manufacturer to non-Company owned entities. All intercompany sales transactions are eliminated in the consolidated financial statements.

Consolidated net sales were $9.4 million for each of the three months ended March 31, 2007 and 2006. Domestic net sales represented 77% and 85% of total net sales for the three months ended March 31, 2007 and 2006, respectively. Foreign net sales represented 23% and 15% of total net sales for the three months ended March 31, 2007 and 2006, respectively. The sales mix on a dollar basis for three months ended March 31, 2007 and 2006 was 93% and 94%, respectively, for eyewear and 7% and 6%, respectively, for apparel and accessories.

In three months ended March 31, 2007, we experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. These delays have been a result of poor logistical operations, lack of manufacturing equipment and weak management infrastructure in our newly acquired Italian subsidiary, LEM. We anticipate that we will continue to experience manufacturing and shipping delays during the rest of 2007, and that these delays may have a material impact on our results of operations.

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Cost of Sales and Gross Profit

Our cost of sales consists primarily of finished product, retail packaging and shipping costs. Other costs include costs associated with the purchasing function of our products, quality control and realized gains and losses on currency contracts, in Euros, used to hedge our purchase risk on inventories. In addition, it includes both raw materials and indirect production and overhead costs related to our Italian based manufacturer. All intercompany purchases are eliminated in the consolidated financial statements. In addition, gross profit related to intercompany purchases still in inventory products at the end of the accounting period reported is eliminated in the consolidated financial statements.

Our consolidated gross profit increased 9% to $4.9 million for the three months ended March 31, 2007 from $4.5 million for the three months ended March 31, 2006. Gross profit as a percentage of sales increased to 52.2% for the three months ended March 31, 2007 from 48.1% for the three months ended March 31, 2006. The increase in gross profit and gross profit as a percentage of sales is primarily due to sales of some inventory that was previously written down and efficiencies achieved at LEM S.r.l., our subsidiary and primary manufacturer.

Sales and Marketing Expense

Our sales and marketing expense consists primarily of wages and related payroll and employee benefit costs, point-of-purchase expenses (depreciation) and store display and promotional items, athlete contracts and royalty expenses, advertising costs and trade show expenses. Advertising costs are expensed as incurred.

Sales and marketing expense increased 9% to $3.8 million for the three months ended March 31, 2007 from $3.5 million for the three months ended March 31, 2006. The increase was primarily due to increased depreciation expense on point-of-purchase store displays of $0.2 million due to a reduction in depreciable lives to two years on the point-of-purchase displays effective as of October 1, 2006 and employee-related compensation.

General and Administrative Expense

Our general and administrative expense consists primarily of wages and related payroll and employee benefit costs, facility costs, business insurance, bad debt expense, utilities, legal and accounting professional fees, other facility-related costs including depreciation, and other general corporate expenses.

General and administrative expense increased 17% to $2.5 million for the three months ended March 31, 2007 from $2.1 million for the three months ended March 31, 2006. The increase in general and administrative expense was primarily due to increases in employee-related compensation expense in the U.S. of approximately $0.2 million, increased severance pay for LEM employees of $0.1 million, accounting and software consulting costs due to the implementation of our new enterprise resource planning system of $0.1 million, and increases in depreciation expense, bank fees related to the new BFI Loan Agreement, and share-based compensation in accordance with SFAS No. 123(R). The increases were partially offset by a decrease in legal and audit fees of $0.3 million.

Shipping and Warehousing Expense

Shipping and warehousing expense consists primarily of wages and related payroll and employee benefit costs, packaging supplies, third-party warehousing and third-party fulfillment costs, facility costs and utilities. Shipping and warehousing expense increased 34% to $0.6 million for the three months ended March 31, 2007 from $0.5 million for the three months ended March 31, 2006. The increase was primarily due to increased costs related to shipping methods used (air freight versus sea shipment) as a result of manufacturing and shipping delays experienced in 2006 and the three months ended March 31, 2007. These delays have been a result of poor logistical operations, lack of manufacturing equipment and weak management infrastructure in our Italian subsidiary, LEM.

Research and Development Expense

Research and development expense currently consists primarily of wages and related payroll and employee benefit costs, consulting fees to Mage Design, LLC, travel expenses and prototype and sample expenses. Research and development expense decreased 27% to $0.2 million for the three months ended March 31, 2007 from $0.3 million for the three months ended March 31, 2006. The decrease is mainly due to an effort made late in 2006 to reduce research and development expense through a reduction in employee compensation expense.

Other Expense

Other net expense was $0.2 million for the three months ended March 31, 2007 compared to other net expense of $0.1 million for the three months ended March 31, 2006. The change in other net expense is primarily due to increases in net interest expense, foreign exchange losses and losses on disposals of fixed assets.

Income Tax Benefit

The income tax benefit for the three months ended March 31, 2007 was $0.7 million compared to $0.2 million for the three months ended March 31, 2006. The effective tax rate for the three months ended March 31, 2007 and 2006 was 27% and 11%, respectively. The increase in the effective tax rate was due to the significant proportion of the pretax losses incurred in the U.S. versus in Italy.

Net Loss

A net loss of $1.8 million was incurred for the three months ended March 31, 2007 compared to a net loss of $1.7 million for the three months ended March 31, 2006.

Liquidity and Capital Resources

Cash flow activities

Cash provided by or used in operating activities consists primarily of net income (loss) adjusted primarily for certain non-cash items, including depreciation, amortization, deferred income taxes, provision for bad debts, stock compensation expense and the effect of changes in working capital and other activities. Cash provided by operating activities for the three months ended March 31, 2007 was $0.2 million, which consisted of a net loss of $1.8 million, adjustments for non-cash items of approximately $0.4 million, and $1.5 million provided by working capital and other activities. Working capital and other activities consisted primarily of a $1.9 million decrease in accounts receivable due to timing of cash receipts, a $1.2 million increase in net inventory due primarily to an increase in inventory in anticipation of future sales, a $1.5 million decrease in prepaid expenses and other current assets due to timing of payments and a $0.7 million increase in accounts payable and accrued liabilities due to timing of payments of vendor invoices. Cash provided by operating activities for the three months ended March 31, 2006 was approximately $1.4 million and consisted of a net loss of $1.7 million, adjustments for non-cash items of approximately $0.6 million, and $2.5 million provided by working capital and other activities. Working capital and other activities consisted primarily of a decrease in accounts receivables of $1.9 million, and a decrease in inventory of $2.0 million due to sales and improved inventory management. This was offset by a decrease in accounts payable and accrued liabilities of $1.1 million.

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Cash used in investing activities during the three months ended March 31, 2007 was $1.0 million and was primarily attributable to the purchase of $0.8 million of fixed assets, including retail point-of-purchase displays. Additionally, we made a $0.3 million net investment in restricted cash of which $0.7 million is related to collateralization of our financing arrangements with Comerica Bank offset partly by disbursements in restricted cash of $0.4 million related to requirements of the purchase agreement for the acquisition of LEM that were paid out during the quarter. We had an offset of approximately $0.5 million due to net proceeds received on short-term investments. Cash used in investing activities for the three months ended March 31, 2006 was $0.4 million and was attributable primarily to net short-term investments made primarily from a portion of the net proceeds of our initial public offering of $4.5 million, capital expenditures of $0.7 million, and $2.8 million for the acquisition of LEM. Capital expenditures were primarily for the purchase of retail point-of-purchase displays.

Cash provided by financing activities for the three months ended March 31, 2007 was $0.9 million and was mainly attributable to $0.8 million in proceeds received through the issuance of notes payable and $0.3 million in net proceeds received through our BFI Loan Agreement, partially offset by $0.1 million for capital lease principal payments and notes payables. Cash provided by financing activities for the three months ended March 31, 2006 was $0.6 million and was due primarily to an increase in advances on LEM’s lines of credit of $0.7 million. This was offset by principal payments on LEM note payables and capital leases of $0.2 million.

Credit Facilities

At December 31, 2006, we had financing arrangements with Comerica Bank consisting of a line of credit facility with a $5.0 million limit, a foreign exchange facility and letter of credit accommodations. These arrangements were secured by all of our assets, excluding our intellectual property, and a $1.0 million collateral cash deposit with Comerica, and were subject to certain covenants. The $5.0 million available line of credit was reduced by the amount of outstanding letters of credit (sub limit of $4.1 million) and 10% of outstanding foreign exchange forward contracts ($0.9 million sub limit). Borrowings were limited to cover any outstanding letters of credit issued to San Paolo IMI on behalf of LEM (3.0 million Euros or $3.9 million at December 31, 2006).

Our foreign exchange facility allowed us to purchase currency contracts which we used primarily to hedge our foreign currency exposure. The amount of allowable purchases of such contracts was $9.0 million. At December 31, 2006, net foreign exchange forward contracts outstanding amounted to $5.7 million, which reduced the amount available to us under the line of credit by $570,000. As a result, at December 31, 2006, we had an unused line of credit of approximately $0.5 million with Comerica Bank.

At December 31, 2006, we were not in compliance with two financial covenants under the financing arrangements with Comerica related to maintaining a minimum tangible net worth and not incurring net losses in two consecutive quarters. On February 22, 2007, we amended our financing arrangements with Comerica, which decreased our letter of credit sub limit to $1.8 million, decreased our foreign exchange facility limit from $9.0 million to $7.2 million and extended the expiration date to May 15, 2007. We later replaced this line of credit with a line of credit from BFI Business finance on February 26, 2007, as described below.

On February 26, 2007, Spy Optic, Inc. entered into a Loan and Security Agreement (“Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million. Actual borrowing availability under the Loan Agreement is based on eligible trade receivable and inventory levels of Spy Optic, Inc. Loans extended pursuant to the Agreement will bear interest at a rate per annum of 2.5% above the higher of (i) the prime rate as reported in the western edition of the Wall Street Journal from time to time or (ii) 8% with a minimum monthly interest charge of $2,000. We granted BFI a security interest in all of Spy Optic, Inc.’s assets as security for its obligations under the Agreement, except for its copyrights, patents, trademarks, servicemarks and related applications. Additionally, the obligations under the Loan Agreement are guaranteed by Orange 21 Inc.

The Loan Agreement imposes certain covenants on Spy Optic, Inc., including, but not limited to, covenants requiring it to provide certain periodic reports to BFI, inform BFI of certain changes in the business, refrain from incurring additional debt in excess of $100,000 and refrain from paying dividends. Spy Optic, Inc. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy Optic, Inc. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy Optic, Inc. any amounts remaining after payment of all amounts due under the Loan Agreement. To secure its obligations under the guaranty, Orange 21 Inc. granted BFI a blanket security interest in all of its assets, except for its stock in Spy Optic, Inc., which it has covenanted not to pledge to any other person or entity.

We received a loan in the amount of $650,000 upon the execution of the Loan Agreement. These proceeds were used to fully collateralize Comerica Bank for the letter of credit issued by Comerica on behalf of Orange 21 Inc. and LEM to San Paolo IMI in the amount of 1.2 million Euros. At March 31, 2007, there were outstanding borrowings of $1.2 million under this line, bearing an interest rate of 10.88% and remaining availability under this line of $3.8 million, subject to eligible accounts receivable and inventory levels.

At March 31, 2007 and December 31, 2006, we also had a 2.2 million Euro line of credit in Italy with San Paolo IMI for LEM, which expires on September 31, 2007. This debt is normally negotiated on a yearly basis. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At March 31, 2007, there was approximately 1.1 million Euro available under this line of credit. At March 31, 2007 and December 31, 2006, lines of credit amounted to $1.4 million and $3.0 million, respectively, and bear interest at rates ranging from 4.0% to 4.85%.

We believe that our cash on hand and available loan facilities will be sufficient to enable us to meet our financing and operating requirements for at least the next 12 months. Changes in operating plans, lower than anticipated net sales, increased expenses or other events, including those described in Item 1A, “Risk Factors,” may make it difficult for us to seek additional debt or equity financing in the future. Our future capital requirements will depend on many factors, including our rate of net sales growth, financing requirements related to our recent acquisition of LEM, the expansion of our sales and marketing activities and the continuing market acceptance of our product designs. We may be required to seek equity or debt financing in the future, which would result in additional dilution of our stockholders. Additional debt would result in increased interest expense and could result in covenants that would restrict our operations.

Off-balance sheet arrangements

We did not enter into any off-balance sheet arrangements during the three months ended March 31, 2007 or during 2006, nor did we have any off-balance sheet arrangements outstanding at March 31, 2007 or December 31, 2006.

Long-term financial obligations and other commercial commitments

We have summarized our significant financial contractual obligations as of December 31, 2006 in our Annual Report on Form 10-K. There have been no subsequent material changes to our contractual obligations since December 31, 2006 except for the Loan Agreement entered into on February 26, 2007 as discussed above. At March 31, 2007 the total amount due under the Loan Agreement is $1.2 million which is considered to be short term and payable within one year.

Income Taxes

In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of

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future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based on the level of historical operating results and projections for the taxable income for the future, management has determined that it is more likely than not that the deferred tax assets, net of the valuation allowance, will be realized. Accordingly, we have recorded no valuation allowance for our U.S. operations at March 31, 2007 and December 31, 2006. At March 31, 2007 and December 31, 2006, we have recorded a valuation allowance of $1,107,000 for our wholly owned subsidiary, Spy Optic, S.r.l. At March 31, 2007 and December 31, 2006, we recorded a valuation allowance of $1,640,000 for our wholly owned subsidiary, LEM.

Backlog

Historically, purchases of sunglass and motocross eyewear products have not involved significant pre-booking activity. Purchases of our snow goggle products are generally pre-booked and shipped primarily from August to October.

We experienced delays in manufacturing and shipping our sunglass and goggle products in the three months ended March 31, 2007 and in fiscal year 2006. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2007, and that these delays will continue to have a material effect on our results of operations.

Seasonality

Our net sales fluctuate from quarter to quarter as a result of changes in demand for our products. Historically, we have experienced greater net sales in the second half of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products. We generally sell more of our sunglass products in the first half of the fiscal year and a majority of our goggle products in the last half of the fiscal year. We anticipate that this seasonal impact on our net sales is likely to continue. As a result, our net sales and operating results have fluctuated significantly from period-to-period in the past and are likely to do so in the future.

Inflation

We do not believe inflation had a material impact on our operations in the past, although there can be no assurance that this will be the case in the future.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of consolidated financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosures. On an ongoing basis, we evaluate our estimates, including those related to inventories, sales returns, income taxes, accounts receivable allowances, share-based compensation, impairment testing and warranty. We base our estimates on historical experience, performance metrics and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results will differ from these estimates under different assumptions or conditions.

We apply the following critical accounting policies in the preparation of our consolidated financial statements:

Revenue Recognition

Revenues are recognized when the risk of ownership and title passes to our customers. Generally, we extend credit to our customers and do not require collateral. Our payment terms generally range from net-30 to net-90, depending on the country or whether we sell directly to retailers in the country or to a distributor. Generally, our sales agreements with any of our customers do not provide for any rights of return. However, we do approve returns on a case-by-case basis in our sole discretion to protect our brand and our image. We provide allowances for estimated returns when revenues are recorded, and related losses have historically been within our expectations. If returns are higher than our estimates, our earnings would be adversely affected.

Accounts Receivable, Reserve for Refunds and Returns and Allowance for Doubtful Accounts

Throughout the year, we perform credit evaluations of our customers, and we adjust credit limits based on payment history and the customer’s current creditworthiness. We continuously monitor our collections and maintain a reserve for estimated credit. We reserve for estimated future refunds and returns at the time of shipment based upon historical data. We adjust reserves as we consider necessary. We make judgments as to our ability to collect outstanding receivables and provide allowances for anticipated bad debts and refunds. Provisions are made based upon a review of all significant outstanding invoices and overall quality and age of those invoices not specifically reviewed. In determining the provision for invoices not specifically reviewed, we analyze collection experience, customer credit-worthiness and current economic trends. If the data used to calculate these allowances does not reflect our future ability to collect outstanding receivables, an adjustment in the reserve for refunds may be required. Historically, our losses have been consistent with our estimates, but there can be no assurance that we will continue to experience the same credit loss rates that we have experienced in the past. Unforeseen, material financial difficulties experienced by our customers could have an adverse impact on our profits.

Share-based Compensation Expense

We account for share-based compensation in accordance with SFAS No. 123(R), which requires us to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the consolidated statement of operations over the period during which the employee is required to provide service in exchange for the award—the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The grant-date fair value of employee share options and similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments. SFAS No. 123(R) eliminates the use of Accounting Principles Board (“APB”) Opinion 25 and the option for pro forma disclosure in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”).

Determining Fair Value under SFAS No. 123(R)

Valuation and Amortization Method. Consistent with the valuation method used for the disclosure only provisions of SFAS No. 123, we are using the Black-Scholes option-pricing valuation model (single option approach) to calculate the fair value of stock option grants. For options with graded vesting, the option grant is treated as a single award and compensation cost is recognized on a straight-line basis over the vesting period of the entire award.

Expected Term. The expected term of options granted represents the period of time that the option is expected to be outstanding. We estimate the expected term of the option grants based on historical exercise patterns that we believe to be representative of future behavior as well as other various factors.

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Expected Volatility. We estimate our volatility using our historical share price performance over the expected life of the options, which management believes is materially indicative of expectations about expected future volatility.

Risk-Free Interest Rate. We use risk-free interest rates in the Black-Scholes option valuation model that are based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life of the options.

Dividend Rate. We have not paid dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Therefore, we use an expected dividend yield of zero.

Forfeitures. SFAS No. 123(R) requires companies to estimate forfeitures at the time of grant and revise those estimates in subsequent reporting periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of calculating pro forma information under SFAS No. 123 for periods prior to the date of adoption of SFAS No. 123(R), we accounted for forfeitures as they occurred. The impact of the adoption of SFAS No. 123(R) related to forfeitures was not material to our financial statements.

Restricted Cash

As of March 31, 2007, we had $404,000 of restricted cash held in an escrow account in accordance with the terms of the purchase agreement, pursuant to which we purchased LEM. The escrow account relates to the earn-out provision of the purchase agreement. The escrow account must be maintained at a minimum level of 300,000 Euro through June 30, 2007. As of March 31, 2007, we also had $1.7 million on deposit with Comerica Bank to be used as collateral to secure the line of credit facility. See Note 9 of the Notes to Consolidated Financial Statements.

Inventories

Inventories consist primarily of raw materials and finished products, including sunglasses, goggles, apparel and accessories, product components such as replacement lenses, purchasing and quality control costs, and packaging and shipping materials. Inventory items are carried on the books at the lower of cost or market using the weighted average cost method for LEM and first in first out method for our distribution business. Periodic physical counts of inventory items are conducted to help verify the balance of inventory. A reserve is maintained for obsolete or slow moving inventory.

Goodwill

Goodwill is not amortized but instead is measured for impairment at least annually, or when events indicate that a likely impairment exists. We evaluate the recoverability of goodwill at least annually based on a two-step impairment test. The first step compares the fair value of each reporting unit with its carrying amount, including goodwill. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. The fair value of each reporting unit was determined using a combination of the income approach and the market approach. Under the income approach, the fair value of a reporting unit is calculated based on the present value of estimated future cash flows. The present value of estimated future cash flows uses our estimates of revenue for the reporting units, driven by assumed market growth rates and assumed market segment share, and estimated costs as well as appropriate discount rates. These estimates are consistent with the plans and estimates that we use to manage the underlying business. Under the market approach, fair value is estimated based on market multiples of earnings for comparable companies and similar transactions.

We performed our annual test of goodwill on October 1, 2006, which did not indicate any impairment and thus the second step was not performed. Determining fair value under the first step of the goodwill impairment test is judgmental in nature and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the extent of such charge.

Research and Development

We expense research and development costs as incurred. We capitalize product molds and tooling and depreciate these costs over the useful life of the asset.

Income Taxes

We account for income taxes pursuant to the asset and liability method, whereby deferred tax assets and liabilities are computed at each balance sheet date for temporary differences between the consolidated financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the temporary differences are expected to affect taxable income. We consider future taxable income and ongoing, prudent and feasible tax planning strategies in assessing the value of our deferred tax assets. If we determine that it is more likely than not that these assets will not be realized, we will reduce the value of these assets to their expected realizable value, thereby decreasing net income. Evaluating the value of these assets is necessarily based on our management’s judgment. If we subsequently determined that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.

Foreign Currency and Derivative Instruments

The functional currency of each of our wholly owned subsidiaries, Spy Optic, S.r.l., LEM and our Canadian division is the respective local currency. Accordingly, we are exposed to transaction gains and losses that could result from changes in foreign currency. Assets and liabilities denominated in foreign currencies are translated at the rate of exchange on the balance sheet date. Revenues and expenses are translated using the average exchange rate for the period. Gains and losses from translation of foreign subsidiary financial statements are included in accumulated other comprehensive income (loss).

We designate our derivatives based upon the criteria established by SFAS No. 133, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133, as amended by SFAS No. 138 “Accounting for Certain Derivative Instruments and Certain hedging Activities – an amendment of SFAS 133”, (“SFAS No. 138”) and Statement of Financial Accounting Standards No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS No. 149”), requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for the changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation. For a derivative designated as a cash flow hedge, the effective portion of the derivative’s fair value gain or loss is initially reported as a component of accumulated other comprehensive income (loss). Any realized gain or loss on such derivative is reported in cost of goods sold in the accounting period in which the hedged transaction affects earnings. The fair value gain or loss from the ineffective portion of the derivative is reported in other income (expense) immediately. For a derivative that does not qualify as a cash flow hedge, the change in fair value is recognized at the end of each accounting period in other income (expense).

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Commitments and Contingencies

We have entered into operating leases, primarily for facilities, and have commitments under endorsement contracts with selected athletes and others who endorse our products. We also have an agreement with our primary product designer.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

Market risk represents the risk of loss arising from adverse changes in market rates and foreign exchange rates. At March 31, 2007, we had $1.2 million outstanding debt under our Loan Agreement with BFI and an availability under the Loan Agreement of $3.3 million. The amounts outstanding under these loan facilities at any time may fluctuate and we may from time to time be subject to refinancing risk. We do not believe that a change of 100 basis points in interest rate would have a material effect on our results of operations or financial condition based on our current borrowing needs.

Foreign Currency Risk

In the normal course of business, we are exposed to foreign currency exchange rate risk that could impact our financial position and results of operations. We are exposed to foreign currency exchange rate risk inherent in our sales commitments, anticipated sales, anticipated purchases, assets and liabilities denominated in currencies other than the U.S. Dollar. Our risk management strategy with respect to this market risk includes the use of derivative financial instruments. We do not use derivative contracts for speculative purposes. Our risks, risk management strategy and a sensitivity analysis estimating the effects of changes in fair values for these exposures are outlined below.

We operate our business and derive a substantial portion of our net sales outside of the United States. We also purchase a majority of our products in transactions denominated in Euros. As a result, we are exposed to movements in foreign currency exchange rates between the local currencies of the foreign markets in which we operate and the U.S. Dollar. Our foreign currency exposure is generally related to Europe. A strengthening of the Euro relative to the U.S. dollar or to other currencies in which we receive revenues could negatively impact the demand for our products, could increase our manufacturing costs and could reduce our results of operations. In addition, we manufacture a substantial amount of our sunglass and goggle products in Italy. Because these purchases are paid in Euros, we face currency risk. A strengthening Euro could negatively affect the cost of our products and reduce our gross profit margins.

We use forward contracts designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in our forecasted purchase of products at prices denominated in Euros. We also use other derivatives not designated as hedging instruments under SFAS No. 133 consisting of forward contracts to hedge foreign currency balance sheet exposures. We recognize the gains and losses on foreign currency forward contracts not designated as hedging instruments in the same period as the remeasurement losses and gains of the related foreign currency-denominated exposures.

As of March 31, 2007, we had a total of $2.5 million in Euro foreign currency contracts designated as cash flow hedges at an average Euro rate of 1.33 Euro to U.S. dollar and $0.3 million in Euro foreign currency contracts at an average Euro rate of 1.34 not designated as hedging instruments. The exchange rate for the Euro to the U.S. dollar ranged from 1.29 to 1.34 during the three months ended March 31, 2007.

As part of our risk management procedure, a sensitivity analysis model is used to measure the potential loss in future earnings of market-sensitive instruments resulting from a change in foreign currency values. The sensitivity analysis model quantifies the estimated potential effect of unfavorable movements of 10% in foreign currencies to which we were exposed at March 31, 2007 through its derivative financial instruments.

The estimated one-day loss from our foreign currency derivative financial instruments, calculated using the sensitivity model described above, is approximately $280,000 at March 31, 2007. We believe that such a hypothetical loss from derivatives would be offset by increases in the value of the underlying transactions being hedged.

The sensitivity analysis model is a risk analysis tool and does not purport to represent actual losses in earnings that we may incur, nor does it consider the potential effect of favorable changes in market rates. It also does not represent the maximum possible loss that may occur. Actual future gains and losses will differ from those estimated because of changes or differences in market rates, hedging instruments and hedge percentages, timing and other factors.

Recently Issued Accounting Pronouncements

On January 1, 2007, the Company adopted the provisions of FIN 48, which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. There has been no material effect on our financial statements as a result of the adoption of FIN 48 as of March 31, 2007.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”(“SFAS No. 157”), 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. This statement is effective for us beginning January 1, 2008. We are currently assessing the potential impact that the adoption of SFAS No. 157 will have on our financial statements.

In February 2007, the FASB released FASB No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which is effective for fiscal years beginning after November 15, 2007. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. We are currently assessing the impact the adoption of this pronouncement will have on the financial statements.

Item 4. Controls and Procedures

Based on their evaluation as of the end of the period covered by this report, under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), our CEO and CFO have concluded that, as of the end of such period, our disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”) were effective in timely making known to them material information relating to the Company required to be disclosed in our reports filed or submitted under the Exchange Act.

There was no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings

Oakley

On March 7, 2005, Oakley, Inc., a major competitor of ours, filed a lawsuit alleging patent, trade dress and trademark infringement, unfair competition, and false designation of origin. The lawsuit specifically identified three of the our product styles which accounted for 4% and 5% of our total sales, excluding sales related to LEM, for the years ended December 31, 2006 and 2005, respectively. On February 26, 2007, we entered into a Settlement Agreement and Release with Oakley with respect to this action. Pursuant to the terms of the Settlement Agreement, in exchange for Oakley’s agreement to release all claims, known or unknown, related to or arising out of this action and to dismiss this action, we and Spy Optic, Inc. agreed to release all of their claims, known or unknown, related to or arising out of this action and (i) sell all of their remaining inventory of e Eyewear product to Oakley for $1.00; (ii) cease all further manufacture and sale of e Eyewear products; (iii) refrain from making, offering or selling any eyeglasses bearing any marks having the letter “e” or “E” itself or as a commercially discrete component of the mark or having the mark “E Eyewear” or any confusingly similar variation thereof; (iv) abandon all existing trademark applications worldwide for marks related to sunglasses, eyeglasses or related products having the letter “e” or “E” itself or as a commercially discrete component of the mark or having the mark “E Eyewear” or any confusingly similar variation thereof; (v) cease all manufacturing of their Espada and Meteor sunglasses, provided that we and Spy Optic, Inc. have 180 days from the date of the Settlement Agreement to sell any remaining inventory of Espada and Meteor products; and (vi) refrain from opposing certain of Oakley’s trademark applications. Under the Settlement Agreement, this action was dismissed in March 2007.

Securities Class Action

We, our directors and certain of our officers were named as defendants in two stockholder lawsuits filed in the United States District Court for the Southern District of California. A consolidated complaint, filed October 11, 2005, sought unspecified damages on behalf of an alleged class of persons who purchased our common stock pursuant to the registration statement filed in connection with our initial public offering of stock on December 14, 2004. The complaint alleged that we and our officers and directors violated federal securities laws by failing to disclose in the registration statement material information about plans to make a distribution change in our European operations, our dealings with one of our customers and whether certain of our products infringe on the intellectual property rights of Oakley, Inc. We filed a motion to dismiss the complaint, which the court granted on March 29, 2006. The court allowed the plaintiffs to file an amended complaint with respect to their claim about the European distribution change only. The plaintiffs filed an amended complaint on April 7, 2006. On May 7, 2006, we filed a motion to dismiss that amended complaint. On January 16, 2007, we announced that we had reached an agreement to settle this action, subject to court approval. Under the proposed settlement, $1.4 million was paid to the class of plaintiffs and for plaintiffs’ attorneys’ fees from proceeds of our directors’ and officers’ insurance. No amounts will be paid by us. The settlement received court approval on May 1, 2007.

Derivative Action

In December 2005, two stockholders filed derivative lawsuits in state court in San Diego, purportedly on our behalf, against eight of our current or former directors and officers and against one of our stockholders, No Fear. A consolidated amended complaint was filed in March 2006 alleging that the defendants breached their fiduciary duties and injured us by allowing us to issue a misleading registration statement and prospectus in connection with our December 2004 initial public offering and alleging that No Fear sold our stock while having knowledge of material, non-public information. The derivative plaintiffs sought compensatory damages, disgorgement of profits, treble damages and other relief. On May 4, 2006, the Court granted the defendants’ demurrer and dismissed the consolidated complaint, with leave to file an amended complaint. An amended complaint was filed on May 25, 2006, and on June 29, 2006 the defendants filed their demurrer to that amended complaint. On January 16, 2007, we announced that we had reached an agreement to settle this action, subject to court approval. Under the proposed settlement, No Fear and the insurer for the officer and director defendants have agreed to pay plaintiffs’ attorneys’ fees. In addition, we have agreed to continue adherence to a set of corporate governance guidelines. No amounts will be paid by us. The proposed settlement was approved by court in March 2007.

Item 1A. Risk Factors

Risks Related to Our Business

You should consider each of the following factors as well as the other information in this Quarterly Report in evaluating our business and our prospects. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations. If any of the following risks actually occur, our business and financial results could be harmed. In that case, the trading price of our common stock could decline. You should also refer to the other information set forth in this Quarterly Report, including our financial statements and the related notes.

Our manufacturers must be able to continue to procure raw materials and we must continue to receive timely deliveries from our manufacturers to sell our products profitably.

The capacity of our manufacturers, including our subsidiary LEM, to manufacture our products is dependent in substantial part, upon the availability of raw materials used in the fabrication of sunglasses and goggles. Our manufacturers, including LEM, have experienced in the past, and may experience in the future, shortages of raw materials and other production delays, which have resulted in, and may in the future result in, delays in deliveries of our products up to several months.

We have experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during 2007, and that these delays will continue to have a material effect on our results of operations.

Any shortage of raw materials or inability of a manufacturer to manufacture or ship our products in a timely manner, or at all, could impair our ability to ship orders of our products in a timely manner and could cause us to miss the delivery requirements of our customers. As a result, we could experience cancellation of orders, refusal to accept deliveries or a reduction in purchase prices, any of which could harm our net sales, results of operations and reputation. In addition, LEM provides manufacturing services to other companies under supply agreements. The inability of LEM and our other suppliers to manufacture and ship products in a timely manner could result in breaches of the agreements with our customers, which could harm our results of operations, reputation and demand for our products.

We may not successfully address problems encountered in connection with our acquisition of LEM or any future acquisitions, which could result in operating difficulties and other harmful consequences.

In January 2006, we acquired LEM. The aggregate purchase price was 3.5 million Euro or $4.2 million in cash, plus a two year earn-out based on LEM’s future sales. Under the terms of the earn-out, we are obligated to make quarterly payments based on unit sales, up to a maximum of 1.4 million Euros, through December 31, 2007 of which we have paid 978,000 Euro or $1,020,000 as of March 31, 2007. We expect to continue to consider other opportunities to acquire or make investments in other technologies,

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products and businesses that could enhance our capabilities, complement our current products or expand the breadth of our markets or customer base, although we have no specific agreements with respect to potential acquisitions or investments. We have limited experience in acquiring other businesses and technologies. Potential and completed acquisitions, including our acquisition of LEM, and strategic investments involve numerous risks, including:

• problems assimilating the purchased technologies, products or business operations;

• problems maintaining uniform standards, procedures, controls and policies;

• unanticipated costs associated with the acquisition;

• diversion of management’s attention from our core business;

• harm to our existing business relationships with manufacturers and customers;

• risks associated with entering new markets in which we have no or limited prior experience; and

• potential loss of key employees of acquired businesses.

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our stockholders would be diluted.

In addition, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), we are required to test goodwill for impairment at least annually, or more frequently if events or circumstances exist which indicate that goodwill may be impaired. As a result of changes in circumstances after valuing assets in connection with acquisitions, we may be required to take write-downs of intangible assets, including goodwill, which could be significant.

If we are unable to continue to develop innovative and stylish products, demand for our products may decrease.

The action sports and youth lifestyle markets are subject to constantly changing consumer preferences based on fashion and performance trends. Our success depends largely on the continued strength of our brand and our ability to continue to introduce innovative and stylish products that are accepted by consumers in our target markets. We must anticipate the rapidly changing preferences of consumers and provide products that appeal to their preferences in a timely manner while preserving the relevancy and authenticity of our brand. Achieving market acceptance for new products may also require substantial marketing and product development efforts and expenditures to create consumer demand. Decisions regarding product designs must be made several months in advance of the time when consumer acceptance can be measured. If we do not continue to develop innovative and stylish products that provide greater performance and design attributes than the products of our competitors and that are accepted by our targeted consumers, we may lose customer loyalty, which could result in a decline in our net sales and market share.

We may not be able to compete effectively, which will cause our net sales and market share to decline.

The action sports and youth lifestyle markets in which we compete are intensely competitive. We compete with sunglass and goggle brands in various niches of the action sports market including Von Zipper, Electric Visual, Arnette, Oakley, Scott and Smith Optics. We also compete with broader youth lifestyle brands that offer eyewear products, such as Hurley International and Quiksilver, and in the broader fashion sunglass sector of the eyewear market, which is fragmented and highly competitive. We compete with a number of brands in these sectors of the market, including brands such as Armani, Christian Dior, Dolce & Gabbana, Gucci, Prada and Versace. In both markets, we compete primarily on the basis of fashion trends, design, performance, value, quality, brand recognition, marketing and distribution channels.

The purchasing decisions of consumers are highly subjective and can be influenced by many factors, such as marketing programs, product design and brand image. Several of our competitors enjoy substantial competitive advantages, including greater brand recognition, a longer operating history, more comprehensive lines of products and greater financial resources for competitive activities, such as sales and marketing, research and development and strategic acquisitions. Our competitors may enter into business combinations or alliances that strengthen their competitive positions or prevent us from taking advantage of such combinations or alliances. They also may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or consumer preferences.

If our marketing efforts are not effective, our brand may not achieve the broad recognition necessary to our success.

We believe that broader recognition and favorable perception of our brand by persons ranging in age from 12 to 29 is essential to our future success. Accordingly, we intend to continue an aggressive brand strategy through a variety of marketing techniques designed to foster an authentic action sports and youth lifestyle company culture, including athlete sponsorship, sponsorship of surfing, snowboarding, skateboarding, wakeboarding, and motocross events, vehicle marketing, internet and print media, action sports industry relationships, sponsorship of concerts and music festivals and celebrity endorsements. If we are unsuccessful, these expenses may never be offset, and we may be unable to increase net sales. Successful positioning of our brand will depend largely on:

• the success of our advertising and promotional efforts;

• preservation of the relevancy and authenticity of our brand in our target demographic; and

• our ability to continue to provide innovative, stylish and high-quality products to our customers.

To increase brand recognition, we must continue to spend significant amounts of time and resources on advertising and promotions. These expenditures may not result in a sufficient increase in net sales to cover such advertising and promotional expenses. In addition, even if brand recognition increases, our customer base may decline or fail to increase and our net sales may not continue at present levels and may decline.

If we are unable to leverage our business strategy successfully to develop new products, our business may suffer.

We are continuously evaluating potential entries into or expansion of new product offerings. In expanding our product offerings, we intend to leverage our sales and marketing platform and customer base to develop these opportunities. While we have generally been successful promoting our sunglasses and goggles in our target markets, we cannot predict whether we will be successful in gaining market acceptance for any new products that we may develop. In addition, expansion of our business strategy into new product offerings will require us to incur significant sales and marketing expenses. These requirements could strain our management and financial and operational resources. Additional challenges that may affect our ability to expand our product offerings include our ability to:

• increase awareness and popularity of our existing Spy^® brand;

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• establish awareness of any new brands we may introduce or acquire;

• increase customer demand for our existing products and establish customer demand for any new product offering;

• attract, acquire and retain customers at a reasonable cost;

• achieve and maintain a critical mass of customers and orders across all of our product offerings;

• maintain or improve our gross margins; and

• compete effectively in highly competitive markets.

We may not be able to address successfully any or all of these challenges in a manner that will enable us to expand our business in a cost-effective or timely manner. If new products we develop are not received favorably by consumers, our reputation and the value of our brand could be damaged. The lack of market acceptance of new products we develop or our inability to generate satisfactory net sales from any new products to offset their cost could harm our business.

Substantially all of our assets are pledged to secure obligations under our line of credit.

On February 26, 2007, Spy Optic, Inc. entered into a Loan and Security Agreement (the “Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million. Actual borrowing availability is based on Spy Optic, Inc.’s eligible trade receivables and inventory levels. Loans extended pursuant to the Loan Agreement will bear interest at a rate per annum of 2.5% above the higher of (i) the prime rate as reported in the western edition of the Wall Street Journal from time to time or (ii) 8%. Interest will be payable monthly in arrears and Spy Optic, Inc. is required to pay at least $2,000 a month in interest regardless of the amounts outstanding under the Loan Agreement at any particular time. The Loan Agreement also imposes certain covenants on Spy Optic, Inc., including covenants requiring it to (i) deliver financial statements and inventory and accounts payable reports to BFI; (ii) maintain certain minimum levels of insurance; (iii) make required payments under all leases; (iv) refrain from incurring additional debt in excess of $100,000; (v) maintain its corporate name, structure and existence; (vi) refrain from paying dividends; (vii) notify BFI in advance of relocating its premises; and (viii) refrain from substantially changing its management or business. As of March 31, 2007, there were outstanding borrowings under the Loan Agreement of $1.2 million.

Spy Optic, Inc. granted a security interest in all of its assets, except for its copyrights, patents, trademarks, servicemarks and related applications, to BFI as security for its obligations under the Loan Agreement. Spy Optic, Inc. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy Optic, Inc. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy Optic, Inc. any amounts remaining after payment of all amounts due under the Loan Agreement. Additionally, Orange 21 Inc. guarantied Spy Optic, Inc.’s obligations under the Loan Agreement and granted BFI a blanket security interest in all of its assets, except for its stock in Spy Optic, Inc., which it covenanted not to pledge to any other person or entity, as security for its obligations under its guaranty.

If Spy Optic, Inc. defaults in any of its obligations under the Loan Agreement, BFI will be entitled to exercise its remedies under the Loan Agreement and applicable law, which could harm our results of operations and reputation. Specifically, the remedies available to BFI include, without limitation, increasing the applicable interest rate on all amounts outstanding under the Loan Agreement, declaring all amounts under the Loan Agreement immediately due and payable, assuming control of the Collateral Account or any other assets pledged by Spy Optic, Inc. or Orange 21 Inc. and directing our customers to make payments directly to BFI.

Our business could be impacted negatively if our sales are concentrated in a small number of popular products.

If sales become concentrated in a limited number of our products, we could be exposed to risk if consumer demand for such products were to decline. For the three months ended both March 31, 2007 and 2006, 70% of our net sales were derived from sales of our sunglass products and 23% and 24%, respectively, of our net sales were derived from sales of our goggle products. As a result of these concentrations in net sales, our operating results could be harmed if sales of any of these products were to decline substantially and we were not able to increase sales of other products to replace such lost sales.

Our business could be harmed if we fail to maintain proper inventory levels.

We place orders with our manufacturers for some of our products prior to the time we receive orders for these products from our customers. We do this to minimize purchasing costs, the time necessary to fill customer orders and the risk of non-delivery. We also maintain an inventory of selected products that we anticipate will be in high demand. We may be unable to sell the products we have ordered in advance from manufacturers or that we have in our inventory. Inventory levels in excess of customer demand may result in inventory write-downs, and the sale of excess inventory at discounted prices could significantly impair our brand image and harm our operating results and financial condition. Conversely, if we underestimate consumer demand for our products or if our manufacturers fail to supply the quality products that we require at the time we need them, we may experience inventory shortages. Inventory shortages might delay shipments to customers, negatively impact retailer and distributor relationships and diminish brand loyalty, thereby harming our business.

In the three months ended March 31, 2007 and during fiscal year 2006, we experienced delays in manufacturing and shipping of our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2007, and that these delays will continue to have a material effect on our results of operations.

If we are unable to recruit and retain key personnel necessary to operate our business, our ability to develop and market our products successfully may be harmed.

We are heavily dependent on our current executive officers and management. The loss of any key employee or the inability to attract or retain qualified personnel, including product design and sales and marketing personnel, could delay the development and introduction of, and harm our ability to sell our products and damage our brand. We believe that our future success is highly dependent on the contributions of Mark Simo, who became our Chief Executive Officer in October 2006 as well as Jerry Collazo, our new Chief Financial Officer. We do not have an employment agreement with Mr. Simo. The loss of the services of Mr. Simo or Mr. Collazo would be very difficult to replace. Our future success may also depend on our ability to attract and retain additional qualified management, design and sales and marketing personnel. We do not carry key man insurance.

In addition, our senior management is relatively new to our business, for example, Mr. Collazo, our Chief Financial Officer, joined us in October 2006. If our management team is unable to execute on our business strategy, our business may be harmed, which could adversely impact our branding strategy, product development strategy and net sales.

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If we are unable to retain the services of our primary product designer, our ability to design and develop new products likely will be harmed.

We are heavily dependent on our primary product designer, Jerome Mage, for the design and development of our eyewear products. Mr. Mage provides his services to us as an independent consultant through his business, Mage Design, LLC. We cannot be certain that Mr. Mage will not be recruited by our competitors or otherwise terminate his relationship with us. If Mr. Mage terminates his relationship with us, we will need to obtain the services of another qualified product designer to design our eyewear products, and even if we are able to locate a qualified product designer, we may not be able to agree on commercially reasonable terms acceptable to us, if at all. If we were to enter into an agreement with a qualified product designer, we could experience a delay in the design and development of new sunglass and goggle product lines, and we may not experience the same level of consumer acceptance with any such product offerings. Any such delay in the introduction of new product lines or the failure by customers to accept new product lines could reduce our net sales.

If we are unable to maintain and expand our endorsements by professional athletes, our ability to market and sell our products may be harmed.

A key element of our marketing strategy has been to obtain endorsements from prominent action sports athletes to sell our products and preserve the authenticity of our brand. We generally enter into endorsement contracts with our athletes for terms of one to three years. There can be no assurance that we will be able to maintain our existing relationships with these individuals in the future or that we will be able to attract new athletes or public personalities to endorse our products in order to grow our brand or product categories. Further, we may not select athletes that are sufficiently popular with our target demographics or successful in their respective action sports. Even if we do select successful athletes, we may not be successful in negotiating commercially reasonable terms with those individuals. If we are unable in the future to secure athletes or arrange athlete endorsements of our products on terms we deem to be reasonable, we may be required to modify our marketing platform and to rely more heavily on other forms of marketing and promotion which may not prove to be as effective as endorsements. In addition, negative publicity concerning any of our sponsored athletes could harm our brand and adversely impact our business.

Any interruption or termination of our relationships with our manufacturers could harm our business.

Although our manufacturing relationship with LEM is secure as a result of our acquisition of LEM in January 2006, we do not have long-term agreements with any of our other manufacturers or with vendors that supply raw materials to LEM. We cannot be certain that we will not experience difficulties with our manufacturers, such as reductions in the availability of production capacity, errors in complying with product specifications, insufficient quality control, failures to meet production deadlines or increases in manufacturing costs and failures to comply with our requirements for the proper utilization of our intellectual property. If our relationship with any of our manufacturers is interrupted or terminated for any reason, including the failure of any manufacturer to perform its obligations under our agreement or the termination of our agreement by any of our manufacturers, we would need to locate alternative manufacturing sources. The establishment of new manufacturing relationships involves numerous uncertainties, and we cannot be certain that we would be able to obtain alternative manufacturing sources in a manner that would enable us to meet our customer orders on a timely basis or on satisfactory commercial terms. If we are required to change any of our major manufacturers, we would likely experience increased costs, substantial disruptions in the manufacture and shipment of our products and a loss of net sales.

Historically, we have purchased substantially all of our sunglass products from two manufacturers, LEM and Intersol. In January 2006, we acquired LEM. As a result, we expect in the future that the majority of our sunglass products will be manufactured by LEM and the portion of our products manufactured by Intersol will decrease. In addition, the majority of our goggle products are manufactured by OGK in China. We expect in 2007 to continue to manufacture most of our goggles through OGK.

In the three months ended March 31, 2007 and during fiscal year 2006, we experienced delays in manufacturing and shipping our sunglass and goggle products. These delays have materially affected our results of operations. We anticipate that we will continue to experience manufacturing and shipping delays during the remainder of 2007, and that these delays will continue to have a material effect on our results of operations.

Any failure to maintain ongoing sales through our independent sales representatives or maintain our international distributor relationships could harm our business.

We sell our products to retail locations in the United States and internationally through retail locations serviced by us through our direct sales team and a network of independent sales representatives in the United States, and through our international distributors. We rely on these independent sales representatives and distributors to provide customer contacts and market our products directly to our customer base. Our independent sales representatives are not obligated to continue selling our products, and they may terminate their arrangements with us at any time with limited notice. We do not have long-term agreements with all our international distributors. Our ability to maintain or increase our net sales will depend in large part on our success in developing and maintaining relationships with our independent sales representatives and our international distributors. It is possible that we may not be able to maintain or expand these relationships successfully or secure agreements with additional sales representatives or distributors on commercially reasonable terms, or at all. Any failure to develop and maintain our relationships with our independent sales representatives or our international distributors, and any failure of our independent sales representatives or international distributors to effectively market our products, could harm our net sales.

We face business, political, operational, financial and economic risks because a significant portion of our operations and sales are to customers outside of the United States.

Our European sales and administration operations as well as our primary manufacturers are located in Italy. In addition, we distribute our products from an outsourced facility based in the Netherlands. We are subject to risks inherent in international business, many of which are beyond our control, including:

• difficulties in obtaining domestic and foreign export, import and other governmental approvals, permits and licenses and compliance with foreign laws, including employment laws;

• difficulties in staffing and managing foreign operations, including cultural differences in the conduct of business, labor and other workforce requirements;

• transportation delays and difficulties of managing international distribution channels;

• longer payment cycles for, and greater difficulty collecting, accounts receivable;

• ability to finance our foreign operations;

• trade restrictions, higher tariffs or the imposition of additional regulations relating to import or export of our products;

• unexpected changes in regulatory requirements, royalties and withholding taxes that restrict the repatriation of earnings and effects on our effective income tax rate due to profits generated or lost in foreign countries;

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• political and economic instability, including wars, terrorism, political unrest, boycotts, curtailment of trade and other business restrictions; and

• difficulties in obtaining the protections of the intellectual property laws of other countries.

Any of these factors could reduce our net sales, decrease our gross margins or increase our expenses.

Fluctuations in foreign currency exchange rates could harm our results of operations.

We sell a majority of our products in transactions denominated in U.S. dollars; however, we purchase a substantial portion of our products from our manufacturers in transactions denominated in Euros. As a result, if the U.S. dollar were to weaken against the Euro, our cost of sales could increase substantially. We also are exposed to gains and losses resulting from the effect that fluctuations in foreign currency exchange rates have on the reported results in our consolidated financial statements due to the translation of the operating results and financial position of our Italian subsidiaries Spy Optic, S.r.l. and LEM, and due to net sales in Canada. Between January 1, 2006 and March 31, 2007, the Euro to U.S. dollar exchange rate has ranged from 1.18 to 1.34. Between January 1, 2006 and March 31, 2007, the Canadian dollar to U.S. dollar exchange rate has ranged from 0.84 to 0.91. For the three months ended March 31, 2007 and 2006, we had net foreign currency losses of approximately $51,000 and $28,000, representing 0% and 0% of our net sales, respectively. As of March 31, 2007, we had a total of $2.5 million in Euro foreign currency contracts designated as cash flow hedges at an average Euro rate of 1.33 Euro to U.S. dollar and $0.3 million in Euro foreign currency contracts at an average Euro rate of 1.34 not designated as hedging instruments.

The effect of foreign exchange rates on our financial results can be significant. We therefore engage in certain hedging activities to mitigate over time the impact of the translation of foreign currencies on our financial results. Our hedging activities reduce, but do not eliminate, the effects of foreign currency fluctuations. Factors that could affect the effectiveness of our hedging activities include the volatility of currency markets and the availability of hedging instruments. For the effect of our hedging activities during the current reporting periods, see “Quantitative and Qualitative Disclosures about Market Risk.” The degree to which our financial results are affected will depend in part upon the effectiveness or ineffectiveness of our hedging activities.

We may experience conflicts of interest with our significant stockholder, No Fear, Inc., which could harm our other stockholders.

No Fear, Inc. (“No Fear”) and its affiliates beneficially own approximately 14% of our outstanding common stock. As a result of this ownership interest, No Fear and its affiliates have the ability to influence who is elected to our Board of Directors each year and, through those directors, to influence our management, operations and potential significant corporate actions. Specifically, Mark Simo, our Chief Executive Officer and a Co-Chairman of our Board of Directors, is a member of No Fear’s Board of Directors, was the Chief Executive Officer of No Fear through October 2006, and owns approximately 37% of No Fear’s outstanding common stock. As a result of his position in No Fear, Mr. Simo may face conflicts of interest in connection with transactions between us and No Fear. In addition, as a purchaser of our products, No Fear accounted for approximately $795,000, $1,025,000 and $927,000 of our net sales for the years ended December 31, 2006, 2005 and 2004, respectively and for approximately $183,000 and $248,000 of our net sales during the three months ended March 31, 2007 and 2006, respectively. No Fear and its affiliates may have interests that conflict with, or are different from, the interests of our other stockholders. These conflicts of interest could include potential competitive business activities, corporate opportunities, indemnity arrangements, registration rights, sales or distributions by No Fear of our common stock and the exercise by No Fear of its ability to influence our management and affairs. Further, this concentration of ownership may discourage, delay or prevent a change of control of our company, which could deprive our other stockholders of an opportunity to receive a premium for their stock as part of a sale of our company, could harm the market price of our common stock and could impede the growth of our company. Our certificate of incorporation does not contain any provisions designed to facilitate resolution of actual or potential conflicts of interest or to ensure that potential business opportunities that may become available to both No Fear and us will be reserved for or made available to us. If these conflicts of interest are not resolved in a manner favorable to our stockholders, our stockholders’ interests may be substantially harmed.

If we fail to secure or protect our intellectual property rights, competitors may be able to use our technologies, which could weaken our competitive position, reduce our net sales or increase our costs.

We rely on patent, trademark, copyright, trade secret and trade dress laws to protect our proprietary rights with respect to product designs, product research and trademarks. Our efforts to protect our intellectual property may not be effective and may be challenged by third parties. Despite our efforts, third parties may have violated and may in the future violate our intellectual property rights. In addition, other parties may independently develop similar or competing technologies. If we fail to protect our proprietary rights adequately, our competitors could imitate our products using processes or technologies developed by us and thereby potentially harm our competitive position and our financial condition. We are also susceptible to injury from parallel trade (i.e., gray markets) and counterfeiting of our products, which could harm our reputation for producing high-quality products from premium materials. Infringement claims and lawsuits likely would be expensive to resolve and would require substantial management time and resources. Any adverse determination in litigation could subject us to the loss of our rights to a particular patent, trademark, copyright or trade secret, could require us to obtain licenses from third parties, could prevent us from manufacturing, selling or using certain aspects of our products or could subject us to substantial liability, any of which would harm our results of operations.

Since we sell our products internationally and are dependent on foreign manufacturing in Italy and China, we also are dependent on the laws of foreign countries to protect our intellectual property. These laws may not protect intellectual property rights to the same extent or in the same manner as the laws of the U.S. Although we will continue to devote substantial resources to the establishment and protection of our intellectual property on a worldwide basis, we cannot be certain that these efforts will be successful or that the costs associated with protecting our rights abroad will not be extensive. As of the date of this report, we have been unable to register Spy as a trademark for our products in a few selected markets in which we do business. In addition, although we have filed applications for federal registration, we have no trademark registrations for Spy for our accessory products currently being sold. We may face significant expenses and liability in connection with the protection of our intellectual property rights both inside and outside of the United States and, if we are unable to successfully protect our intellectual property rights or resolve any conflicts, our results of operations may be harmed.

We may be subject to claims by third parties for alleged infringement of their proprietary rights, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.

From time to time, we may receive notices of claims of infringement, misappropriation or misuse of other parties’ proprietary rights. Some of these claims may lead to litigation. Any intellectual property lawsuit, whether or not determined in our favor or settled, could be costly, could harm our reputation and could divert our management from normal business operations. Adverse determinations in litigation could subject us to significant liability and could result in the loss of our proprietary rights. A successful lawsuit against us could also force us to cease sales or to develop redesigned products or brands. In addition, we could be required to seek a license from the holder of the intellectual property to use the infringed technology, and it is possible that we may not be able to obtain a license on reasonable terms, or at all. If we are unable to redesign our products or obtain a license, we may have to discontinue a particular product offering. If we fail to develop a non-infringing technology on a timely basis or to license the infringed technology on acceptable terms, our business, financial condition and results of operations could be harmed.

If we fail to manage any growth that we might experience, our business could be harmed and we may have to incur significant expenditures to address this growth.

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If we continue to experience growth in our operations, our operational and financial systems, procedures and controls may need to be expanded and we may need to train and manage an increasing number of employees, any of which will distract our management team from our business plan and involve increased expenses. Our future success will depend substantially on the ability of our management team to manage any growth effectively. These challenges may include:

• maintaining our cost structure at an appropriate level based on the net sales we generate;

• implementing and improving our operational and financial systems, procedures and controls;

• managing operations in multiple locations and multiple time zones; and

• ensuring the distribution of our products in a timely manner.

We incur significant expenses as a result of being a public company.

We incur significant legal, accounting, insurance and other expenses as a result of being a public company. The Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and NASDAQ, has required changes in corporate governance practices of public companies. These new rules and regulations have, and will continue, to increase our legal and financial compliance costs and make some activities more time-consuming and costly. These new rules and regulations have also made, and will continue to make, it more difficult and more expensive for us to obtain director and officer liability insurance.

Our eyewear products may subject us to product liability claims, which are expensive to defend and may require us to pay damages.

Due to the nature of our products and the activities in which our products may be used, we may be subject to product liability claims, including claims for serious personal injury. Successful assertion against us of one or a series of large claims could harm our business.

We could incur substantial costs to comply with foreign environmental laws, and violations of such laws may increase our costs or require us to change certain business practices.

Because we manufacture a wide variety of eyewear products at our Italian manufacturing facility, we use and generate numerous chemicals and other hazardous by-products in our manufacturing operations. As a result, we are subject to a broad range of foreign environmental laws and regulations. These environmental laws govern, among other things, air emissions, wastewater discharges and the acquisition, handling, use, storage and release of wastes and hazardous substances. Such laws and regulations can be complex and change often. Contaminants have been detected at some of our present facilities, principally in connection with historical practices conducted at LEM. We have undertaken to remediate these contaminants. Although we currently do not expect that these remediation efforts will involve substantial expenditure of resources by us, the costs associated with this remediation could be substantial, which would reduce our cash available for operations, consume valuable management time, reduce our profits or impair our financial condition.

Risks Related to the Market for Our Common Stock

Our stock price may be volatile, and you may not be able to resell our shares at a profit or at all.

The trading price of our common stock fluctuates due to the factors discussed in this section and elsewhere in this report. The trading market for our common stock also is influenced by the research and reports that industry or securities analysts publish about us or our industry. If one or more of the analysts who cover us were to publish an unfavorable research report or to downgrade our stock, our stock price likely would decline. If one or more of these analysts were to cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.

Fluctuations in our operating results on a quarterly and annual basis could cause the market price of our common stock to decline.

Our operating results fluctuate from quarter to quarter as a result of changes in demand for our products, our effectiveness in managing our suppliers and costs, the timing of the introduction of new products and weather patterns. Historically, we have experienced greater net sales in the second and third quarters of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products, and our first and fourth fiscal quarters have traditionally been our weakest operating quarters due to seasonality. We generally sell more of our sunglass products in the first half of the fiscal year and a majority of our goggle products in the last half of the fiscal year. We anticipate that this seasonal impact on our net sales is likely to continue. As a result, our net sales and operating results have fluctuated significantly from period to period in the past and are likely to do so in the future. These fluctuations could cause the market price of our common stock to decline. You should not rely on period-to-period comparisons of our operating results as an indication of our future performance. In future periods, our net sales and results of operations may be below the expectations of analysts and investors, which could cause the market price of our common stock to decline.

Our expense levels in the future will be based, in large part, on our expectations regarding net sales and based on acquisitions we may complete. For example, in January 2006 we completed the acquisition of our primary manufacturer LEM. Many of our expenses are fixed in the short term or are incurred in advance of anticipated sales. We may not be able to decrease our expenses in a timely manner to offset any shortfall of sales.

Future sales of our common stock in the public market could cause our stock price to fall.

Sales of our common stock in the public market, or the perception that such sales might occur, could cause the market price of our common stock to decline. As of March 31, 2007, we have 8,100,564 shares of common stock outstanding and an additional 110,000 shares reserved for the issuance of common stock upon vesting of restricted stock awards. In addition, we have 738,125 shares of our common stock reserved for the exercise of outstanding stock options, of which 653,161 are fully vested and exercisable as of March 31, 2007. Additionally, in connection with our initial public offering, we issued warrants to purchase up to 147,000 shares of common stock to Roth Capital Partners, LLC, and an affiliate, which are fully vested as of March 31, 2007. All 8,100,564 of our outstanding shares of common stock may be sold in the open market, subject to certain limitations.

Delaware law and our corporate charter and bylaws contain anti-takeover provisions that could delay or discourage takeover attempts that stockholders may consider favorable.

Provisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:

• the establishment of a classified Board of Directors requiring that not all directors be elected at one time;

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• the size of our Board of Directors can be expanded by resolution of our Board of Directors;

• any vacancy on our board can be filled by a resolution of our Board of Directors;

• advance notice requirements for nominations for election to the Board of Directors or for proposing matters that can be acted upon at a stockholders’ meeting;

• the ability of the Board of Directors to alter our bylaws without obtaining stockholder approval;

• the ability of the Board of Directors to issue and designate the rights of, without stockholder approval, up to 5,000,000 shares of preferred stock, which rights could be senior to those of common stock; and

• the elimination of the right of stockholders to call a special meeting of stockholders and to take action by written consent.

In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, or Delaware law. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us. The provisions in our charter, bylaws and Delaware law could discourage potential takeover attempts and could reduce the price that investors might be willing to pay for shares of our common stock in the future, resulting in the market price being lower than it would without these provisions.

We are party to securities litigation that distracts our management, is expensive to conduct and seeks a damage award against us.

Securities Class Action

We, our directors and certain of our officers were named as defendants in two stockholder lawsuits filed in the United States District Court for the Southern District of California. A consolidated complaint, filed October 11, 2005, sought unspecified damages on behalf of an alleged class of persons who purchased our common stock pursuant to the registration statement filed in connection with our initial public offering of stock on December 14, 2004. The complaint alleged that the we and our officers and directors violated federal securities laws by failing to disclose in the registration statement material information about plans to make a distribution change in our European operations, our dealings with one of our customers and whether certain of our products infringe on the intellectual property rights of Oakley, Inc. We filed a motion to dismiss the complaint, which the court granted on March 29, 2006. The court allowed the plaintiffs to file an amended complaint with respect to their claim about the European distribution change only. The plaintiffs filed an amended complaint on April 7, 2006. On May 7, 2006, we filed a motion to dismiss that amended complaint. On January 16, 2007, we announced that we had reached an agreement to settle this action, subject to court approval. Under the proposed settlement, $1.4 million will be paid to the class of plaintiffs and for plaintiffs’ attorneys’ fees from proceeds of our directors’ and officers’ insurance. No amounts will be paid by us. The settlement received to court approval on May 1, 2007.

In December 2005, two stockholders filed derivative lawsuits in state court in San Diego, purportedly on our behalf, against eight of our current or former directors and officers and against one of our stockholders, No Fear. A consolidated amended complaint was filed in March 2006 alleging that the defendants breached their fiduciary duties and injured us by allowing us to issue a misleading registration statement and prospectus in connection with our December 2004 public offering and alleging that No Fear sold Orange 21 stock while having knowledge of material, non-public information. The derivative plaintiffs seek compensatory damages, disgorgement of profits, treble damages and other relief. On May 4, 2006 the Court granted the defendants’ demurrer and dismissed the consolidated complaint, with leave to file an amended complaint. An amended complaint was filed on May 25, 2006, and on June 29, 2006 defendants filed their demurrer to that amended complaint. On January 16, 2007, the Company announced that it had reached an agreement to settle this action, subject to court approval. Under the settlement, No Fear and the insurer for the officer and director defendants have agreed to pay plaintiffs’ attorneys’ fees. In addition, the Company has agreed to continue adherence to a set of corporate governance guidelines. No amounts will be paid by the Company. The proposed settlement was approved by court in March 2007.

Litigation presents a distraction to our management, is expensive to conduct and could negatively affect our operating results.

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Item 6. Exhibits

Exhibit Number	Description of Document
3.2	Restated Certificate of Incorporation (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)
3.4	Amended and Restated Bylaws (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)
10.42	Loan and Security Agreement entered February 26, 2007 by and between Spy Optic, Inc. and BFI Business Finance (incorporated by reference to Form 8-K filed March 2, 2007)
10.43	General Continuing Guaranty entered February 26, 2007 by and between Orange 21 Inc. and BFI Business Finance (incorporated by reference to Form 8-K filed March 2, 2007)
31.1	Rules 13(a) -14(a) Certification of the Company’s Chief Executive Officer
31.2	Rules 13(a) -14(a) Certification of the Company’s Chief Financial Officer
32.1	Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)
32.2	Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	Orange 21 Inc.
Date: May 21, 2007
	By	/s/ Jerry Collazo
		Jerry Collazo
		Chief Financial Officer

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