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SKUL > SEC Filings for SKUL > Form 10-Q on 7-Nov-2012All Recent SEC Filings

Show all filings for SKULLCANDY, INC.

Form 10-Q for SKULLCANDY, INC.


7-Nov-2012

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 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 is a global designer, marketer and distributor of performance audio and gaming headphones and other accessory related products under the Skullcandy, Astro Gaming and 2XL by Skullcandy brands. 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 approximately 80 other countries around the world. We also offer products through our websites, with online sales representing approximately 8.4% and 9.1% of our net sales for the nine months ended September 30, 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.


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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 and the nine months ended September 30, 2012 , Best Buy accounted for more than 10% of our net sales. 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 North America segment primarily consists of Skullcandy and Astro Gaming product sales generated in the United States and Mexico (through our joint venture). The International segment primarily includes Skullcandy product sales generated 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, Astro Gaming and 2XL by Skullcandy brands. Amounts billed to retailers for shipping and handling are included in net sales. Sales are reported net of estimated product returns and pricing adjustments.

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 tables sets forth selected items in our statements of operations
in dollars (in thousands) and as a percentage of net sales and net sales and
gross profit by segment for the periods presented:



                                           Three Months Ended September 30,                      Nine Months Ended September 30,
                                            2012                      2011                      2012                        2011
Net sales                           $ 71,000       100.0 %    $ 60,641       100.0 %    $ 196,716       100.0 %    $ 149,056        100.0 %
Cost of goods sold                    36,886        52.0        31,843        52.5        100,951        51.3         75,144         50.4

Gross profit                          34,114        48.0        28,798        47.5         95,765        48.7         73,912         49.6
Selling, general and
administrative expenses               23,494        33.1        20,571        33.9         71,944        36.6         52,195         35.0

Income from operations                10,620        15.0         8,227        13.6         23,821        12.1         21,717         14.6
Other expense                            219         0.3         1,734         2.9            592         0.3          1,716          1.2
Interest expense                         184         0.3         3,101         5.1            455         0.2          7,389          5.0

Income before income taxes and
noncontrolling interests              10,217        14.4         3,392         5.6         22,774        11.6         12,612          8.5
Income taxes                           3,782         5.3         2,440         4.0          8,391         4.3          6,323          4.2

Net income                          $  6,435         9.1      $    952         1.6      $  14,383         7.3      $   6,289          4.2

Noncontrolling interests                  57         0.1             7         0.0             33         0.0              7          0.0
Preferred dividends                       -           -             -           -              -           -             (17 )        0.0

Net income attributable to
Skullcandy, Inc.                    $  6,492         9.1 %    $    959         1.6 %    $  14,416         7.3 %    $   6,279          4.2 %

                  Three Months Ended September 30,            Nine Months Ended September 30,
                     2012                  2011                 2012                   2011
Net sales
North America   $        57,412       $        56,239     $        167,613       $        144,654
International            13,588                 4,402               29,103                  4,402

Consolidated             71,000                60,641              196,716                149,056
Gross profit
North America            27,182                27,236               80,842                 72,350
International             6,932                 1,562               14,923                  1,562

Consolidated             34,114                28,798               95,765                 73,912

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

Net Sales

Net sales increased $10.4 million, or 17.1%, to $71.0 million for the three months ended September 30, 2012 from $60.6 million for the three months ended September 30, 2011.

North America net sales increased $1.2 million, or 2.1% to $57.4 million from $56.2 million. The increase was primarily driven by increased Astro Gaming sales of $4.7 million. International net sales increased $9.2 million, or 208.7%, to $13.6 million from $4.4 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 believe is allowing us to capture revenue that would otherwise have been earned by 57 North and accelerate our growth in this region. Prior to our acquisition of Kungsbacka 57 AB, we operated in one business segment. As a result, the three months ended September 30, 2012 are not comparable to the three months ended September 30, 2011 as the prior year does not include a full quarter of activity for our direct European Business. Included in the North America segment for the three


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months ended September 30, 2012 and 2011 are net sales of $6.0 million and $10.7 million, respectively, which represent products that were sold from North America to retailers and distributors in other countries. Adjusting for these sales from North America to retailers and distributors in other countries, North America net sales increased 12.9% to $51.4 million from $45.5 million and International net sales increased 29.7% to $19.6 million from $15.1 million. We are in the process of transitioning these international relationships from Skullcandy, Inc. to Skullcandy GmbH, our European subsidiary, as Skullcandy GmbH's warehouses have better geographic locations to serve most of our international customers.

Online net sales, substantially all of which are included in North America net sales, decreased $0.2 million, or 3.8%, to $6.0 million for the three months ended September 30, 2012 from $6.2 million for the three months ended September 30, 2011. An increase in Astro Gaming online net sales was offset by declines in our direct audio consumer business.

Gross Profit

Gross profit increased $5.3 million, or 18.5%, to $34.1 million for the three months ended September 30, 2012 from $28.8 million for the three months ended September 30, 2011. Gross profit as a percentage of net sales, or gross margin, was 48.0% for the three months ended September 30, 2012 compared to 47.5% for the three months ended September 30, 2011. North America gross margin decreased to 47.3% for the three months ended September 30, 2012 from 48.4% for the three months ended September 30, 2011 as a result of a shift in sales mix to higher price point products with lower gross margin structures. The North America gross margin in the third quarter of 2011 was negatively impacted by sales of Astro Gaming inventory that had been recorded at fair value under the acquisition method of accounting. International gross margin increased to 51.0% for the three months ended September 30, 2012 from 35.5% for the three months ended September 30, 2011. We experienced lower gross margins on our direct business in Europe from the date of our Kungsback 57AB 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 $2.9 million, or 14.2 %, to $23.5 million for the three months ended September 30, 2012 from $20.6 million for the three months ended September 30, 2011. Depreciation and amortization expense increased $1.2 million as a result of increased investments for international operational growth, product design, fixtures and the acquisition of certain intangible assets related to our acquisition of the distribution rights in Europe in August 2011. As a percentage of net sales, selling, general and administrative expenses decreased to 33.1% for the three months ended September 30, 2012 from 33.9% for the three months ended September 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 $2.4 million, or 29.1%, to $10.6 million for the three months ended September 30, 2012 from $8.2 million for the three months ended September 30, 2011. Income from operations as a percentage of net sales increased 1.4 percentage points to 15.0% for the three months ended September 30, 2012 from 13.6% for the three months ended September 30, 2011.

Other Expense

Other expense for the three months ended September 30, 2012 consisted of foreign currency remeasurement losses. 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.

Interest Expense

Interest expense decreased $2.9 million to $0.2 million for the three months ended September 30, 2012 from $3.1 million for the three months ended September 30, 2011. Included in interest expense for the three months ended September 30, 2011 was 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. All long-term debt was repaid with the proceeds of our IPO in July 2011, or was converted to common stock. In addition, as of September 30, 2012, there were $5.2 million in borrowings outstanding on the revolving credit facility compared to $14.2 million outstanding as of September 30, 2011.


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Income Taxes

Income taxes were $3.8 million for the three months ended September 30, 2012 compared to $2.4 million for the three months ended September 30, 2011. Our effective tax rate for the three months ended September 30, 2012 and 2011 was 36.8% and 71.8%, 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 and third contingent payments pursuant to the securities purchase and redemption agreement which were not deductible for tax purposes in 2011. 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 $5.5 million to $6.4 million for the three months ended September 30, 2012 from $1.0 million for the three months ended September 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 interests consists of losses from our Mexico joint venture that are attributable to the other partner in the joint venture.

Net Income Attributable to Skullcandy, Inc.

As a result of the factors above, net income attributable to Skullcandy, Inc. was $6.5 million for the three months ended September 30, 2012 compared to $1.0 million for the three months ended September 30, 2011.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Net Sales

Net sales increased $47.7 million, or 32.0%, to $196.7 million for the nine months ended September 30, 2012 from $149.1 million for the nine months ended September 30, 2011.

North America net sales increased $23.0 million, or 13.7% to $167.6 million from $144.7 million. International net sales increased $24.7 million, or 84.9%, to $29.1 million from $4.4 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 believe is allowing us to capture revenue that would otherwise have been earned by 57 North and accelerate our growth in this region. Prior to our acquisition of Kungsbacka 57 AB on August 26, 2011, we operated in one business segment. As a result, the nine months ended September 30, 2012 are not comparable to the nine months ended September 30, 2011 as the prior year does not include a full year of activity for our direct European business. Included in the North America segment for the nine months ended September 30, 2012 and 2011 are net sales of $17.2 and $28.6 million, respectively, which represent products that were sold from North America to retailers and distributors in other countries. Adjusting for these sales from North America to retailers and distributors in other countries, North America net sales increased 29.6% to $150.4 million from $116.1 million and International net sales increased 40.4% to $46.3 million from $33.0 million.

Online net sales, substantially all of which are included in North America net sales, increased $2.9 million, or 21.1%, to $16.5 million for the nine months ended September 30, 2012 from $13.6 million for the three months ended September 30, 2011. The increase in online net sales is primarily due to the acquisition of Astro Gaming, Inc. on April 21, 2011.

Gross Profit

Gross profit increased $21.9 million, or 29.6%, to $95.8 million for the nine months ended September 30, 2012 from $73.9 million for the nine months ended September 30, 2011. Gross margin was 48.7% for the nine months ended September 30, 2012 compared to 49.6% for the nine months ended September 30, 2011. The decrease in North America gross margin to 48.2% for the nine months ended September 30, 2012 from 50.0% for the nine months ended September 30, 2011 is mostly due to a shift in sales mix to higher price point products with lower gross margin structures and lower margin sales to the closeout channel. North America gross margin for the nine months ended September 30, 2011 was negatively impacted by Astro Gaming inventory that had been recorded at fair value under the acquisition method of accounting. The International gross margin increased to 51.3% for the nine months ended September 30, 2012 from 35.5% for the nine months ended September 30, 2011. We experienced lower gross margins on our direct business in Europe from the date of our Kungsback 57AB acquisition 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 $19.7 million, or 37.8%, to $71.9 million for the nine months ended September 30, 2012 from $52.2 million for the nine months ended September 30, 2011. Payroll and benefits expenses increased 40.7%, or $7.9 million, due to an increased employee headcount to support planned growth. Depreciation and amortization expense increased $3.2 million as a result of increased investments for international operational growth, product design, fixtures and the acquisition of certain intangible assets related to our acquisition of the distribution rights in Europe in August 2011. Employee travel related expenses increased $1.2 million due to international expansion and increased employee headcount. As a percentage of net sales, selling, general and administrative expenses increased to 36.6% for the nine months ended September 30, 2012 from 35.0% for the nine months ended September 30, 2011.

Income from Operations

As a result of the factors above, income from operations increased $2.1 million, or 9.7%, to $23.8 million for the nine months ended September 30, 2012 from $21.7 million for the nine months ended September 30, 2011. Income from operations as a percentage of net sales decreased 2.5 percentage points to 12.1% for the nine months ended September 30, 2012 from 14.6% for the nine months ended September 30, 2011.

Other Expense

Other expense for the nine months ended September 30, 2012 primarily consisted of foreign currency remeasurement losses. For the nine 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.

Interest Expense

Interest expense decreased $6.9 million to $0.5 million for the nine months ended September 30, 2012 from $7.4 million for the nine months ended September 30, 2011. Included in interest expense for the nine months ended September 30, 2011 was 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. All long-term debt was repaid with the proceeds of our IPO in July 2011 or was converted to common stock. In addition, as of September 30, 2012 there were $5.2 million in borrowings outstanding on the revolving credit facility compared to $14.2 million outstanding as of September 30, 2011.

Income Taxes

Income taxes were $8.4 million for the nine months ended September 30, 2012 compared to $6.3 million for the nine months ended September 30, 2011. Our effective tax rate for the nine months ended September 30, 2012 and September 30, 2011 was 36.8% and 50.1%, 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 . . .

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