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 sales to international customers representing approximately 21.8% and 20.2% of our net sales for six months ended June 30, 2012 and 2011, respectively. We also offer products through our websites, with online sales representing approximately 8.4% of our net sales for the six months ended June 30, 2012 and 2011.

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 six months ended June 30, 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 International. The International segment was previously called the European segment and was changed to the International segment in connection with the opening of our office in Shanghai, China during the quarter ended June 30, 2012. The North America segment primarily consists of Skullcandy and Astro Gaming product sales to customers in the United States, Canada and Mexico (through our joint venture). The International segment primarily includes Skullcandy product sales to customers in Europe and Asia that are served by our European and Asian 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 attributable to direct sales to our retailers and distributors that are served by our European and Asian operations. Included in international net sales are also net sales of products that were sold from the United States to retailers and distributors in other countries.

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 June 30,                           Six months ended June 30,
                                            2012                      2011                       2012                       2011
Net sales                           $ 72,436       100.0 %    $ 52,397        100.0 %    $ 125,716       100.0 %    $ 88,415        100.0 %
Cost of goods sold                    36,769        50.8        25,598         48.9         64,065        51.0        43,301         49.0

Gross profit                          35,667        49.2        26,799         51.1         61,651        49.0        45,114         51.0
Selling, general and
administrative expenses               23,950        33.1        17,225         32.9         48,450        38.5        31,624         35.8

Income from operations                11,717        16.2         9,574         18.3         13,201        10.5        13,490         15.3
Other expense (income)                   421         0.6            (5 )                       373         0.3           (18 )
Interest expense                         147         0.2         2,290          4.4            271         0.2         4,288          4.8

Income before income taxes and
noncontrolling interests              11,149        15.4         7,289         13.9         12,557        10.0         9,220         10.4
Income taxes                           4,342         6.0         3,031          5.8          4,609         3.7         3,883          4.4

Net income                          $  6,807         9.4      $  4,258          8.1      $   7,948         6.3      $  5,337          6.0

Noncontrolling interests                  -           -             -            -             (24 )       0.0            -            -
Preferred dividends                       -           -             (8 )        0.0             -           -            (17 )        0.0

Net income attributable to
Skullcandy, Inc.                    $  6,807         9.4 %    $  4,250          8.1 %    $   7,924         6.3 %    $  5,320          6.0 %

Three Months Ended June 30, 2012 Compared to Three Months Ended June 30, 2011

Net Sales

Net sales increased $20.0 million, or 38.2%, to $72.4 million for the three months ended June 30, 2012 from $52.4 million for the three months ended June 30, 2011.

Domestic net sales increased $12.9 million, or 34.1%, to $50.6 million for the three months ended June 30, 2012 from $37.7 million for the three months ended June 30, 2011. This increase primarily reflects increased volume to existing retailers and higher average selling prices. As a percentage of net sales, domestic net sales decreased to 69.9% for the three months ended June 30, 2012 from 72.0% for the three months ended June 30, 2011.

International net sales increased $6.2 million, or 59.9%, to $16.5 million, or 22.8% of our net sales for the three months ended June 30, 2012 from $10.3 million, or 19.7% of our net sales for the three months ended June 30, 2011. This increase was primarily attributable to a $2.0 million increase in net sales in Europe, 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. The remaining increase is primarily due to increased volumes to our international distributors.

Online net sales increased $1.0 million, or 22.8%, to $5.3 million for the three months ended June 30, 2012 from $4.3 million for the three months ended June 30, 2011. The increase in online net sales is primarily due to the acquisition of Astro Gaming, Inc. on April 21, 2011, which primarily sells products through the site astrogaming.com. Net sales for Astro Gaming included in online net sales were $2.2 million for the three months ended June 30, 2012 compared to $1.6 million for the three months ended June 30, 2011. As a percentage of net sales, online net sales decreased to 7.4% for the three months ended June 30, 2012 from 8.3% for the three months ended June 30, 2011. The decrease in online net sales as a percentage of net sales was primarily due to the discontinuation of selling clearance-related items on skullcandy.com in the third quarter last year in order to better preserve the integrity of the brand.

Gross Profit

Gross profit increased $8.9 million, or 33.1%, to $35.7 million for the three months ended June 30, 2012 from $26.8 million for the three months ended June 30, 2011. Gross profit as a percentage of net sales, or gross margin, was 49.2% for the three months ended June 30, 2012 compared to 51.1% for the three months ended June 30, 2011. The decrease in gross margin is mostly due to a shift in sales mix to higher price point products with lower gross margin structures.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $6.7 million, or 39.0%, to $24.0 million for the three months ended June 30, 2012 from $17.2 million for the three months ended June 30, 2011. Approximately half of the increase was related to strategic investments in our direct international and gaming platforms, including expansion of personnel. The other half of the selling, general and administrative expenses increase consisted of $0.9 million of additional depreciation and amortization expense and approximately $2.4 million of infrastructure, public company compliance and variable expenses. The higher depreciation and amortization was the result of increased investments in a number of key strategic areas. This includes an in-house product design model, fixtures and point of purchase displays developed to improve our in-store presentation, property and equipment to support operational growth and the purchase of certain intangible assets related to our acquisition of the distribution rights in Europe. As a percentage of net sales, selling, general and administrative expenses increased to 33.1% for the three months ended June 30, 2012 from 32.9% for the three months ended June 30, 2011. We expect to continue to make critical investments in the business to support long-term growth, including additional personnel in key areas, product development, point of sale merchandising, international expansion and development of our gaming platform.

Income from Operations

As a result of the factors above, income from operations increased $2.1 million, or 22.4%, to $11.7 million for the three months ended June 30, 2012 from $9.6 million for the three months ended June 30, 2011. Income from operations as a percentage of net sales decreased 2.1 percentage points to 16.2% for the three months ended June 30, 2012 from 18.3% for the three months ended June 30, 2011.

Other Expense

Other expense for the three months ended June 30, 2012 primarily consisted of foreign currency remeasurement losses. Other expense was immaterial for the three months ended June 30, 2011.

Interest Expense

Interest expense decreased $2.1 million to $0.1 million for the three months ended June 30, 2012 from $2.3 million for the three months ended June 30, 2011. All long-term debt was repaid with the proceeds of our initial public offering in July 2011, the IPO, or was converted to common stock. In addition, as of June 30, 2012, there were $5.1 million in borrowings outstanding on the revolving credit facility compared to $22.4 million outstanding as of June 30, 2011.

Income Taxes

Income taxes were $4.3 million for the three months ended June 30, 2012 compared to $3.0 million for the three months ended June 30, 2011. Our effective tax rate for the three months ended June 30, 2012 and 2011 was 38.9% and 41.6%, respectively. Our effective tax rate decreased due to higher earnings in countries that have lower statutory rates than the United States. All earnings for the three months ended June 30, 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 increased $2.5 million, or 59.9%, to $6.8 million for the three months ended June 30, 2012 from $4.3 million for the three months ended June 30, 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 consists of income from our Mexico joint venture that is attributable to the other partner in the joint venture. There was no change in net income for the Mexico joint venture from March 31, 2012 to June 30, 2012 and thus no change in the noncontrolling interest.

Preferred Dividends

Preferred dividends were immaterial for the three months ended June 30, 2011. Subsequent to July 2011, there have been no preferred dividends. All shares of our preferred stock that were previously 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 $6.8 million for the three months ended June 30, 2012 compared to $4.3 million for the three months ended June 30, 2011.

Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011

Net Sales

Net sales increased $37.3 million, or 42.2%, to $125.7 million for the six months ended June 30, 2012 from $88.4 million for the six months ended June 30, 2011.

Domestic net sales increased $24.7 million, or 39.1%, to $87.8 million for the six months ended June 30, 2012 from $63.1 million for the six months ended June 30, 2011. This increase primarily reflects increased volume to existing retailers and higher average selling prices. As a percentage of net sales, domestic net sales decreased to 69.8% for the six months ended June 30, 2012 from 71.4% for the six months ended June 30, 2011.

International net sales increased $9.5 million, or 53.2%, to $27.4 million, or 21.8% of our net sales for the six months ended June 30, 2012 from $17.9 million, or 20.2% of our net sales for the three months ended June 30, 2011. This increase was primarily attributable to a $4.2 million increase in net sales in Europe, primarily based on our transition to a direct model. The remaining increase is primarily due to increased volumes to our international distributors.

Online net sales increased $3.1 million, or 42.0%, to $10.5 million, or 8.4% of our net sales for the six months ended June 30, 2012 from $7.4 million, or 8.4% of our net sales for the six months ended June 30, 2011. The increase in online net sales is primarily due to the acquisition of Astro Gaming, Inc. on April 21, 2011, which primarily sells products through the site astrogaming.com. Net sales for Astro Gaming included in online net sales increased $2.9 million to $4.5 million for the six months ended June 30, 2012 from $1.6 million of the six months ended June 30, 2011. Net sales for the six months ended June 30, 2011 includes net sales from the date of acquisition, April 21, 2011 through June 30, 2011.

Gross Profit

Gross profit increased $16.5 million, or 36.7%, to $61.7 million for the six months ended June 30, 2012 from $45.1 million for the six months ended June 30, 2011. Gross profit as a percentage of net sales, or gross margin, was 49.0% for the six months ended June 30, 2012 compared to 51.0% for the six months ended June 30, 2011. The decrease in gross margin is mostly due to a shift in sales mix to higher price point products with lower gross margin structures. The decrease in gross margin was also due to lower margin sales to the closeout channel in the first quarter of 2012.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $16.8 million, or 53.2%, to $48.5 million for the six months ended June 30, 2012 from $31.6 million for the six months ended June 30, 2011. Approximately half of the increase was related to strategic investments in our direct international and gaming platforms, including expansion of personnel. The other half of the selling, general and administrative expenses increase consisted of $2.0 million of additional depreciation and amortization expense and approximately $3.5 million of infrastructure, public company compliance and variable expenses. The higher depreciation and amortization is the result of increased investments in a number of key strategic areas. This includes an in-house product design model, fixtures and point of purchase displays to improve our in-store presentation, property and equipment to support operational growth and the purchase of certain intangible assets related to our acquisition of the distribution rights in Europe. As a percentage of net sales, selling, general and administrative expenses increased 2.7 percentage points to 38.5% for the six months ended June 30, 2012 from 35.8% for the six months ended June 30, 2011.

Income from Operations

As a result of the factors above, income from operations decreased $0.3 million, or 2.1%, to $13.2 million for the six months ended June 30, 2012 from $13.5 million for the six months ended June 30, 2011. Income from operations as a percentage of net sales decreased 4.8 percentage points to 10.5% for the six months ended June 30, 2012 from 15.3% for the six months ended June 30, 2011.

Other Expense

Other expense for the six months ended June 30, 2012 primarily consisted of foreign currency remeasurement losses. Other expense was immaterial for the six months ended June 30, 2011.

Interest Expense

Interest expense decreased $4.0 million to $0.3 million for the six months ended June 30, 2012 from $4.3 million for the six months ended June 30, 2011. All long-term debt was repaid with the IPO proceeds or was converted to common stock. In addition, as of June 30, 2012 there were $5.1 million in borrowings outstanding on the revolving credit facility compared to $22.4 million outstanding as of June 30, 2011.

Income Taxes

Income taxes were $4.6 million for the six months ended June 30, 2012 compared to $3.9 million for the six months ended June 30, 2011. Our effective tax rate for the six months ended June 30, 2012 and June 30, 2011 was 36.8% and 42.1%, respectively. The Company's effective tax rate decreased due to disqualifying dispositions of incentive stock options and higher earnings in countries that have lower statutory rates than the United States. All earnings for the six months ended June 30, 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 increased $2.6 million, or 48.9%, to $7.9 million for the six months ended June 30, 2012 from $5.3 million for the six months ended June 30, 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 six months ended June 30, 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 six months ended June 30, 2011. Subsequent to July 2011, there have been no preferred dividends. All shares of our preferred stock that were previously 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 $7.9 million for the six months ended June 30, 2012 compared to $5.3 million for the six months ended June 30, 2011.

Segment Information

Net sales for the three months ended June 30, 2012 for the North America and International segment were $64.0 million and $8.4 million, respectively. Gross profit in the North America and International segment was $31.6 million and $4.1 million, respectively. Gross margin in the North America and International segment was 49.3% and 49.1%, respectively. Income from operations in the North America and International segment was $10.4 million and $1.3 million, respectively.

Net sales for the six months ended June 30, 2012 for the North America and International segment were $110.2 million and $15.5 million, respectively. Gross profit in the North America and International segment was $53.7 million and $8.0 . . .