Spy 10Q 2008 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, 2008

¨	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 92011

(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. x

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

Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company 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 8, 2008, there were 8,166,813 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	4
	Item 1.Financial Statements	4
	Consolidated Balance Sheets as of March 31, 2008 (Unaudited) and December 31, 2007	4
	Consolidated Statements of Operations (Unaudited) for the three months ended March 31, 2008 and 2007	5
	Consolidated Statements of Cash Flows (Unaudited) for the three months ended March 31, 2008 and 2007	6
	Notes to Unaudited Consolidated Financial Statements	7
	Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
	Item 4.Controls and Procedures	18
PART II	OTHER INFORMATION	19
	Item 1.Legal Proceedings	19
	Item 1A.Risk Factors	19
	Item 1B.Unresolved Staff Comments	25
	Item 6.Exhibits	27
Signatures		26

EXPLANATORY NOTE ABOUT RESTATEMENT

We have restated herein our consolidated financial statements for the quarter ended March 31, 2007 to correct errors in such consolidated financial statements and financial information. For more information regarding the restatement, please see Note 2 to the financial statements included in Item 8 of Part II to our Annual Report for the fiscal year ended December 31, 2007 on Form 10-K filed with the Securities Exchange Commission on April 8, 2008.

PART I. FINANCIAL INFORMATION

ITEM 1.

Financial Statements

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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


	March 31, 2008			December 31, 2007
	(Unaudited)
Assets
Current assets
Cash and cash equivalents	$	618		$	555
Accounts receivable, net		8,288			10,510
Inventories, net		11,717			11,297
Prepaid expenses and other current assets		1,362			1,460
Income taxes receivable		132			123
Deferred income taxes		1,962			1,722

Total current assets		24,079			25,667
Property and equipment, net		6,160			5,775
Goodwill		10,443			9,735
Intangible assets, net of accumulated amortization of $536 and $504 at March 31, 2008 and December 31, 2007, respectively		496			493
Deferred income taxes		822			719
Other long-term assets		74			202

Total assets	$	42,074		$	42,591

Liabilities and Shareholders’ Equity
Current liabilities
Lines of credit	$	4,789		$	5,805
Current portion of capital leases		338			378
Current portion of notes payable		524			498
Accounts payable		7,239			6,715
Accrued expenses and other liabilities		4,540			4,964
Income taxes payable		274			207

Total current liabilities		17,704			18,567
Capitalized leases, less current portion		838			837
Notes payable, less current portion		773			704
Deferred income taxes		427			384

Total liabilities		19,742			20,492
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; 8,165,564 and 8,161,814shares issued and outstanding at March 31, 2008 and December 31, 2007, respectively		1			1
Additional paid-in-capital		36,980			36,845
Accumulated other comprehensive income		3,475			2,526
Accumulated deficit		(18,124	)		(17,273	)

Total stockholders’ equity		22,332			22,099

Total liabilities and stockholders’ equity	$	42,074		$	42,591

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

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Thousands, except per share amounts)


	Three Months Ended March 31,
	2008			2007 (As restated)
	(Unaudited)
Net sales	$	11,554		$	9,389
Cost of sales		6,110			4,466

Gross profit		5,444			4,923
Operating expenses:
Sales and marketing		2,952			3,911
General and administrative		2,462			2,523
Shipping and warehousing		507			392
Research and development		290			193

Total operating expenses		6,211			7,019

Loss from operations		(767	)		(2,096	)
Other expense:
Interest expense		(178	)		(67	)
Foreign currency transaction loss		(205	)		(51	)
Other income (expense)		30			(48	)

Total other expense		(353	)		(166	)

Loss before benefit for income taxes		(1,120	)		(2,262	)
Income tax benefit		(269	)		(589	)

Net loss	$	(851	)	$	(1,673	)

Net loss per share of Common Stock
Basic	$	(0.10	)	$	(0.21	)

Diluted	$	(0.10	)	$	(0.21	)

Shares used in computing net loss per share of Common Stock
Basic		8,164			8,101

Diluted		8,164			8,101

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

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Thousands)


	Three Months Ended March 31,
	2008			2007 (As restated)
	(Unaudited)
Operating Activities
Net loss	$	(851	)	$	(1,673	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		472			1,044
Deferred income taxes		(329	)		(692	)
Share-based compensation		135			62
Provision for (recovery of) bad debts		(25	)		59
(Gain) loss on sale/transfer of property and equipment		(3	)		19
Change in operating assets and liabilities:
Accounts receivable		2,443			1,942
Inventories, net		(109	)		(1,420	)
Prepaid expenses and other current assets		217			1,473
Other assets		134			(3	)
Accounts payable		157			1,118
Accrued expenses and other liabilities		(681	)		(1,835	)
Income tax payable/receivable		50			64

Net cash provided by operating activities		1,610			158
Investing Activities
Purchases of property and equipment		(424	)		(844	)
Proceeds from maturities of short-term investments		—			500
Investment in restricted cash		—			(343	)
Proceeds from sale of property and equipment		3			41
Acquisition of business, net of cash acquired		—			(345	)
Purchase of intangibles		(15	)		(40	)

Net cash used in investing activities		(436	)		(1,031	)
Financing Activities
Line of credit borrowings, net		(1,127	)		253
Principal payments on notes payable		(104	)		(39	)
Proceeds from issuance of notes payable		—			772
Principal payments on capital leases		(106	)		(100	)

Net cash (used in) provided by financing activities		(1,337	)		886
Effect of exchange rate changes on cash and cash equivalents		226			(62	)

Net increase (decrease) in cash and cash equivalents		63			(49	)
Cash and cash equivalents at beginning of period		555			1,279

Cash and cash equivalents at end of period	$	618		$	1,230

Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	200		$	52
Summary of noncash financing and investing activities:
Acquisition of property and equipment through capital leases	$	128		$	—

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

ORANGE 21 INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1.	Organization and Significant Accounting Policies

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 8-03 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, 2008 are not necessarily indicative of the results of operations for the year ending December 31, 2008. 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, 2007.

2.	Recently Issued Accounting Pronouncements

Recently Issued Accounting Pronouncements

In September 2006, the FASB issued Statement of Financial Accounting Standards (“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 the Company beginning January 1, 2008. Subsequent to the issuance of SFAS No. 157, the FASB issued FASB Staff Position 157-2 (“FSP 157-2”). FSP 157-2 delays the effective date of the application of SFAS No. 157 to fiscal years beginning after November 15, 2008 for all nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. The Company adopted all the provisions of SFAS No. 157 on January 1, 2008 with the exception of the application of the Statement to non-recurring nonfinancial assets and nonfinancial liabilities; however the adoption did not have an impact to the Company’s unaudited financial statements for the three months ended March 31, 2008.

In February 2007, the FASB released SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” and 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. This Statement became effective for the Company on January 1, 2008 and had no impact on the Company’s unaudited financial statements for the three months ended March 31, 2008.

In December 2007, the FASB issued SFAS No. 141 (Revised), “Business Combinations” (“SFAS No. 141 (R)”), replacing SFAS No. 141, “Business Combinations” (“SFAS No. 141”). SFAS No. 141 (R) retains the fundamental requirements of SFAS No. 141, broadens its scope by applying the acquisition method to all transactions and other events in which one entity obtains control over one or more other businesses, and requires, among other things, that assets acquired and liabilities assumed be measured at fair value as of the acquisition date, that liabilities related to contingent consideration be recognized at the acquisition date and remeasured at fair value in each subsequent reporting period, that acquisition-related costs be expensed as incurred, and that income be recognized if the fair value of the net assets acquired exceeds the fair value of the consideration transferred. SFAS No. 141 (R) is to be applied prospectively in financial statements issued for fiscal years beginning after December 15, 2008. We do not expect that the adoption of SFAS No. 141 (R) will have a material effect on our consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS No. 161”). SFAS No. 161 is intended to improve financial reporting of derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company is evaluating the impact of this new standard but currently does not anticipate a material impact on its financial statements as a result of the implementation of SFAS No. 161.

3.	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 has used foreign exchange contracts in the form of forward contracts.

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, 2008 and December 31, 2007, the notional amounts of the Company’s foreign exchange contracts designated as cash flow hedges were $0 for each period. As of March 31, 2008 and December 31, 2007, a net gain of approximately $0 and $11,000, respectively, related to derivative instruments designated as cash flow hedges was recorded in accumulated other comprehensive loss.

During the three months ended March 31, 2007, 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.

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.

4.	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. The following table lists the potentially dilutive equity instruments, each convertible into one share of common stock, used in the calculation of diluted earnings per share for the periods presented:


	Three Months Ended March 31,
	2008	2007
	(Thousands)
Weighted average common shares outstanding - basic	8,164	8,101
Assumed conversion of dilutive stock options, restricted stock and warrants	—	—

Weighted average common shares outstanding - dilutive	8,164	8,101

The following potentially dilutive instruments were not included in the diluted per share calculation for periods presented as their inclusion would have been antidilutive:


	Three Months Ended March 31,
	2008	2007
	(Thousands)
Stock options	938	738
Restricted stock	34	110
Warrants	147	147

Total	1,119	995

5.	Comprehensive Income (Loss)

Comprehensive income (loss) represents the results of operations adjusted to reflect all items recognized under accounting standards as components of accumulated other comprehensive income (loss). Total comprehensive income (loss) for the three months ended March 31, 2008 and 2007 was $0.1 million and ($1.7 million), respectively.

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


	March 31, 2008		December 31, 2007
	(Thousands)
Unrealized gain on cash flow hedges, net of tax	$	—	$	11
Equity adjustment from foreign currency translation		2,473		1,882
Unrealized gain on foreign currency exposure of net investment in foreign operations		1,002		633

Accumulated other comprehensive income	$	3,475	$	2,526

6.	Accounts Receivable

Accounts receivable consisted of the following:


	March 31, 2008			December 31, 2007
	(Thousands)
Trade receivables	$	11,093		$	13,240
Less allowance for doubtful accounts		(608	)		(775	)
Less allowance for returns		(2,197	)		(1,955	)

Accounts receivable, net	$	8,288		$	10,510

7.	Inventories

Inventories consisted of the following:


	March 31, 2008		December 31, 2007
	(Thousands)
Raw materials	$	1,797	$	1,756
Work in process		771		350
Finished goods		9,149		9,191

Inventories, net	$	11,717	$	11,297

The Company’s balances are net of an allowance for obsolescence of approximately $1,939,000 and $2,264,000 at March 31, 2008 and December 31, 2007, respectively.

8.	Financing Arrangements

Credit Facilities

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, which was subsequently modified on December 7, 2007 and February 12, 2008 to extend the maximum borrowing capacity to $8.0 million and affect certain other changes. 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 equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5% 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 was in compliance with the covenants at March 31, 2008.

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. The letter of credit with Comerica expired in May 2007. The collateral of 1.2 million Euros was transferred to an interest bearing account with San Paolo IMI in Italy to serve as collateral for the LEM San Paolo IMI line of credit. During September 2007 San Paolo released the collateral requirement in conjunction with the reduction of the San Paolo IMI line of credit.

At March 31, 2008, there were outstanding borrowings of $3.1 million under the Loan Agreement, bearing an interest rate of 7.85% and availability under this line of $4.9 million subject to eligible accounts receivable and inventory levels.

The Company has a 1.4 million Euros line of credit in Italy with San Paolo IMI for LEM. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At March 31, 2008, there was approximately 0.3 million Euros available under this line of credit. At March 31, 2008 and December 31, 2007, outstanding amounts under this line of credit amounted to $1.7 million and $1.3 million, respectively. The interest rate at March 31, 2008 was 5.85%.

9.	Notes Payable

Notes payable at March 31, 2008 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	$	713
Unsecured long-term debt, EURIBOR 1-month interest rate plus 1.5% spread, payable in half year installments due from December 2005 to December 2010		172
Unsecured long-term debt, fixed interest rate at 0.5%, payable in half year installments due from December 2005 to December 2010		71
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.		341

		1,297
Less current portion		(524	)

Notes payable, less current portion	$	773

10.

Share-Based Compensation

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. In April 2007, in connection with a determination by the Board of Directors to reduce the annual cash compensation paid to the non-employee directors of the Company, the Board of Directors approved an amendment and restatement of the Plan that: (1) increases the number of shares of the Company’s Common Stock underlying the non-qualified stock options that are automatically granted to the Company’s non-employee directors upon their appointment to the Board of Directors and on an annual basis thereafter and (2) modifies the vesting schedule for the automatic option grants made to non-employee directors upon their initial appointment to the Board of Directors. The amendment and restatement of the Plan was approved by the Company’s stockholders at the annual meeting held on June 12, 2007.

Prior to the adoption of the 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		Weighted- Average Remaining Contractual Term (years)	Aggregate Intrinsic Value
					(Thousands)
Options outstanding at December 31, 2007	937,875	$	6.54

Options outstanding at March 31, 2008	937,875	$	6.54	6.91	$	126

Options exercisable at March 31, 2008	645,276	$	6.93	5.94	$	126

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, 2008 and 2007, the Company received $0 in cash proceeds from the exercise of stock options.

Restricted Stock Award Activity

The Company periodically issues restricted stock awards to certain key employees subject to certain vesting requirements based on future service.


	Shares		Weighted- Average Grant Date Fair Value
Non-vested at December 31, 2007	37,500		$	5.01
Released	(3,750	)		5.01

Non-vested at March 31, 2008	33,750		$	5.01

The Company recognized the following share-based compensation expense during the three months ended March 31, 2008 and 2007 in accordance with SFAS No. 123(R):


	Three Months Ended March 31,
	2008			2007
Stock options
General and administrative expense	$	121		$	32
Restricted stock
General and administrative expense		9			20
Selling and marketing		2			7
Research and development		3			2

Total		135			61
Income tax benefit		(46	)		(21	)

Stock-based compensation expense, net of taxes		89			40

Effect of stock-based compensation on net loss per share:
Basic		(0.01	)		(0.00	)
Diluted		(0.01	)		(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	$	480	1.65
Restricted stock awards		248	2.20

Total	$	728

11.

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, 2008 and 2007 were approximately $198,000 and $183,000, respectively. Accounts receivable due from these stores amounted to $241,000 and $529,000 at March 31, 2008 and December 31, 2007, 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, 2008 and 2007 were approximately $180,000 and $491,000, respectively. Accounts receivable due from these entities amounted to approximately $497,000 and $880,000 at March 31, 2008 and December 31, 2007, respectively.

12.

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 $202,000 and $161,000 for the three months ended March 31, 2008 and 2007, 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.

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

On October 30, 2007, John Flynn Caro, a former sales representative of the Company and his wife filed an action against Spy Optic, Inc. in Puerto Rico seeking damages of not less than $200,000 relating to the termination of a sales representative agreement. The action was removed to federal district court on January 3, 2008, and Spy Optic, Inc. filed an answer and counterclaim on January 10, 2008. The Company presently has no estimate of any potential loss, if any, or range of loss with respect to the lawsuit or any estimate as to the potential costs of defending the lawsuit.

Additionally, from time to time the Company is involved in various lawsuits and legal proceedings which arise in the ordinary course of business. An adverse result in the matter described above or any other legal matters that may arise from time to time may harm the Company’s business.

13.

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. The Company owns its primary manufacturer LEM located in Italy. LEM manufactures 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. The Company operates in two business segments: distribution and manufacturing.

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


	Three Months Ended March 31,
	2008			2007 (As Restated)
	(Thousands)
Net sales:
Distribution	$	10,656		$	8,379
Manufacturing		898			1,010
Intersegment		3,417			3,625
Eliminations		(3,417	)		(3,625	)

Total	$	11,554		$	9,389

Operating income (loss):
Distribution	$	(855	)	$	(2,025	)
Manufacturing		88			(71	)

Total	$	(767	)	$	(2,096	)

Net loss:
Distribution	$	(801	)	$	(1,502	)
Manufacturing		(50	)		(171	)

Total	$	(851	)	$	(1,673	)


	March 31, 2008		December 31, 2007
	(Thousands)
Tangible long-lived assets:
Distribution	$	2,247	$	2,225
Manufacturing		3,913		3,550

Total	$	6,160	$	5,775

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,
	U.S. and Canada		Europe and Asia Pacific		Consolidated		Intersegment
			(Thousands)				(Thousands)
	2008						2008
Net sales	$	8,665	$	2,889	$	11,554	$	3,417

	2007						2007
Net sales	$	7,225	$	2,164	$	9,389	$	3,625


	March 31, 2008		December 31, 2007
	(Thousands)
Tangible long-lived assets:
U.S. and Canada	$	1,657	$	1,648
Europe and Asia Pacific		4,503		4,127

Total	$	6,160	$	5,775

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 to our history of losses; risks related to 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 and inventory levels; 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 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, 2007, 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 brands, Spy™ and SpyOptic™. These products target the action sport and power sports markets, including surfing, skateboarding, snowboarding, ski, 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 3,300 retail locations in the United States and Canada and internationally through approximately 2,000 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 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 17 to 35. 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 sunglass and goggle 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), 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.

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

Results of Operations

Three Months Ended March 31, 2008 and 2007

Net Sales

Consolidated net sales increased 23% to $11.6 million for the three months ended March 31, 2008 from $9.4 million for the three months ended March 31, 2007. The increase is partly due to increased sales and marketing efforts, an improvement in product mix and availability and increased prices.

Domestic net sales represented 75% and 77% of total net sales for the three months ended March 31, 2008 and 2007, respectively. Foreign net sales represented 25% and 23% of total net sales for the three months ended March 31, 2008 and 2007, respectively.

Cost of Sales and Gross Profit

Consolidated gross profit increased 10% to $5.4 million for the three months ended March 31, 2008 from $4.9 million for the three months ended March 31, 2007. Gross profit as a percentage of sales decreased to 47% for the three months ended March 31, 2008 from 52% for the three months ended March 31, 2007 largely due to increased materials costs due to increased gas and oil prices and an increase in Euro foreign exchange rates, partly offset by decrease in outsourcing costs at LEM, our subsidiary and primary manufacturer.

The increase in gross profit is also due to net decreases in inventory reserves for slow moving and obsolete inventory that is no longer being marketed for resale of approximately of $0.3 million. During the three months ended March 31, 2008, inventory with an adjusted basis of $0.1 million was sold for approximately $0.2 million in revenue, affecting margins by $0.1 million or 0.7% of net sales. The remaining decrease in the inventory reserve was mainly due to the disposal of product which has no effect on the results of operations.

Sales and Marketing Expense

Sales and marketing expense decreased 25% to $3.0 million for the three months ended March 31, 2008 from $3.9 million for the three months ended March 31, 2007. The decrease was primarily due to a $0.6 million decrease in depreciation expense for point-of-purchase displays in the U.S. partly offset by a $0.2 million increase in expense related to purchases of new point-of-purchase displays. During June 2007, the point-of-purchase displays in the U.S. were written off as a result of transferring ownership of the point-of-purchase displays to our customers. In addition, in the U.S., further purchases of point-of-purchase displays will no longer be capitalized since the displays will be owned by the customers. The cost of these displays will be charged to sales and marketing expense. We do not expect this change to materially affect our results of operations in future periods. There was also a decrease in the U.S. for employee-related expenses of $0.3 million.

General and Administrative Expense

General and administrative expense remained consistent at $2.5 million for the three months ended March 31, 2008 and 2007.

Shipping and Warehousing Expense

Shipping and warehousing expense increased 29% to $0.5 million for the three months ended March 31, 2008 from $0.4 million for the three months ended March 31, 2007. The increase is primarily due to increased employee-related expense at LEM.

Research and Development Expense

Research and development expense increased 50% to $0.3 million for the three months ended March 31, 2008 from $0.2 million for the three months ended March 31, 2007. The increase is mainly due to an increase in employee-related expense.

Other Net Expense

Other net expense was $0.4 million for the three months ended March 31, 2008 compared to other net expense of $0.2 million for the three months ended March 31, 2007. The increase in other net expense is primarily due to increases in net interest expense and foreign currency transaction losses.

Income Tax (Benefit) Provision

The income tax benefit for the three months ended March 31, 2008 and 2007 was $0.3 million and $0.6 million, respectively. The effective tax rate for the three months ended March 31, 2008 and 2007 was (24%) and (26%), respectively.

Net Loss

A net loss of $0.9 million was incurred for the three months ended March 31, 2008 compared to a net loss of $1.7 million for the three months ended March 31, 2007.

Liquidity and Capital Resources

Cash flow activities

Cash provided by or used in operating activities consists primarily of net income (loss) adjusted 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, 2008 was approximately $1.6 million, which consisted of a net loss of approximately $0.9 million, adjustments for non-cash items of approximately $0.3 million and $2.2 million provided by working capital and other activities. Working capital and other activities includes a $2.4 million decrease in accounts receivable due to timing of cash receipts offset partly by a $0.5 million decrease in accounts payable and accrued liabilities due to timing of invoices received and payments.

Cash provided by operating activities for the three months ended March 31, 2007 was $0.2 million, which consisted of a net loss of $1.7 million, adjustments for non-cash items of approximately $0.5 million, and $1.3 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 $1.4 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 decrease in accounts payable and accrued liabilities due to timing of payments of vendor invoices.

Cash used in investing activities during the three months ended March 31, 2008 was $0.4 million and was primarily attributable to the purchase of fixed assets.

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 financing activities for the three months ended March 31, 2008 was $1.3 million and was attributable to $1.1 million in net repayments of our lines of credit and $0.2 million for notes payable and capital lease principal payments.

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.

Credit Facilities

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 equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5%, 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 Loan 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 were in compliance with the covenants at March 31, 2008.

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. The letter of credit with Comerica expired in May 2007. The collateral of 1.2 million Euros was transferred to an interest bearing account with San Paolo IMI in Italy to serve as collateral for the LEM San Paolo IMI line of credit. During September 2007 San Paolo released the collateral requirement in conjunction with the reduction of the San Paolo IMI line of credit.

We have a 1.4 million Euros line of credit in Italy with San Paolo IMI for LEM. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At March 31, 2008, there was approximately 0.3 million Euros available under this line of credit. At March 31, 2008 and December 31, 2007, amounts outstanding under this line of credit amounted to $1.7 million and $1.3 million, respectively. The interest rate at March 31, 2008 was 5.85%.

If we are able to achieve anticipated net sales, manage our inventory and manage operating expenses, we believe that our cash on hand, cash equivalents and available loan facilities will be sufficient to enable us to meet our operating requirements for at least the next 12 months. Otherwise, changes in operating plans, lower than anticipated net sales, increased expenses or other events, including those described in Item 1A, “Risk Factors,” may require us to seek additional debt or equity financing in the future. In addition, we are in the process of streamlining our Italian manufacturing operations, which we expect will provide future savings to us. This process will involve our consolidation into a single building and our acquisition of a substantial amount of new equipment. We have already placed orders for the equipment and expect the remaining outstanding balance that we will need to pay for this equipment will be approximately 1.35 million Euros. We also expect to incur expenses associated with consolidating our multiple facilities into a single facility. Although we are uncertain as to the exact amount of expense associated with such consolidation, we expect that such consolidation may require a substantial upfront cost. We intend to finance the equipment through an equipment financing facility and to finance our costs of consolidating into a single building as well; however, we cannot be certain that financing will be available to us on commercially reasonable terms or at all. If we are unable to secure acceptable debt financing, we may be required to curtail our plans to streamline our Italian operations, which could reduce the savings we expect to achieve from such consolidation.

Our future capital requirements will depend on many factors, including our rate of net sales growth, continuing financing requirements related to our acquisition of LEM, our expected capital expenditures, 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. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future needs which could also restrict our operations.

Off-balance sheet arrangements

We did not enter into any off-balance sheet arrangements during the three months ended March 31, 2008 and 2007, nor did we have any off-balance sheet arrangements outstanding at March 31, 2008 and December 31, 2007.

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 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 in the U.S. at March 31, 2008. Accordingly, we have recorded a valuation allowance for our U.S. operations at March 31, 2008 and December 31, 2007 of $3,164,000. At March 31, 2008 and December 31, 2007, we have recorded a full valuation allowance for our wholly owned subsidiaries, Spy Optic, S.r.l and LEM.

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

The Company’s revenue is primarily generated through sales of sunglasses, goggles and apparel, net of returns and discounts. Revenue is recognized in accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104 (“SAB 104”), Revenue Recognition. Under SAB 104, revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. These criteria are usually met upon delivery to our carrier, which is also when the risk of ownership and title passes to our customers.

Generally, we extend credit to our customers after performing credit evaluations 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. Our distributors are typically set up as prepay accounts; however credit may be extended to certain distributors, usually upon receipt of a letter of credit. Generally, our sales agreements with our customers, including distributors, do not provide for any rights of return or price protection. However, we do approve returns on a case-by-case basis in our sole discretion. We record an allowance for estimated returns when revenues are recorded. The allowance is calculated using historical evidence of actual returns. Historically, actual returns have been within our expectations. If future 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.

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.

Inventories

Inventories consist primarily of raw materials and finished products, including sunglasses, goggles, apparel and accessories, product components such as replacement lenses and purchasing and quality control costs. 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. Products are reserved at certain percentages based on their probability of selling, which is estimated based on current and estimated future customer demands and market conditions. Historically, there has been variability in the amount of write offs, compared to estimated reserves. These estimates could vary significantly, either favorably or unfavorably, from actual experience if future economic conditions, levels of consumer demand, customer inventory or competitive conditions differ from expectations.

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 profit 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 as of October 1, 2007, 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 subjective 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.

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 our net income. Evaluating the value of these assets is necessarily based on our management’s judgment. If we subsequently determine 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.

We have established a valuation allowance against our deferred tax assets in each jurisdiction where we cannot conclude that it is more likely than not that those assets will be realized. In the event that actual results differ from our forecasts or we adjust the forecast or assumptions in the future, the change in the valuation allowance could have a significant impact on future income tax expense.

We are subject to income taxes in the United States and foreign jurisdictions. In the ordinary course of our business, there are calculations and transactions, including transfer pricing, where the ultimate tax determination is uncertain. In addition, changes in tax laws and regulations as well as adverse judicial rulings could materially affect the income tax provision.

Foreign Currency and Derivative Instruments

The functional currency of each of our foreign 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 SFAS 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).

Recently Issued Accounting Pronouncements

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. Subsequent to the issuance of SFAS No. 157, the FASB issued FASB Staff Position 157-2 (“FSP 157-2”). FSP 157-2 delays the effective date of the application of SFAS No. 157 to fiscal years beginning after November 15, 2008 for all nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. We adopted all the provisions of SFAS No. 157 on January 1, 2008 with the exception of the application of the Statement to non-recurring nonfinancial assets and nonfinancial liabilities; however the adoption did not have an impact to our unaudited financial statements for the three months ended March 31, 2008.

In February 2007, the FASB released SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), 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. This Statement became effective for us on January 1, 2008 and had no impact on our unaudited financial statements for the three months ended March 31, 2008.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS No. 161”). SFAS No. 161 is intended to improve financial reporting of derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We are evaluating the impact of this new standard but currently do not anticipate a material impact on our financial statements as a result of the implementation of SFAS No. 161.

Item 4.

Controls and Procedures

Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) under the Exchange Act, we conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing evaluation, our principal executive officer and our principal financial officer concluded that as of the end of the period covered by this report our disclosure controls and procedures were effective at the reasonable assurance level.

Description of Material Weaknesses as of December 31, 2007

Management identified the following material weaknesses in internal control over financial reporting as of December 31, 2007:

•

An appropriate review of the open purchase orders and goods/services received but not invoiced was not being performed timely or thoroughly at our Italian-based subsidiary, Spy S.r.l.

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A proper search for unrecorded liabilities was not being conducted at our Italian-based subsidiary, Spy S.r.l.

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A calculation to determine appropriate inventory costs had not been performed on an accurate or timely basis in both the U.S. and at our Italian-based subsidiary, Spy S.r.l.

The above weaknesses resulted in the restatement of the Company’s previously issued financial statements as presented in this Annual Report on Form 10-K and adjustments to our fiscal 2007 quarterly unaudited financial statements.

Changes in Internal Control Over Financial Reporting

In order to successfully remediate our material weaknesses identified above for the fiscal year ended December 31, 2007, we have improved our controls and procedures in our Italian-based subsidiary, Spy S.r.l. during the quarter ended March 31, 2008 as follows:

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An analysis and review of certain accrued liabilities, including a review of open purchase orders on a monthly basis to identify goods and services received, but not invoiced.

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A monthly review of the reasonableness of related expense accounts in conjunction with a search for unrecorded liabilities to ensure expenses have been recorded properly on a timely basis.

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We have also improved our controls and processes in both the U.S. and Italy regarding capitalization of inventory costs.

PART II – OTHER INFORMATION

Item 1.

Legal Proceedings

On October 30, 2007, John Flynn Caro, a former sales representative of the Company and his wife filed an action against Spy Optic, Inc. in Puerto Rico seeking damages of not less than $200,000 relating to the termination of a sales representative agreement. The action was removed to federal district court on January 3, 2008, and Spy Optic, Inc. filed an answer and counterclaim on January 10, 2008. We presently have no estimate of any potential loss with respect to the lawsuit or any estimate as to the potential costs of defending the lawsuit.

Additionally, from time to time we are involved in litigation arising from our activities. Presently, we are not involved in any litigation the outcome of which, if determined in a manner adverse to us, likely would have a material adverse effect on us, our operations or our results of operations.

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.

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, recent weakening of the U.S. Dollar has increased our cost of sales substantially and if the U.S. Dollar continues to weaken against the Euro, our cost of sales could further increase. 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, 2007 and May 8, 2008, the Euro exchange rate has ranged from U.S. $1.29 to U.S. $1.60. Between January 1, 2007 and May 8, 2008, the Canadian Dollar exchange rate has ranged from U.S. $0.84 to U.S. $1.10. For the three months ended March 31, 2008 and 2007, we had net foreign currency losses of $205,000 and $51,000, respectively, which represented 2% and 1% of our net sales, respectively.

The effect of foreign exchange rates on our financial results can be significant. Therefore we have engaged in the past, and may in the future engage in certain hedging activities to mitigate over time the impact of the translation of foreign currencies on our financial results. Our hedging activities have in the past reduced, but have not eliminated, 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. The degree to which our financial results are affected have depended in part upon the effectiveness or ineffectiveness of our hedging activities. As of March 31, 2008, we had no foreign currency contracts.

The current substantial downturn in the economy may affect consumer purchases of discretionary items, which would reduce our net sales.

The retail industry historically has been subject to substantial cyclical variations. The merchandise sold by us is generally a discretionary expense for our customers. The substantial downturn or a recession in the general economy that is currently occurring in the United States or uncertainties regarding future economic prospects may significantly reduce consumer spending which could reduce our sales, perhaps substantially.

We have a history of significant losses. If we do not achieve or sustain profitability, our financial condition and stock price could suffer.

We have a history of losses and we may continue to incur losses for the foreseeable future. As of March 31, 2008, our accumulated deficit was $18.1 million and, during the three months ended March 31, 2008 the Company incurred a net loss of $0.9 million. We have not achieved profitability for a full fiscal year since our initial public offering. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, we may not be able to achieve full fiscal year profitability in the near future or at all. Even if we do achieve full fiscal year profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If we are unable to achieve full fiscal year profitability within a short period of time, or at all, or if we are unable to sustain profitability at satisfactory levels, our financial condition and stock price could be adversely affected.

Our future capital needs are uncertain, and we may need to raise additional funds in the future which may not be available on acceptable terms or at all.

Our capital requirements will depend on many factors, including:

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acceptance of, and demand for our products;

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the costs of developing and selling new products;

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the extent to which we invest in new equipment and product development;

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the number and timing of acquisitions and other strategic transactions; and

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the costs associated with the growth of our business, if any.

Although we believe we have sufficient funds to operate our business over the next twelve months, our existing sources of cash and cash flows may not be sufficient to fund our activities. In addition, we are in the process of streamlining our Italian manufacturing operations, which we expect will provide future savings to us. This process will involve our consolidation into a single building and our acquisition of a substantial amount of new equipment. We have already placed orders for the equipment and expect the remaining outstanding balance that we will need to pay for this equipment will be approximately 1.35 million Euros. We also expect to incur expenses associated with consolidating our multiple facilities into a single facility. Although we are uncertain as to the exact amount of expense associated with such consolidation, we expect that such consolidation may require a substantial upfront cost. We intend to finance the equipment through an equipment financing facility and to finance our costs of consolidating into a single building as well; however, we cannot be certain that financing will be available to us on commercially reasonable terms or at all. If we are unable to secure acceptable debt financing, we may be required to curtail our plans to streamline our Italian operations, which could reduce the savings we expect to achieve from such consolidation.

As a result, we may need to raise additional funds, and such funds may not be available on favorable terms, or at all. Furthermore, if we issue equity or convertible debt securities to raise additional funds, our existing stockholders may experience dilution, and the new equity or debt securities may have rights, preferences, and privileges senior to those of our existing stockholders. If we incur additional debt, it may increase our leverage relative to our earnings or to our equity capitalization. If we cannot raise funds on acceptable terms, we may need to scale back our expenditures and we may not be able to develop or enhance our products, execute our business plan, take advantage of future opportunities, or respond to competitive pressures.

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 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 17 to 35 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:

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the success of our advertising and promotional efforts;

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

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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 or 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:

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

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

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

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attract, acquire and retain customers at a reasonable cost;

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

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maintain or improve our gross margins; and

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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, which was extended to $8.0 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 equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5%. 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, 2008 there were outstanding borrowings under the Loan Agreement of $3.1 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 March 31, 2008, 72% and 28% of our net sales were derived from sales of our sunglass and goggle products, respectively. For the three months ended March 31, 2007, 70% of our net sales were derived from sales of our sunglass products and 23% 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.

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. 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. 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. 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.

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 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. 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.

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. Our agreement with Mage Design, LLC expires on December 31, 2008. We cannot be certain that Mr. Mage will not be recruited by our competitors or otherwise terminate his relationship with us at or prior to the time our agreement with him expires. 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 with such designer. 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.

We purchase substantially all of our sunglass products from our wholly owned subsidiary, LEM and over half of our goggle products are manufactured by OGK in China. We expect in 2008 to continue to manufacture more than half of our goggles through OGK. We do not have long-term agreements with any of our other manufacturers other than LEM 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.

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:

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

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

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transportation delays and difficulties of managing international distribution channels;

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

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ability to finance our foreign operations;

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

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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

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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.

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 $198,000 and $183,000 of our net sales for the three months ended March 31, 2008 and 2007, 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 significant. 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.

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:

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

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

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managing operations in multiple locations and multiple time zones; and

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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 and business may subject us to product liability claims or other litigation, which are expensive to defend, distracting to our management 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 or other litigation, including claims for serious personal injury, breach of contract, shareholder litigation, or other litigation. Successful assertion against us of one or a series of large claims could harm our business by causing us to incur legal fees, distracting our management or causing us to pay damage awards.

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.

In the event we are unable to remedy any deficiency we identify in our system of internal controls over financial reporting, or if our internal controls are not effective, our business and our stock price could suffer.

Under Section 404 of the Sarbanes-Oxley Act, or Section 404, management is required to assess the adequacy of our internal controls, remediate any deficiency that may be identified for which there are no compensating controls in place, validate that controls are functioning as documented and implement a continuous reporting and improvement process for internal controls. As part of this continuous process, we may discover deficiencies that require us to improve our procedures, processes and systems in order to ensure that our internal controls are adequate and effective and that we are in compliance with the requirements of Section 404. If any deficiency we may find from time to time is not adequately addressed, or if we are unable to complete all of our testing and any remediation in time for compliance with the requirements of Section 404 and the SEC rules thereunder, we would be unable to conclude that our internal controls over financial reporting are effective, which could adversely affect investor confidence in our internal controls over financial reporting.

We may not successfully integrate any future acquisitions, which could result in operating difficulties and other harmful consequences.

In January 2006, we acquired LEM for 3.5 million Euros or $4.2 million in cash, plus a two year earn-out based on LEM’s future sales. We expect to continue to consider other opportunities to acquire or make investments in other technologies, 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:

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problems assimilating the purchased technologies, products or business operations;

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problems maintaining uniform standards, procedures, controls and policies;

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unanticipated costs associated with the acquisition;

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diversion of management’s attention from our core business;

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harm to our existing business relationships with manufacturers and customers;

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

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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 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.

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. For example, between January 1, 2007 and March 9, 2008, our stock has traded as high as $6.75 and as low as $3.50. In addition, the trading market for our common stock may be influenced by the public float that exists in our stock from time to time. For example, although we have approximately 8.2 million shares outstanding, approximately 5.8 million, which is more than 70%, of those shares are held by less than 10 stockholders. If any of those investors were to decide to sell a substantial portion of their respective shares, it would place substantial downward pressure on our stock price. We also have 33,750 shares reserved for the issuance of common stock upon vesting of restricted stock awards. In addition, we have 937,875 shares of our common stock reserved for the exercise of outstanding stock options, of which 645,276 are fully vested and exercisable as of March 31, 2008. 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, 2008. All 8,165,564 of our outstanding shares of common stock may be sold in the open market, subject to certain limitations.

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 will 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. 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.

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:

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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;

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

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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;

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

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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

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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 be without these provisions.

Item 1B.

Unresolved Staff Comments

We have received a comment letter from the Staff dated May 12, 2008, in regards to the Staff’s review of our Annual Report on Form 10-K for the year ended December 31, 2007.

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 15, 2008	By	/s/ Jerry Collazo
		Jerry Collazo
		Chief Financial Officer

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)

4.1		Form of Common Stock Certificate (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)

4.2		Common Stock Purchase Warrant to Purchase 142,000 shares of Common Stock of Orange 21 Inc. issued to Roth Capital Partners, LLC dated June 22, 2005 (incorporated by reference to Form 10-Q filed August 11, 2005)

4.3		Common Stock Purchase Warrant to Purchase 5,000 shares of Common Stock of Orange 21 Inc. issued to Dana Mackie dated June 22, 2005 (incorporated by reference to Form 10-Q filed August 11, 2005)

10.1		Second Modification to Loan and Security Agreement entered into on February 12, 2008 by and between Spy Optic, Inc. and BFI Business Finance (incorporated by reference to Form 10-K filed April 8, 2008)

31.1		Section 302 Certification of the Company’s Chief Executive Officer

31.2		Section 302 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)

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Good

Spy (XSPY) Inactive 10-Q2008 Q1 Quarterly report

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