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SKUL > SEC Filings for SKUL > Form 10-Q on 8-Nov-2011All Recent SEC Filings

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Form 10-Q for SKULLCANDY, INC.


8-Nov-2011

Quarterly Report


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

The following discussion and analysis of the financial condition and results of our operations should be read together with the condensed consolidated financial statements and the related notes of Skullcandy, Inc. included in Part I of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and the related notes included in our final prospectus dated July 19, 2011.

Cautionary Statement Regarding Forward-Looking Statements

This quarterly report contains forward-looking statements. The words "may," "will," "plan," "believe," "expect," "anticipate," "intend," "estimate" and other expressions that are predictions of or indicate future events and trends and that do not relate to historical matters identify forward-looking statements. Although forward-looking statements reflect our current views, reliance should not be placed on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, which may cause the actual results, performance or achievements to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements speak only as of the date the statements are made. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changed circumstances or otherwise. These forward-looking statements are subject to numerous risks and uncertainties, including the risks and uncertainties described under "Risk Factors" in Part II of this quarterly report and in our final prospectus dated July 19, 2011, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this quarterly report. Moreover, we operate in an evolving environment. New risk factors and uncertainties emerge from time to time and it is not possible for our management to predict all risk factors and uncertainties, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors may cause actual results to differ materially from those contained in any forward-looking statement. We qualify all of our forward-looking statements by these cautionary statements.

Overview

Skullcandy is a leading audio brand that reflects the collision of the music, fashion and action sports lifestyles. Our brand symbolizes youth and rebellion and embodies our motto, "Every revolution needs a soundtrack." We believe we have revolutionized the headphone market by stylizing a previously-commoditized product and capitalizing on the increasing pervasiveness, portability and personalization of music. The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position, robust net sales growth and strong profitability and return on our invested capital.

Our net sales are derived primarily from the sale of headphones and audio accessories. We pioneered the distribution of headphones in specialty retailers focused on action sports and the youth lifestyle, such as Zumiez, Tilly's and hundreds of independent snow, skate and surf retailers. Through this channel we reach consumer influencers, individuals who help establish and maintain the credibility and authenticity of our brand. Building on this foundation, we have successfully expanded our distribution to select consumer electronics, mass, sporting goods and mobile phone retailers such as Best Buy, Target, Dick's Sporting Goods and AT&T Wireless. Skullcandy products are sold in the United States and in more than 70 other countries around the world, with international sales representing approximately 18.9% and 21.8% of our net sales in the nine months ended September 30, 2010 and 2011, respectively. Sales to our former European distributor, 57 North, represented more than 10% of our net sales for the nine months ended September 30, 2011. On August 26, 2011, we completed the purchase of all outstanding stock of Kungsbacka 57 AB, a subsidiary of 57 North in order to take direct control of our European business. We also offer products through our websites, with online sales representing approximately 3.5% and 9.1% of our net sales for the nine months ended September 30, 2010 and 2011, respectively.

A number of industry trends have facilitated our growth to date, and we expect these trends to continue. The increasing use of portable media devices, such as Apple's iPod, and smartphones with integrated music and video capabilities, such as Apple's iPhone and third-party Android-based phones, has driven growth in the headphones and audio accessories markets. Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our consumer influencers are teens and young adults that associate themselves with snowboarding, skateboarding, surfing and other action sports. These consumers influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the youth action sports lifestyle, and headphones have become an accessory worn to express individuality. We believe these trends provide us with an expanding consumer base for our products. Furthermore, we believe that these trends in preferences and lifestyles are not unique to the United States and are prevalent in a number of markets around the world.

We face potential challenges that could limit our ability to take advantage of these opportunities, including, among others, the risk that we may not be able to effectively extend the recognition and reputation of our brand or continue to develop innovative and popular products. We also face the risk that we may not be able to sustain our past growth or manage our anticipated future growth. In addition, we rely on Target and Best Buy for a significant portion of our net sales. Target


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and Best Buy each accounted for more than 10% of our net sales in 2010. Best Buy continued to account for more than 10% of our net sales for the nine months ended September 30, 2011. Moreover, we expect to experience growth internationally, which will require significant additional operating expenditures and increase our exposure to the risks inherent in international operations. We rely primarily on two key manufacturers in China, Antonio Precise Products Manufactory and Guangzhou Sun Young Electronics Company, for substantially all of our products. Furthermore, our industry is very competitive and we cannot assure you that we will be able to compete effectively. For a more complete discussion of the risks facing our business, please see "Risk Factors" in Part II of this quarterly report and in our final prospectus dated July 19, 2011.

On April 21, 2011, we completed the purchase of substantially all the assets of Astro Gaming, Inc. for $10.8 million. Astro Gaming, Inc. is a leader in gaming headphones based in San Francisco, California. We paid the purchase price using cash on hand and borrowings of approximately $10.0 million under our credit facility.

In July 2011, we completed an initial public offering of common stock, or IPO, in which we issued and sold 4,166,667 shares of common stock at a price of $20 per share, less underwriting discounts and commissions. Certain of our stockholders also sold 5,275,026 shares in the IPO at a price of $20 per share. We did not receive any of the proceeds from the sale of stock by our stockholders. As a result of the IPO, we raised approximately $77.5 million, net of underwriting discounts and commissions and before offering expenses. Simultaneously with the IPO, all shares of our preferred stock outstanding automatically converted into 4,507,720 shares of common stock. In addition, our convertible note converted into 3,862,124 shares of common stock and the related accrued interest of $5.6 million was repaid. We used a portion of the proceeds from the IPO to repay the outstanding balance on our unsecured subordinated promissory of $7.3 million, the outstanding balance on our unsecured subordinated promissory note issued in connection with the management incentive bonus of $9.3 million, the additional stockholder payment of $17.5 million relating to obligations under our securities purchase and redemption agreement and the contingent amount payable to stockholders of $3.8 million.

On August 26, 2011, we completed the purchase of all outstanding stock of Kungsbacka 57 AB, a subsidiary of 57 North, for $18.6 million. Kungsbacka 57 AB previously held an exclusive distribution agreement for Skullcandy products in Europe through November of 2013. The acquisition has enabled us to take direct control of our European business, which we expect will allow us to capture revenue that would otherwise have been earned by 57 North and accelerate our growth in this region. We paid the purchase price using proceeds from the IPO.

Basis of Presentation

Our net sales are derived primarily from the sale of headphones and audio accessories under the Skullcandy brand name. Amounts billed to retailers for shipping and handling are included in net sales. Sales are reported net of estimated product returns and pricing adjustments. Domestic net sales are derived primarily from sales to our retailers, while our international net sales are primarily attributable to sales to our retailers and distributors.

Gross profit is influenced by cost of goods sold, which consists primarily of product costs, packaging, freight, duties and warehousing. We are experiencing higher product costs due to increasing labor and other costs in China. If we are unable to pass along these costs to our retailers and distributors or shift our sales mix to higher margin products, our gross profit as a percentage of net sales, or gross margin, may decrease.

Our selling, general and administrative expenses consist primarily of wages and related payroll and employee benefit expenses, including stock-based compensation, marketing and advertising expense, commissions to outside sales representatives, legal and professional fees, travel expenses, utilities, other facility related costs, such as rent and depreciation and amortization, and consulting expenses. The primary components of our marketing and advertising expenses include in-store advertising, brand building fixtures, sponsorship of trade shows and events, promotional products and sponsorships for athletes, DJs, musicians and artists. We expect our selling, general and administrative expenses to increase in absolute dollars as we hire additional personnel and incur increased costs related to the growth of our business and our operation as a public company.


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Results of Operations

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



                                            $149,056        $149,056         $149,056       $149,056        $149,056        $149,056        $149,056        $149,056
                                                       Three months ended September 30,                                Nine months ended September 30,
                                                     2010                            2011                            2010                            2011
Net sales                                 $   38,493           100.0 %     $   60,641          100.0 %    $   95,940           100.0 %    $  149,056           100.0 %
Cost of goods sold                            18,487            48.0           31,843           52.5          46,629            48.6          75,144            50.4

Gross profit                                  20,006            52.0           28,798           47.5          49,311            51.4          73,912            49.6
Selling, general and administrative
expenses                                      13,288            34.5           20,571           33.9          30,206            31.5          52,195            35.0

Income from operations                         6,718            17.5            8,227           13.6          19,105            19.9          21,717            14.6
Other expense                                  3,813             9.9            1,734            2.9           7,621             7.9           1,716             1.2
Interest expense                               2,450             6.4            3,101            5.1           6,559             6.8           7,389             5.0

Income before income taxes and
noncontrolling interests                         455             1.2            3,392            5.6           4,925             5.1          12,612             8.5
Income taxes                                   1,683             4.4            2,440            4.0           4,887             5.1           6,323             4.2

Net income (loss)                         $   (1,228 )          (3.2 )     $      952            1.6      $       38             0.0      $    6,289             4.2

Noncontrolling interests                          -               -                 7            0.0              -               -                7             0.0
Preferred dividends                               (8 )           0.0               -              -              (22 )           0.0             (17 )           0.0

Net income (loss) attributable to
Skullcandy, Inc.                          $   (1,236 )          (3.2 )%    $      959            1.6 %    $       16             0.0 %    $    6,279             4.2 %

Three Months Ended September 30, 2011 Compared to Three Months Ended September 30, 2010

Net Sales

Net sales increased $22.1 million, or 57.5%, to $60.6 million for the three months ended September 30, 2011 from $38.5 million for the three months ended September 30, 2010.

Domestic net sales increased $10.8 million, or 37.2%, to $39.8 million, or 65.7% of our net sales for the three months ended September 30, 2011 from $29.0 million, or 75.3% of our net sales for the three months ended September 30, 2010. This increase primarily reflects increased volumes to existing retailers and the addition of new retailers.

International net sales, which consist primarily of net sales in Europe and Canada, increased $6.3 million, or 75.9%, to $14.6 million, or 24.1% of our net sales for the three months ended September 30, 2011 from $8.3 million, or 21.6% of our net sales for the three months ended September 30, 2010. This increase was primarily attributable to a $4.5 million increase in net sales in Europe. An arbitration hearing with 57 North, our previous exclusive European distributor, resulted in a decrease in net sales in Europe in 2010. The arbitration was resolved in the third quarter of 2010. On August 26, 2011, we completed the purchase of all outstanding stock of Kungsbacka 57 AB, a subsidiary of 57 North, for $18.6 million. Kungsbacka 57 AB previously held an exclusive distribution agreement for Skullcandy products in Europe through November of 2013. As part of the acquisition, we acquired certain key employees and customer lists. Net sales by Skullcandy International GmbH from the date of acquisition through September 30, 2011 were $4.4 million. The acquisition has enabled us to take direct control of our European business, which we expect will allow us to capture revenue that would otherwise have been earned by 57 North and accelerate our growth in this region. We paid the purchase price using net proceeds from the IPO.

Online net sales increased $5.0 million, or 416.7%, to $6.2 million, or 10.2% of our net sales for the three months ended September 30, 2011 from $1.2 million, or 3.1% of our net sales for the three months ended September 30, 2010. The increase in online net sales is primarily due to the acquisition of Astro Gaming, Inc. on April 21, 2011 which sells products through the site astrogaming.com. Net sales related to Astro Gaming, Inc. were $2.9 million for the three months ended September 30, 2011.

In the third quarter of 2011, the company began separating online net sales from domestic net sales for reporting purposes. On a combined basis, domestic net sales and online net sales increased 52.3% to $46.0 million for the three months ended September 30, 2011.

Gross Profit

Gross profit increased $8.8 million, or 43.9%, to $28.8 million for the three months ended September 30, 2011 from $20.0 million for the three months ended September 30, 2010. Gross profit as a percentage of net sales, or gross margin, was


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47.5% for the three months ended September 30, 2011 compared to 52.0% for the three months ended September 30, 2010. The decrease in gross margin is partially due to the sale of Astro Gaming, Inc. inventory that was recorded at fair value under the acquisition method of accounting. Excluding the $0.5 million increase in cost of goods sold related to the step-up in fair value of Astro Gaming Inc. inventory in purchase accounting, gross margin would have been 48.3%. In addition, we have experienced lower gross margins on our direct business in Europe from the date of our Kungsbacka 57 AB acquisition through September 30, 2011 as a result of inventory that was recorded at fair value under the acquisition method of accounting.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $7.3 million, or 54.8%, to $20.6 million for the three months ended September 30, 2011 from $13.3 million for the three months ended September 30, 2010. This increase was primarily the result of $4.2 million in increased payroll related expenses and benefits due to an increased employee headcount to support planned growth and $1.3 million in increased marketing expenses primarily related to in-store advertising, in-store displays, trade show attendance, event and athlete sponsorships and promotional products. As a percentage of net sales, selling, general and administrative expenses decreased 0.6 percentage points to 33.9% for the three months ended September 30, 2011 from 34.5% for the three months ended September 30, 2010.

Income from Operations

As a result of the factors above, income from operations increased $1.5 million, or 22.5%, to $8.2 million for the three months ended September 30, 2011 from $6.7 million for the three months ended September 30, 2010. Income from operations as a percentage of net sales decreased 3.9 percentage points to 13.6% for the three months ended September 30, 2011 from 17.5% for the three months ended September 30, 2010.

Other Expense

Other expense decreased $2.1 million, or 54.5%, to $1.7 million for the three months ended September 30, 2011 from $3.8 million for the three months ended September 30, 2010. For the three months ended September 30, 2011, other expense consisted primarily of a $1.4 million expense related to a derivative liability associated with the third contingent payment paid pursuant to the securities purchase and redemption agreement. The derivative liability was recorded as a derivative due to the variability in the potential amount payable. The estimated fair value of this derivative was approximately $2.4 million as of December 31, 2010 and June 30, 2011. The amount became fixed at $3.8 million upon the consummation of our IPO and the additional $1.4 million was included in other expense. The derivative liability was paid on July 29, 2011. For the three months ended September 30, 2010, other expense consisted primarily of a $3.8 million expense related to a derivative liability associated with the second and third contingent payments paid pursuant to the securities purchase and redemption agreement. The liability was recorded as a derivative due to the variability in the potential amount payable.

Interest Expense

Interest expense increased $0.7 million to $3.1 million for the three months ended September 30, 2011 from $2.5 million for the three months ended September 30, 2010. The higher expense for the three months ended September 30, 2011 was due to an expense of $2.2 million related to the second contingent payment paid pursuant to the securities purchase and redemption agreement that was incurred upon the consummation of our IPO. Because this obligation had a stated term and no stated interest rate, it was recorded at its net present value of $15.1 million as of December 31, 2010 using an implied interest rate of 5%. The obligation was $15.4 million as of June 30, 2011. As of July 19, 2011, when the IPO became effective, the amount payable was accreted to its stated value of $17.5 million and the additional $2.2 million was recognized as interest expense. The amount payable was paid on July 29, 2011 from the proceeds of the IPO. Total borrowings on the credit facility at September 30, 2011 were $14.2 million compared to $11.2 million at September 30, 2010.

The second and third contingent payments paid pursuant to the securities purchase and redemption agreement, were paid in connection with the completion of our IPO. There will be no expenses associated with the securities purchase and redemption agreement in the future.

Income Taxes

Income taxes were $2.4 million for the three months ended September 30, 2011 compared to $1.7 million for the three months ended September 30, 2010. Our effective tax rate for the three months ended September 30, 2011 and September 30, 2010 was 71.8% and 369.9%, respectively. The decrease in the effective income tax rate is primarily due to the difference between the book and tax treatment of incentive stock options and the expenses related to the second contingent payment and third contingent payment pursuant to the securities purchase and redemption agreement which were not deductible for tax purposes. The effective tax rate for the three months ended September 30, 2011 differs from the U.S. federal statutory rate of 35% primarily due to incentive stock options and expenses incurred during the third quarter related to the IPO that were not deductible for tax purposes. The amounts incurred that were not tax deductible consisted of a $2.2 million expense related to


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the second contingent payment pursuant to the securities purchase and redemption agreement and a $1.4 million expense related to the third contingent payment pursuant to the securities purchase and redemption agreement that were incurred in connection with the IPO.

Net Income (loss)

As a result of the factors above, net income increased $2.2 million, or 177.5%, to $1.0 million for the three months ended September 30, 2011 compared to a net loss of $1.2 million for the three months ended September 30, 2010.

Noncontrolling Interest

Noncontrolling interest for the three months ended September 30, 2011 consists of losses from our Mexico joint venture that are attributable to the other partner in the joint venture.

Preferred Dividends

Preferred dividends were immaterial for the three months ended September 30, 2011 and 2010.

Net Income (Loss) Attributable to Skullcandy, Inc.

As a result of the factors above, net income (loss) attributable to Skullcandy, Inc. increased $2.2 million, or 177.6%, to $1.0 million for the three months ended September 30, 2011 compared to a net loss of $1.2 million for the three months ended September 30, 2010.

Nine Months Ended September 30, 2011 Compared to Nine Months Ended September 30, 2010

Net Sales

Net sales increased $53.1 million, or 55.4%, to $149.1 million for the nine months ended September 30, 2011 from $95.9 million for the nine months ended September 30, 2010.

Domestic net sales increased $28.6 million, or 38.4%, to $103.0 million, or 69.1% of our net sales for the nine months ended September 30, 2011 from $74.4 million, or 77.6% of our net sales for the nine months ended September 30, 2010. This increase primarily reflects increased volumes to existing retailers and the addition of new retailers.

International net sales, which consist primarily of net sales in Europe and Canada, increased $14.4 million, or 79.6%, to $32.5 million, or 21.8% of our net sales for the nine months ended September 30, 2011 from $18.1 million, or 18.9% of our net sales for the nine months ended September 30, 2010. This increase was primarily attributable to a $10.5 million increase in net sales in Europe. An arbitration hearing with 57 North, our previous exclusive European distributor, resulted in a decrease in net sales in Europe in 2010. The arbitration was resolved in the third quarter of 2010.

Online net sales increased $10.2 million, or 300.0%, to $13.6 million, or 9.1% of our net sales for the nine months ended September 30, 2011 from $3.4 million, or 3.5% of our net sales for the nine months ended September 30, 2010. The increase in online net sales is primarily due to the acquisition of Astro Gaming, Inc. on April 21, 2011 which sells products through the site astrogaming.com. Net sales related to Astro Gaming, Inc. from April 21, 2011 through September 30, 2011 were $4.8 million.

In the third quarter of 2011, the company began separating online net sales from domestic net sales for reporting purposes. On a combined basis, domestic net sales and online net sales increased 49.9% to $116.6 million for the nine months ended September 30, 2011.

Gross Profit

Gross profit increased $24.6 million, or 49.9%, to $73.9 million for the nine months ended September 30, 2011 from $49.3 million for the nine months ended September 30, 2010. Gross profit as a percentage of net sales, or gross margin, decreased 1.8 percentage points to 49.6% for the nine months ended September 30, 2011 from 51.4% for the nine months ended September 30, 2010. The decrease in gross margin is partially due to the sale of inventory that was recorded at fair value under the acquisition method of accounting. Excluding the $0.5 million increase in cost of goods sold related to the step-up in fair value of inventory in purchase accounting, gross margin would have been 49.9%. In addition, we have experienced lower gross margins on our direct business in Europe from August 26, 2011 through September 30, 2011 as a result of inventory that was recorded at fair value under the acquisition method of accounting.


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Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $22.0 million, or 72.8%, to $52.2 million for the nine months ended September 30, 2011 from $30.2 million for the nine months ended September 30, 2010. This increase was primarily the result of $10.3 million in increased payroll related expenses due to an increased employee headcount to support planned growth and $6.1 million in increased marketing expenses primarily related to in-store advertising, in-store displays, trade show attendance, event and athlete sponsorships and promotional products. As a percentage of net sales, selling, general and administrative expenses increased 3.5 percentage points to 35.0% for the nine months ended September 30, 2011 from 31.5% for the nine months ended September 30, 2010.

Income from Operations

As a result of the factors above, income from operations increased $2.6 million, or 13.7%, to $21.7 million for the nine months ended September 30, 2011 from $19.1 million for the nine months ended September 30, 2010. Income from operations as a percentage of net sales decreased 5.3 percentage points to 14.6% for the nine months ended September 30, 2011 from 19.9% for the nine months ended September 30, 2010.

Other Expense

. . .

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