The following discussion and analysis of the financial condition and results of our operations should be read together with our condensed consolidated financial statements and the related notes 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 2011 10-K filed with the Securities and Exchange Commission on March 23, 2012.

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 2011 10-K filed with the Securities and Exchange Commission on March 23, 2012, "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 became one of the world's most distinct audio brands by bringing color, character and performance to an otherwise monochromatic space and helped revolutionize the audio arena by introducing headphones, earbuds and other audio and wireless lifestyle products that possess unmistakable style and exceptional performance. From the award-winning, optic-inspired Roc Nation Aviator headphones to the evolutionary fitting FIX earbuds and a roster of some of the world's finest athletes, musicians and artists, Skullcandy continues to redefine world-class audio performance and style. The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position, robust net sales growth and strong profitability.

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 20.5% and 21.1% of our net sales for three months ended March 31, 2012 and 2011, respectively. Sales to our former European distributor, 57 North, represented more than 10% of our net sales in the three months ended March 31, 2011. We reacquired the rights to European distribution in August 2011 by purchasing Kungsbacka 57 AB, a subsidiary of 57 North. We also offer products through our websites, with online sales representing approximately 8.9% and 8.5% of our net sales for three months ended March 31, 2012 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 skateboarding, snowboarding, 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. During 2011, Best Buy accounted for more than 10% of our net sales. Target and Best Buy each accounted for more than 10% of our net sales for the three months ended March 31, 2012. 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. Furthermore, our industry is very competitive and we cannot assure you that we will be able to compete effectively. See "Risk Factors" in Part II of this quarterly report and in our 2011 10-K filed with the Securities and Exchange Commission on March 23, 2012 for a more complete discussion of the risks facing our business. Historically, we have experienced greater net sales in the second half of the year than those in the first half due to a concentration of shopping during the fall and holiday seasons. We anticipate that this seasonal impact on our net sales is likely to continue. Accordingly, our results of operations for any particular quarter are not indicative of the results we expect for the full year.

Segment Information

We operate exclusively in the consumer products category in which we develop and distribute headphones and other audio accessories. Prior to our acquisition of Kungsbacka 57 AB on August 26, 2011, we operated in one business segment. Following that acquisition we began to operate in two segments -North America and Europe. The North America segment primarily consists of Skullcandy and Astro Gaming product sales from customers in the United States, Canada and Mexico (through our joint venture). The European segment primarily includes Skullcandy product sales generated from customers in Europe that are served by our European operations.

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.

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:



                                                             Three Months Ended March 31,
                                                           2012                         2011
Net sales                                         $ 53,280         100.0 %     $ 36,018         100.0 %
Cost of goods sold                                  27,296          51.2         17,703          49.2

Gross profit                                        25,984          48.8         18,315          50.8
Selling, general and administrative expenses        24,500          46.0         14,399          40.0

Income from operations                               1,484           2.8          3,916          10.9
Other expense                                          (48 )        (0.1 )          (13 )          -
Interest expense                                       124           0.2          1,998           5.5

Income before income taxes and noncontrolling
interests                                            1,408           2.6          1,931           5.4
Income taxes                                           267           0.5            852           2.4

Net income                                        $  1,141           2.1       $  1,079           3.0

Noncontrolling interests                               (24 )          -              -             -
Preferred dividends                                     -             -              (9 )          -

Net income attributable to Skullcandy, Inc.       $  1,117           2.1 %     $  1,070           3.0 %

Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011

Net Sales

Net sales increased $17.3 million, or 47.9%, to $53.3 million for the three months ended March 31, 2012 from $36.0 million for the three months ended March 31, 2011.

Domestic net sales increased $11.8 million, or 46.5%, to $37.2 million, or 69.8% of our net sales for the three months ended March 31, 2012 from $25.3 million, or 70.4% of our net sales for the three months ended March 31, 2011. This increase primarily reflects increased volume to existing retailers.

International net sales, which consist primarily of net sales in Europe and Canada, increased $3.3 million, or 44.1%, to $10.9 million, or 20.5% of our net sales for the three months ended March 31, 2012 from $7.6 million, or 21.1% of our net sales for the three months ended March 31, 2011. This increase was primarily attributable to a $2.2 million increase in net sales in Europe, primarily based on our transition to a direct model. 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. 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.

Online net sales increased $2.1 million, or 69.4%, to $5.2 million, or 9.7% of our net sales for the three months ended March 31, 2012 from $3.1 million, or 8.5% of our net sales for the three months ended March 31, 2011. 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 for Astro Gaming included in online net sales were $2.4 million for the three months ended March 31, 2012.

Gross Profit

Gross profit increased $7.7 million, or 41.9%, to $26.0 million for the three months ended March 31, 2011 from $18.3 million for the three months ended March 31, 2011. Gross profit as a percentage of net sales, or gross margin, was 48.8% for the three months ended March 31, 2012 compared to 50.8% for the three months ended March 31, 2011. The decrease in gross margin was due primarily to lower margin sales to the closeout channel in connection with our transition to an updated product and packaging collection, which will launch in retail stores in the second quarter of 2012 and be rolled out over the course of 2012.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $10.1 million, or 70.2%, to $24.5 million for the three months ended March 31, 2012 from $14.4 million for the three months ended March 31, 2011. The increase was primarily the result of $4.1 million in additional payroll-related expenses, $1.8 million in additional marketing and advertising expenses and $1.0 million in additional depreciation and amortization based on increased investments in property and equipment and the acquisition of certain intangible assets in August 2011. We continue to make critical investments in the business to support long-term growth. These investments include additional personnel in key areas of our business, product development, point-of-sale merchandising, international expansion and development of our gaming platform. Legal expenses increased $0.9 million primarily due to $0.7 million of legal expenses related to a lawsuit with Monster Cable Products, Inc., or Monster, that was settled on February 15, 2012. No further expenses related to the Monster lawsuit will be incurred in subsequent periods. As a percentage of net sales, selling, general and administrative expenses increased 6.0 percentage points to 46.0% for the three months ended March 31, 2012 from 40.0% for the three months ended March 31, 2011.

Income from Operations

As a result of the factors above, income from operations decreased $2.4 million, or 62.1%, to $1.5 million for the three months ended March 31, 2012 from $3.9 million for the three months ended March 31, 2011. Income from operations as a percentage of net sales decreased 8.1 percentage points to 2.8% for the three months ended March 31, 2012 from 10.9% for the three months ended March 31, 2011.

Other Expense

Other expense was immaterial for the three months ended March 31, 2012 and 2011.

Interest Expense

Interest expense decreased $1.9 million to $0.1 million for the three months ended March 31, 2012 from $2.0 million for the three months ended March 31, 2011. All long-term debt was repaid with the IPO proceeds or was converted to common stock. In addition, as of March 31, 2012 there were no meaningful borrowings outstanding on the revolving credit facility compared to $9.0 million outstanding as of March 31, 2011.

Income Taxes

Income taxes were $0.3 million for the three months ended March 31, 2012 compared to $0.9 million for the three months ended March 31, 2011. Our effective tax rate for the three months ended March 31, 2012 and March 31, 2011 was 19.3% and 44.1%, respectively. Our effective tax rate for the three months ended March 31, 2012 decreased, and was lower than the United States federal statutory rate of 35%, as a result of disqualifying dispositions of incentive stock options, as well as higher earnings in countries that have lower statutory rates than the United States. All earnings for the three months ended March 31, 2011 were recognized in the United States for income tax purposes. We expect our effective tax rate will continue to fluctuate significantly on a quarterly basis depending upon the proportionate levels of income in countries with lower statutory rates versus countries with higher statutory rates.

Net Income

As a result of the factors above, net income was $1.1 million for the three months ended March 31, 2012 and 2011.

Noncontrolling Interest

We entered into a joint venture in Mexico in September 2011 to facilitate distribution of our products in Mexico. We own a majority of the joint venture and the voting rights and control the day-to-day operations.

Noncontrolling interest for the three months ended March 31, 2012 consists of income from our Mexico joint venture that is attributable to the other partner in the joint venture.

Preferred Dividends

Preferred dividends were immaterial for the three months ended March 31, 2011. Subsequent to July 2011, there have been no preferred dividends. All shares of the Company's preferred stock outstanding automatically converted into 4,507,720 shares of common stock upon the closing of our IPO.

Net Income Attributable to Skullcandy, Inc.

As a result of the factors above, net income attributable to Skullcandy, Inc. was $1.1 million for the three months ended March 31, 2012 and 2011.

Segment Information

Net sales for the three months ended March 31, 2012 in North America and Europe were $46.2 million and $7.1 million, respectively. Gross profit in North America and Europe was $22.1 million and $3.9 million, respectively. Gross margin in North America and Europe was 47.9% and 54.4%, respectively. The higher gross margin in Europe is due to a sales mix of higher margin products and more favorable pricing with certain retailers. Income (loss) from operations in North America and Europe was ($0.1 million) and $1.6 million, respectively. For further discussion of the changes in net sales, gross profit and income from operations, see Management's Discussion and Analysis of Financial Condition and Results of Operations above.

Liquidity and Capital Resources

Our primary cash needs are working capital and capital expenditures. Historically, we have generally financed these needs with operating cash flows, sales of equity securities and borrowings under our credit facility. These sources of liquidity may be impacted by fluctuations in demand for our products, ongoing investments in our infrastructure and expenditures on marketing and advertising.

The following table sets forth, for the periods indicated, our beginning balance of cash, net cash flows provided by and used in operating, investing and financing activities and our ending balance of cash (in thousands):

                                                                      Three Months Ended
                                                                          March 31,
                                                                    2012              2011
Cash and cash equivalents at beginning of period                  $  23,302         $  6,462
Net cash provided by (used in) operating activities                  (1,643 )          9,492
Net cash used in investing activities                                (1,350 )         (1,105 )
Net cash used in financing activities                                (9,493 )         (8,884 )
Effect of exchange rate changes on cash and cash equivalents             97               -

Cash and cash equivalents at end of period                        $  10,913         $  5,965

Net Cash Provided by (Used in) Operating Activities. Cash from operating activities consists primarily of net income adjusted for certain non-cash items including depreciation and amortization expense, provision for doubtful accounts, deferred income taxes, non-cash interest expense, stock-based compensation expense and the effect of changes in working capital and other activities. For the three months ended March 31, 2012, net cash used in operating activities was $1.6 million and consisted of net income of $1.1 million plus $2.2 million for non-cash items, less $5.0 million for working capital and other activities. Working capital and other activities consisted primarily of a decrease in accounts receivable of $11.3 million, a decrease in prepaid expenses and other current assets of $3.2 million, offset by increases in inventory of $7.1 million and decreases in accounts payable of $1.5 million, income taxes payable of $5.9 million and accrued liabilities of $5.2 million.

For the three months ended March 31, 2011, net cash provided by operating activities was $9.5 million and consisted of net income of $1.1 million plus $2.4 million for non-cash items, plus $6.0 million for working capital and other activities. Working capital and other activities consisted primarily of a decrease in accounts receivable of $20.5 million, partially offset by an increase in inventory of $6.3 million, and decreases in accrued liabilities of $5.1 million and accounts payable of $2.1 million.

Net Cash Used in Investing Activities. Net cash used in investing activities relates almost entirely to capital expenditures. Net cash used in investing activities was $1.4 million and $1.1 million for the three months ended March 31, 2012 and 2011, respectively.

Net Cash Used in Financing Activities. Net cash used in financing activities was $9.5 million and $8.9 million for the three months ended March 31, 2012 and 2011, respectively, which primarily resulted from repayment of debt.

We believe that our cash, cash flow from operating activities, available borrowings under our credit facility will be sufficient to meet our capital requirements for at least the next twelve months.

Indebtedness

On August 31, 2010, we entered into a revolving credit and security agreement, or the credit facility, with PNC Bank and UPS Capital Corporation, as lenders. The credit facility provides for revolving loans and letters of credit of up to $28.8 million (which may be increased to up to $50.0 million upon our request subject to certain conditions) and expires on August 31, 2013. The credit facility is secured by substantially all of our assets. The total amount of available borrowings is subject to limitations based on specified percentages of the value of eligible receivables and inventory. At March 31, 2012, there were $1 thousand in outstanding borrowings and we had $28.4 million of additional availability under the credit facility. We may request up to two increases in the total maximum available amount of the credit facility from the existing lenders, each in an amount not to exceed $10.6 million, such that the aggregate amount of the facility does not exceed $50.0 million. We are required to pay a commitment fee on any unused credit facility commitments at a per annum rate of 0.50%. The credit facility includes restrictions on, among other things, our ability to incur additional indebtedness, pay dividends or make other distributions, make investments, make loans and make capital expenditures, and requires that we maintain a Fixed Charge Coverage Ratio (as defined in the credit facility) of not less than 1.15 to 1.0, measured on a trailing 12-month basis. At March 31, 2012, we were in compliance with all financial covenants.

In October 2011, we entered into a first amendment and waiver to revolving credit and security agreement, or the amendment. The amendment increased the amount of allowable capital expenditures to $6.0 million annually and waived any past non-compliance with the capital expenditure covenant. Under the amendment, we may select from two interest rate options for borrowings under the credit facility: (i) Alternate Base Rate (as defined in the credit facility) plus 1.0% or (ii) Eurodollar Rate (as defined in the credit facility) plus 1.5%. The amendment also allows us to enter into foreign currency contracts with the lenders to hedge our foreign currency risk.

On March 6, 2012, we entered into a second amendment to our revolving credit and security agreement. The amendment provides for an increase in the permitted aggregate annual capital expenditures to $12.0 million.

Contractual obligations

In the three months ended March 31, 2012, there were no material changes to our contractual obligations as discussed in our annual report on Form 10-K for the year ended December 31, 2011.

Off Balance Sheet Arrangements

We currently do not have any off-balance sheet arrangements or financing activities with special-purpose entities.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. To prepare these financial statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities. These estimates also affect our reported net sales and expenses. Judgments must also be made about the disclosure of contingent liabilities. Actual results could be significantly different from these estimates. We believe that the following discussion addresses the accounting policies that are necessary to understand and evaluate our reported financial results.

Revenue Recognition and Sales Returns and Allowances

Net sales are recognized when title and risk of loss pass to the retailer or distributor and when collectability is reasonably assured. Generally, we extend credit to our retailers and distributors and do not require collateral. Our payment terms are typically net-30 with terms up to net-120 for certain international customers. We recognize revenue net of estimated product returns and pricing adjustments. Further, we provide for product warranties in accordance with the contract terms given to various retailers and end users by accruing estimated warranty costs at the time of revenue recognition. We have entered into contracts with various retailers granting a conditional right of return allowance with respect to defective products. The contracts with each retailer specify the defective allowance percentage of gross sales. We have executed an open return program with a major retailer allowing for an unlimited amount of returns. Estimates for these items are based on actual experience and are recorded as a reduction of revenue at the time of recognition or when . . .