The following discussion of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements due to known and unknown risks, uncertainties and other factors. The section entitled "Risk Factors" set forth in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011, and similar discussions in our other Securities and Exchange Commission filings, discuss some of the important risk factors that may affect our business, results of operations and financial condition. You should carefully consider those risks, in addition to the information in this report and in our other filings with the Securities and Exchange Commission, before deciding to purchase, hold or sell our securities. We do not have any intention or obligation to update forward-looking statements included in this Quarterly Report on Form 10-Q after the date of this Quarterly Report on Form 10-Q, except as required by law. In addition, the following discussion should be read in conjunction with the information presented in our audited consolidated financial statements and related notes contained in our Annual Report on Form 10-K for the year ended December 31, 2011.

Business Overview

We are a designer, marketer and distributor of innovative, action sports-inspired products primarily under the HEELYS brand targeted to the youth market. Our primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel.
HEELYS-wheeled footwear allows the user to seamlessly transition from walking or running to rolling by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. We believe our distinctive product offering and our HEELYS brand is synonymous with a popular lifestyle activity. For the three and six months ended June 30, 2012, approximately 87% and 91%, respectively, of our net sales were derived from the sale of HEELYS-wheeled footwear. In each of the three and six months ended June 30, 2011, approximately 99% of our net sales were derived from the sale of HEELYS-wheeled footwear. The remainder of our net sales for the three and six months ended June 30, 2012 was derived primarily from the sale of Blazer Pro and District scooters and accessories, Tony Hawk skateboards, our Nano™ inline footboard and HEELYS' branded accessories, such as replacement wheels. We began to distribute Blazer Pro and District scooters and accessories and Tony Hawk skateboards in Europe during the third quarter of 2011.

We were initially incorporated as Heeling, Inc. in Nevada in 2000. In August 2006, we reincorporated in Delaware and changed our name to Heelys, Inc. Through our general and limited partner interests, we own 100% of Heeling Sports Limited, a Texas limited partnership, which was formed in May 2000. In February 2008, we formed Heeling Sports EMEA SPRL, a Belgian corporation and indirect wholly-owned subsidiary, with offices in Brussels, and branch offices in Germany and France, to manage our operations in Europe, the Middle East and Africa ("EMEA"). In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, with offices in Tokyo, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011. As part of an initiative to improve efficiency and reduce costs, we began taking steps in the first quarter of 2012 to close our office in Brussels, Belgium and transition our business operations conducted through that office to our French, German and U.S. offices. We completed the restructuring of our EMEA operations, including the closing of our office in Belgium and the transition of business operations to our French, German and U.S. offices, as of June 30, 2012.

Financial Overview / Significant Events - Second Quarter of 2012

Domestic net sales decreased $902,000, or 32.9%, for the three months ended June 30, 2012, when compared to the same period last year, attributable to a combination of $325,000 in sales during the first quarter of 2011 that were pushed to the second quarter of 2011 as a result of production delays, Holiday carryover inventory from 2011 with certain retailers that affected replenishment in 2012 and lower average sales price per shoe.

Internationally, our net sales decreased $1.7 million, or 30.1%, for the three months ended June 30, 2012, when compared to the same period last year, the result of decreased sales of our HEELYS-wheeled footwear in France, Germany and Italy, offset by sales increases in Japan and with third-party distributors and sales of our third party scooter and skateboard lines in France and Germany.

Consolidated gross profit margin decreased to 38.5% for the three months ended June 30, 2012, from 46.9% for the three months ended June 30, 2011. The decrease in gross profit percentage from the same quarter in the prior year was primarily the result of changes in product and customer mix from the prior year, with a larger percentage of global sales coming from lower priced shoes sold at smaller product margins, certain European retail customers that are provided larger discounts and sales of certain of our slow moving and older inventory styles at discounted prices in Japan and Germany in order to reduce excess inventories.

Cash and cash equivalents and investments remained consistent at $58.2 million as of June 30, 2012, when compared to $58.4 million as of December 31, 2011.

As part of an initiative to improve efficiency and reduce costs, we began taking steps in the first quarter of 2012 to close our office in Brussels, Belgium and transition our business operations conducted through that office to our French, German and U.S. offices. As part of this initiative, the Company eliminated its workforce in Belgium effective as of June 30, 2012. These workforce reductions primarily came from the elimination of certain finance, supply chain and customer service functions. The work performed by these people was absorbed by our employees in France, Germany and the United States. We hired limited personnel to assist with accounting and logistical support in those offices. Financial management and reporting for our Belgian subsidiary was transitioned to our headquarters in the United States. The total cumulative pre-tax costs to take this action are estimated to be between $0.8 million to $0.9 million. Approximately 85% of these costs will relate to cash outlays related to employee separation expenses, contract termination costs and professional fees. The Company does not anticipate that the actions taken thus far with respect to the initiative will result in pre-tax savings in 2012, but estimates pre-tax annual savings of approximately $1.5 million in future years.

Results of Operations

Net Sales
                                       Three Months Ended June 30,            Six Months Ended June 30,

                                        2012                2011              2012                2011
Net Sales (in thousands)

HEELYS-Wheeled Footwear
Domestic                            $       1,776       $       2,741     $       3,948       $       4,405
International                               3,249               5,514             7,956               9,901
                                            5,025               8,255            11,904              14,306

Other
Domestic                                       32                   5                35                  17
International                                 693                 108             1,130                 173
                                              725                 113             1,165                 190

Freight, Sales
Discounts/Allowances
Domestic                                       28                  (8 )              (2 )               (20 )
International                                 (24 )               (18 )             (42 )               (31 )
                                                4                 (26 )             (44 )               (51 )

Consolidated                        $       5,754       $       8,342     $      13,025       $      14,445

Net Sales (as % of Consolidated
Net Sales)
Domestic                                     31.9 %              32.8 %            30.6 %              30.5 %
International                                68.1 %              67.2 %            69.4 %              69.5 %
                                            100.0 %             100.0 %           100.0 %             100.0 %



                                           Three Months Ended June 30,           Six Months Ended June 30,

                                            2012                 2011              2012               2011
Pairs Sold (HEELYS-wheeled footwear)
Domestic                                       74,000              104,000           156,000          167,000
International                                 101,000              146,000           242,000          260,000
Consolidated                                  175,000              250,000           398,000          427,000

Domestically, our net sales decreased $902,000, or 32.9%, and $421,000, or 9.6%, to $1.8 million and $4.0 million for the three and six months ended June 30, 2012, respectively, from $2.7 million and $4.4 million for the three and six months ended June 30, 2011, respectively, primarily as a result of a decrease in the number of pairs of HEELYS-wheeled footwear sold, combined with a decrease in the average price per pair sold, during the three months ended June 30, 2012, when compared to the same period in the prior year. Sales during the three months and six months ended June 30, 2011 included approximately $325,000 in customer orders placed during the first quarter of 2011 that we were unable to fulfill until the second quarter of 2011 as a result of short-term delays from one of our sourced third-party manufacturers. The decrease in average price per pair sold is primarily the result of change in product mix with a larger percentage of sales coming from our lower-priced, basic skate shoe styles that typically sell for a lower wholesale price than some of our more current styles.

Internationally, our net sales decreased $1.7 million, or 30.1%, and $1.0 million, or 10.0%, to $3.9 million and $9.0 million for the three and six months ended June 30, 2012, respectively, from $5.6 million and $10.0 million for the three and six months ended June 30, 2011, respectively. Sales to independent distributors in our non-EMEA markets increased $69,000 and $312,000, from $108,000 and $180,000 during the three and six months ended June 30, 2011, respectively, to $177,000 and $492,000 during the three and six months ended June 30, 2012, respectively, primarily due to sales to our distributors in Australia and New Zealand. Sales to independent distributors in our EMEA markets decreased approximately $247,000 and $127,000, to approximately $696,000 and $1.5 million during the three and six months ended June 30, 2012, respectively, from approximately $943,000 and $1.7 million during the three and six months ended June 30, 2011, respectively, primarily due to a decrease in sales with certain of our distributors, particularly in our Middle Eastern markets. Sales in our French market decreased approximately $259,000 and $457,000, to approximately $1.1 million and $2.3 million during the three and six months ended June 30, 2012, respectively, from approximately $1.4 million and $2.7 million during the three months and six months ended June 30, 2011, respectively. Sales in our German market decreased approximately $310,000 and $300,000, to approximately $374,000 and $1.1 million during the three and six months ended June 30, 2012, respectively, from approximately $684,000 and $1.4 million during the three and six months ended June 30, 2011, respectively. Sales of HEELYS-wheeled footwear decreased approximately $1.2 million and $1.8 million in France and Germany, to approximately $870,000 and $2.3 million during the three and six months ended June 30, 2012, respectively, from approximately $2.1 million and $4.1 million during the three and six months ended June 30, 2011, respectively. These decreases were offset by sales in France and Germany of Blazer Pro and District scooters and accessories and Tony Hawk skateboards, which accounted for approximately $615,000 and $1.0 million of sales during the three and six months ended June 30, 2012. We believe retailers in our French and German markets are being cautious when placing orders of HEELYS-wheeled footwear to minimize their inventory levels and inventory related risks resulting from a decrease in consumer demand, which we believe is due to market competition from other wheeled products such as coaster boards. Sales in our Italian market decreased approximately $1.1 million and $820,000, to approximately $975,000 and $2.8 million during the three and six months ended June 30, 2012, respectively, from approximately $2.1 million and $3.6 million during the three and six months ended June 30, 2011, respectively. Net sales in our Japanese market increased $133,000 and $324,000, from $382,000 during the three and six months ended June 30, 2011, to $515,000 and $706,000 during the three and six months ended June 30, 2012, respectively. We took over direct distribution in the Japanese market effective March 1, 2011. During the three months ended March 31, 2011, we did not sell any product to either our former distributor in Japan or direct to retailers. We believe the March 2011 earthquake and related tsunami, nuclear and other disasters in the region impacted consumer buying behavior with reduced discretionary spending and purchases of non-essential items during the first and second quarters of 2011.

Gross Profit

                                       Three Months Ended June 30,           Six Months Ended June 30,

                                        2012                2011              2012               2011
Gross Profit (in thousands)
Domestic                            $         606       $       1,150     $      1,375       $      1,820
International                               1,610               2,760            4,065              5,099
Consolidated                        $       2,216       $       3,910     $      5,440       $      6,919


                  Gross Profit (%)
                  Domestic             33.0 %     42.0 %     34.5 %     41.3 %
                  International        41.1 %     49.3 %     44.9 %     50.8 %
                  Consolidated         38.5 %     46.9 %     41.8 %     47.9 %

Gross profit margin on domestic sales decreased to 33.0% and 34.5% for the three and six months ended June 30, 2012, respectively, from 42.0% and 41.3% for the three and six months ended June 30, 2011, respectively. The decrease in gross profit margin is primarily the result of a larger percentage of lower margin products sold during the three and six months ended June 30, 2012 when compared to the same periods in the prior year.

Internationally, gross profit margin decreased to 41.1% and 44.9% for the three and six months ended June 30, 2012, respectively, from 49.3% and 50.8% for the three and six months ended June 30, 2011. The decrease in gross profit margin is primarily the result of lower average sales prices in our French market due to product mix, lower average sales prices in our Italian market resulting from changes in customer mix, with greater sales to larger customers who benefit from discount programs, and lower average sales prices in our German and Japanese markets resulting from the sale of certain of our slow moving and older inventory styles at discounted prices in order to reduce our excess inventories.

 Selling and Marketing Expense

                                        Three Months Ended June 30,           Six Months Ended June 30,
                                                                           \
                                         2012                2011              2012               2011
Selling & Marketing (in thousands)
Domestic                             $         316       $         483     $        820       $        980
International                                1,050               1,572            2,146              2,582
Consolidated                         $       1,366       $       2,055     $      2,966       $      3,562

Domestically, selling and marketing expense, excluding commissions and payroll and payroll related expenses, decreased $84,000 and $97,000, to $46,000 and $223,000 for the three and six months ended June 30, 2012, respectively, from $130,000 and $320,000 for the three and six months ended June 30, 2011, respectively. Consumer marketing and advertising and related costs increased $104,000 and $12,000, from $107,000 and $214,000 for the three and six months ended June 30, 2011, respectively, to $211,000 and $226,000 for the three and six months ended June 30, 2012, respectively. These increases were offset by credits in the amount of $236,000 and $82,000 received during the second quarter of 2012 and 2011, respectively, for unaired purchased television commercial spots.

Internationally, selling and marketing expense, excluding commissions and payroll and payroll related expenses, decreased $263,000 and $248,000, to $475,000 and $801,000 for the three and six months ended June 30, 2012, respectively, from $738,000 and $1.0 million for the three and six months ended June 30, 2011, respectively. Selling and marketing expense, excluding commissions and payroll and payroll related expenses, attributable to our Japanese operations increased $101,000 and $173,000, from $66,000 and $86,000 for the three and six months ended June 30, 2011, respectively, to $167,000 and $259,000 for the three and six months ended June 30, 2012, respectively. These increases are primarily attributable to point-of-sale and consumer advertising related costs to support sales of product during Japan's "Golden Week" holiday period which increased $52,000 and $68,000, from $60,000 for the three and six months ended June 30, 2011, to $112,000 and $128,000 for the three and six months ended June 30, 2012, respectively. The increase in selling and marketing expense, excluding commissions and payroll related expenses, attributable to our Japanese operations was offset by a decrease in selling and marketing expense, excluding commissions and payroll and payroll related expenses, attributable to our EMEA operations, which decreased $364,000 and $409,000, to $307,000 and $535,000 for the three and six months ended June 30, 2012, respectively, from $671,000 and $944,000 for the three and six months ended June 30, 2011, respectively, primarily as a result of a decrease in consumer advertising. Consumer advertising, and related costs, attributable to our EMEA operations decreased $312,000 and $392,000, to $224,000 and $319,000 for the three and six months ended June 30, 2012, respectively, from $536,000 and $711,000 for the three and six months ended June 30, 2011, respectively. During the three months ended June 30, 2012, we incurred approximately $47,000 and $113,000 in advertising, and related costs, in our French and Italian markets, respectively, for our HEELYS-wheeled footwear. The decrease in consumer advertising, and related costs, for the three months ended June 30, 2012, when compared to the same period in the prior year, was primarily the result of increased costs recognized during the three months ended June 30, 2011 due to timing of the holidays which resulted in holiday marketing campaigns shifting from March to April during 2011 due to the later Easter holiday (April 24, 2011) and the school holiday periods immediately following Easter. The decrease in consumer advertising, and related costs, for the six months ended June 30, 2012, when compared to the same period in the prior year was primarily due to a decrease in television commercial advertising related expenses for our HEELYS wheeled-footwear resulting from management's decision to reduce consumer advertising in our German and French markets as a result of decreased consumer demand. These decreases were offset by $30,000 in event marketing related costs incurred during the three months ended March 31, 2012 primarily attributable to marketing of the Blazer Pro and District scooters and accessories and Tony Hawk skateboards, which we began distributing in Europe during the third quarter of 2011.

Domestically, commissions paid to our independent sales representatives decreased $54,000 and $29,000, to $65,000 and $158,000 for the three and six months ended June 30, 2012, respectively, from $119,000 and $187,000 for the three and six months ended June 30, 2011. Internationally, commissions paid to our independent sales representatives decreased $232,000 and $220,000, to $224,000 and $633,000 for the three and six months ended June 30, 2012, respectively, from $456,000 and $853,000 for the three and six months ended June 30, 2011, respectively. Commission expense is impacted by increases and decreases in sales as well as changes in product and customer mix due to differing commission rates paid on those sales.

Payroll and payroll related costs attributable to our domestic operations decreased $29,000 and $34,000, to $205,000 and $439,000 for the three and six months ended June 30, 2012, respectively, from $234,000 and $473,000 for the three and six months ended June 30, 2011, respectively, primarily due to decreases in accrued incentive compensation offset by an increase in recognized stock based compensation costs attributable to restricted stock units awarded in 2012. Payroll and payroll related costs attributable to our international operations decreased $28,000 to $350,000 for the three months ended June 30, 2012, from $378,000 for the three months ended June 30, 2011, primarily as a result of changes in headcount. Payroll and payroll related costs attributable to our international operations increased $32,000 from $680,000 for the six months ended June 30, 2011, to $712,000 for the six months ended June 30, 2012, primarily as a result of the opening of our Japanese subsidiary during the latter part of the first quarter of 2011, offset by changes in headcount.

General and Administrative Expense

                                       Three Months Ended June 30,           Six Months Ended June 30,

                                        2012                2011              2012               2011
General & Administrative (in
thousands)
Domestic                            $         911       $       1,332     $      1,960       $      2,443
International                               1,480               1,384            3,380              2,576
Unallocated                                   172                 207              605                509
Consolidated                        $       2,563       $       2,923     $      5,945       $      5,528

Consolidated general and administrative expenses, excluding unallocated costs, decreased $325,000 to $2.4 million for the three months ended June 30, 2012, from $2.7 million for the three months ended June 30, 2011, and increased $321,000 from $5.0 million for the six months ended June 30, 2011, to $5.3 million for the six months ended June 30, 2012.

General and administrative expense for the three and six months ended June 30, 2012 attributable to our international operations includes $222,000 and $768,000, respectively, in costs incurred in connection with the restructuring of our international operations which we initiated during the first quarter of 2012. These restructuring costs include $457,000 in severance and one-time termination benefit costs ($431,000 of which we recognized during the first quarter of 2012), $92,000 in contract termination costs for each period, $185,000 in other costs ($81,000 of which we recognized during the first quarter of 2012), including, but not limited to, costs to close our office in Belgium, transfer business operations to our French, German and U.S. offices, and repatriate our Vice President, International back to the United States, and $34,000 in fixed asset impairment charges recognized during the first quarter of 2012. These costs are reported as restructuring charges in the statement of operations and are directly attributable to the initiatives we began taking in the first quarter of 2012 to improve efficiency and reduce costs. See Note 3 to our condensed consolidated financial statements for further discussion regarding these initiatives.

Consolidated shipping and handling costs decreased $149,000 to $584,000 for the three months ended June 30, 2012, from $733,000 for the three ended June 30, 2011, and remained consistent at approximately $1.3 million for the six months ended June 30, 2012 and 2011. Shipping and handling costs attributable to our domestic operations decreased $31,000 and $18,000, to $140,000 and $286,000 for the three and six months ended June 30, 2012, from $171,000 and $304,000 for the three and six months ended June 30, 2011, primarily due to a decrease in sales during the three months ended June 30, 2012. Shipping and handling costs attributable to our EMEA operations decreased $105,000 and $29,000, to $377,000 and $833,000 for the three and six months ended June 30, 2012, respectively, from $482,000 and $862,000 for the three and six months ended June 30, 2011, as a result of decreased sales. Shipping and handling costs attributable to our Japanese operations decreased $13,000 to $67,000 for the three months ended June 30, 2012, from $80,000 for the three months ended June 30, 2011, and increased $33,000 from $88,000 for the six months ended June 30, 2011, to $121,000 for the six months ended June 30, 2012. The decrease in shipping and handling costs attributable to our Japanese operations for the three months ended June 30, 2012, when compared to the same period in the prior year, is attributable to costs incurred during the three months ended June 30, 2011 related to the opening of our Japan operations (and third-party warehouse) and were not the result of shipment of goods. The increase in shipping and handling costs attributable to our Japanese operations for the six months ended June 30, 2012, when compared to the same period in the prior year, is a result of increased sales.

Legal and other fees related to our intellectual property and associated enforcement efforts decreased $55,000 and $80,000, to $69,000 and $200,000 for the three and six months ended June 30, 2012, respectively, from $124,000 and $280,000 for the three and six months ended June 30, 2011, respectively, primarily as a result of cost containment efforts by management.

Consolidated payroll and payroll related costs, excluding those employees whose payroll and related costs are included in shipping and handling costs, decreased $66,000 and $53,000, to $857,000 and $1.7 million for the three and six months ended June 30, 2012, respectively, from $923,000 and $1.8 million for the three and six months ended June 30, 2011. Payroll and payroll related costs attributed to our domestic employees decreased $104,000 and $96,000, to $518,000 and $1.1 million for the three and six months ended June 30, 2012, respectively, from $622,000 and $1.2 million for the three and six months ended June 30, 2011, respectively, primarily due to decreases in accrued incentive compensation, offset by an increase in stock based compensation costs attributable to . . .