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IFON > SEC Filings for IFON > Form 10-K on 22-Mar-2013All Recent SEC Filings

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Form 10-K for INFOSONICS CORP


22-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Our management's discussion and analysis of financial condition and results of operations should be read in conjunction with our accompanying Consolidated Audited Financial Statements and related notes, as well as the "Risk Factors" and other information contained in this annual report. The discussion is based upon, among other things, our Consolidated Audited Financial Statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires us to, among other things, make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosures of contingent liabilities at the financial statement dates and the reported amounts of revenues and expenses during the reporting periods. We review our estimates and assumptions on an ongoing basis. Our estimates are based on our historical


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experience and other assumptions that we believe to be reasonable under the circumstances. Actual results are likely to differ from those estimates under different assumptions or conditions, but we do not believe such differences will materially affect our financial position or results of operations, although they could. Our critical accounting policies, the policies we believe are most important to the presentation of our financial statements and require the most difficult, subjective and complex judgments, are outlined below in "Critical Accounting Policies." All references to results of operations in this discussion are references to results of continuing operations, unless otherwise noted.

Overview and Recent Developments

We are a provider of wireless handsets (which may be referred to herein as "phones", "cell phones", "mobile phones", "feature phones" and "smartphones") and accessories to carriers, distributors and OEMs in Latin America, Asia Pacific, Europe and Africa. We design, develop, source and sell our proprietary line of products under the verykool® brand and on a private label basis to certain customers (collectively referred to as verykool® products). verykool® products include entry-level, mid-tier and high-end feature phones and Android-based smartphones. We first introduced the verykool® brand in 2006, and have been working to gain brand identity and grow sales. We are now in the midst of a transformation of our company as we move from our former existence as a distributor of phones designed, developed and manufactured by others, to our new business model of designing, manufacturing, sourcing and selling our own verykool® products. During the year ended December 31, 2012, 92% of our sales were comprised of verykool® products and we are now focused on growing our revenue base for these products.

For the past five years, our business has had two primary components: (1) legacy distribution of wireless handsets supplied by major manufacturers, primarily Samsung, and (2) provision of our own proprietary verykool® products that we originally sourced from independent design houses and original design manufacturers ("ODMs"). Our revenue peaked in 2006 when we recorded approximately $241 million of net sales. In 2009, more than 95% of our net sales of approximately $231 million were derived from distribution sales of Samsung product to carriers in Argentina. In late 2009, however, a stiff import tariff on certain electronic devices, including wireless handsets, was enacted in Argentina. The tariff had a significant negative impact on our sales beginning in the first quarter of 2010, and ultimately resulted in a decrease of 69% of our sales volume in 2010 compared to 2009. Then, in February 2011, Argentina enacted a further import regulation effective March 6, 2011 which signaled the closing stage of our distribution business. Our distribution agreement with Samsung was scheduled to expire December 31, 2011 but was extended until March 31, 2012 to accommodate the orderly conclusion of this business. Since April 1, 2012 , our business has and will continue to be centered on our verykool® product line.

Prior to 2010 we sourced all our verykool® phones from independent design houses and ODMs in China. In late 2009, with a desire to improve our time-to-market, better protect our technology and know-how and improve our cost structure, we began to search for an experienced management team to serve as the core for an in-house design team based in Beijing. In April 2010 we recruited a team of very experienced management and technical personnel who now serve as both our design house for all our markets and as the base for marketing and selling our products in Asia-Pacific. This team currently consists of 55 employees, primarily engineers, located in Beijing. The quarter ended June 30, 2010 was the first full quarter of operation of our China subsidiary. Its expenses are classified as R&D expenses on our statement of operations, together with any NRE (non-recurring engineering) expenses paid to other design houses. We shipped our first product designed by our China team to a customer in China in October 2010 and shipped 6 other new models to customers during 2011. Although we expect to continue to use outside design houses to augment the efforts of our China development team, in 2013 we plan to increase the portion of our portfolio of products that are internally designed. All of our manufacturing continues to be done by contract manufacturers in China.

Areas of Management Focus and Performance Indicators

We focus on the needs of our customers, developing and sourcing new and innovative products, fostering close relationships with manufacturers, and expanding our business in our current markets and entering into new


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geographic markets, all while maintaining close attention to operational efficiencies and costs. We are particularly focused on increasing sales volumes of higher margin proprietary products in a cost effective manner to enable us to return to profitability, as well as monitoring and managing levels of accounts receivable and inventory to minimize risk. Performance indicators that are important for the monitoring and management of our business include top line sales growth, cost of sales and gross margin percentage, operating expenses in absolute dollars and as a percent of revenues and operating and net income
(loss). We rely upon our in-house software management system to exercise real-time control over many elements of our business including customer relationship management, purchasing, inventory management and control, sales order control and pricing management.

Management and employees spend a significant amount of time traveling to Latin America and Asia Pacific with the purpose of spending time with our key customers, suppliers, our Beijing design team and other contractors and employees. We believe that these relationships are vital to our success and we will continue to dedicate a significant amount of time to this area.

Critical Accounting Policies and Estimates

Critical accounting policies are those policies that, in management's view, are most important in the portrayal of our financial condition and results of operations. The notes to our consolidated Financial Statements also include disclosure of significant accounting policies. The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on the condition and results that we report in our financial statements. These critical accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates and assumptions regarding matters that are inherently uncertain. Our critical accounting policies and estimates and assumptions that require the most significant judgment are discussed further below.

Revenue Recognition and Allowance for Returns

Revenues for wireless handset and accessory sales are recognized when
(i) shipment of the products to customers has occurred and title has passed,
(ii) when collection of the outstanding receivables is probable and (iii) the final price of the products is determined, which occurs at the time of shipment. Sales are recorded net of discounts, rebates, cooperative marketing arrangements, returns and allowances. On select sales, we may agree to cooperative arrangements wherein we agree to fund future marketing programs related to the products purchased by the customer. Such arrangements are usually agreed to in advance. The amount of the co-op allowance is recorded as a reduction of the sale and added to accrued expenses as a current liability. Subsequent expenditures made pursuant to the arrangements reduce this liability. To the extent we incur costs in excess of the established cooperative fund, we recognize the amount as a selling or marketing expense. As part of the sales process, we may perform certain value-added services such as programming, software loading and quality assurance testing. These value-added services are considered an ancillary component of the sales process and amounts attributable to these processes are included in the unit cost to the customer. Furthermore, these value-added services are related to services prior to the shipment of the products, and no value-added services are provided after delivery of the products. We recognize as a reserve against the related receivables estimates for product returns based on historical experience and other judgmental factors, evaluate these estimates on an ongoing basis and adjust our estimates each period based on actual product return activity. We recognize freight costs billed to our customers in sales and actual freight costs incurred as a component of cost of sales.

Allowance for Doubtful Accounts

We provide for the possible inability to collect accounts receivable by recording an allowance for doubtful accounts. We evaluate the collectability of our accounts receivable on an ongoing basis. In circumstances where we are aware of a specific customer's inability to meet its financial obligations, we record a specific allowance against amounts due in order to reduce the net recognized receivable to the amount we reasonably believe will be


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collected, after consideration for accounts receivable insurance coverage we may have. For all other customers, we recognize allowances for doubtful accounts based on the length of time the receivables are past due, the current business environment and our historical experience.

Inventory Reserves

We regularly monitor inventory quantities on hand and record a provision for excess, slow moving and obsolete inventories based primarily on historical usage rates and our estimated forecast of product demand and expected pricing. We attempt to tightly control our inventory levels and in the recent past have moved more to a build-to-order model. However, because we need to place non-cancelable orders with our contract manufacturers with a lead time of 30 to 60 days, and because we may not have a confirmed customer purchase order in hand as quickly as we would like to, we sometimes take inventory risk. As our products get closer to end-of-life status, we are more strict about our build-to-order policy in order to limit our inventory exposure on older product.

Results of Operations:

The following table sets forth certain items from our consolidated statements of operations and comprehensive loss as a percentage of net sales for the periods indicated:

                                                        2012         2011         2010
 Net sales                                               100.0 %      100.0 %      100.0 %
 Cost of sales                                            80.2 %       87.0 %       93.4 %

 Gross profit                                             19.8 %       13.0 %        6.6 %

 Operating expenses:
 Selling, general and administrative                      20.6 %       15.7 %       10.8 %
 Research and development                                  6.5 %        4.5 %        1.3 %

                                                          27.1 %       20.2 %       12.1 %

 Operating loss from continuing operations                -7.3 %       -7.2 %       -5.5 %
 Other income (expense):
 Interest income (expense), net                            0.2 %        0.0 %        0.0 %
 Other income (expense), net                              -0.2 %        0.1 %        0.0 %

 Loss from continuing operations before income taxes      -7.3 %       -7.1 %       -5.5 %
 Benefit (provision) for income taxes                      0.0 %        0.0 %        0.5 %

 Loss from continuing operations                          -7.3 %       -7.1 %       -5.0 %
 Income from discontinued operations, net of tax           0.0 %        0.0 %        0.1 %

 Net loss                                                 -7.3 %       -7.1 %       -4.9 %

We do not believe that inflation had a significant impact on our results of operations for the periods reported in our Consolidated Audited Financial Statements.

Year Ended December 31, 2012 Compared With Year Ended December 31, 2011

Net Sales

For the year ended December 31, 2012, our net sales of $34.3 million decreased by $0.6 million, or 1.7%, compared to net sales of $34.9 million in 2011. The significant decrease in our distribution business from 2011 to 2012 was almost entirely offset by the increase in sales of our branded verykool®products. Our Samsung distribution business ended March 31, 2012 as a consequence of a stiff import tariff on certain electronic devices, including wireless handsets, that was enacted in Argentina in November 2009 and an additional import regulation which became effective in March 2011. These protective import actions began to negatively affect our sales beginning in the first quarter of 2010, accelerated through 2010 and continued through the end of 2011. In 2012,


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our Samsung distribution sales declined by $10.7 million, or 81%, to $2.5 million from $13.2 million in 2011. Nearly offsetting this decline was an increase in sales of our branded verykool® products of $10.1 million, or 47.3%, to $31.6 million from $21.4 million in 2011.This represented a record year for sales of verykool® products, both in terms of dollar value and units sold.

Cost of Sales, Gross Profit and Gross Margin



                                     For the Year
                                  Ended December 31,                 Increase
                              2012                   2011           (Decrease)
                             (Dollar amounts in thousands)
         Net sales       $        34,294         $      34,884             (1.7 %)
         Cost of sales            27,488                30,344             (9.4 %)

         Gross profit    $         6,806         $       4,540             49.9 %

         Gross margin               19.8 %                13.0 %           52.3 %

For the year ended December 31, 2012, cost of sales was $27.5 million, 80.2% of net sales, and gross margin was 19.8%, compared to cost of sales of $30.3 million, 87.0% of net sales, and a 13.0% gross margin for the year ended December 31, 2011. In 2012, our gross profit amounted to $6.8 million, an increase of 49.9% from $4.5 million in 2011. The significant improvements in both our gross profit and our gross margin percentage are primarily a result of the shift in the mix of sales to a lower concentration of distribution sales and a higher concentration of branded sales incident to the expiration of our distribution agreement with Samsung. Sales of our verykool®branded products typically result in higher gross margins than our distribution sales. In 2011, distribution sales comprised 38% of total revenues, with 62% represented by branded sales. In 2012, distribution sales fell to 8% of total revenues, with 92% coming from sales of branded verykool® products.

Operating Expenses and Operating Loss from Continuing Operations

For the year ended December 31, 2012, operating expenses of $9.3 million increased by $2.2 million, or 31.5%, from $7.1 million in 2011. Selling, general and administrative ("SG&A") expenses increased by $1.6 million and R&D spending increased by $0.6 million. The increased SG&A expenses include increases in the following areas: personnel additions in the sales, logistics and service departments, sales commissions on increased sales of verykool® branded products, marketing, homologation and an isolated bad debt recorded in the first quarter of 2012. The increased R&D expenses are primarily the result of increased headcount during the second half of 2012 to enable the contemporaneous development of a number of new smartphone models. In December 2012, as these developments drew to a close, we finalized a plan to eliminate the headcount redundancies in the first quarter of 2013 and restructure our China workforce. Severance costs for the terminated employees of $100,000 were recorded in the fourth quarter of 2012 and are also included in R&D expense for the year.

For the year ended December 31, 2012, we sustained an operating loss from continuing operations of $2.5 million, equal to the operating loss of $2.5 million for the year ended December 31, 2011. The $2.2 million increase in gross profit in 2012 was offset by the $2.2 million increase in operating expenses. We expect that the restructuring in China noted above will result in an annual savings of $600,000 per year once it is completed in the first quarter of 2013.

Interest Expense and Other Income

During the year ended December 31, 2012, other income (expense) included $72,000 of expense comprised of $48,000 of foreign exchange losses and a $24,000 loss on disposal of fixed assets. We also recorded $61,000 of interest income primarily related to financed customer receivables. In 2011 we had $30,000 of other income, consisting primarily of gain on sale of fixed assets, and $11,000 of interest income on a tax refund.


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Net Loss

Because other income (expense) in both 2012 and 2011 were minimal, our net losses in both years were substantially equivalent to the losses from continuing operations for the respective years.

Year Ended December 31, 2011 Compared With Year Ended December 31, 2010

Net Sales

For the year ended December 31, 2011, our net sales of $34.9 million decreased by $37.6 million, or 51.9%, compared to net sales of $72.5 million in 2010. The significant decline was primarily the continued effect of a stiff import tariff on certain electronic devices, including wireless handsets, that was enacted in Argentina in November 2009 and an additional import regulation which became effective in March 2011. These protective import actions began to negatively affect our sales beginning in the first quarter of 2010, accelerated through 2010 and continued through the end of 2011. In 2011, our Samsung distribution sales declined by $47.8 million, or 78%, to $13.2 million from $61.0 million in 2010. Partially offsetting this decline was an increase in sales of our branded verykool® products of $10.2 million, or 90.3%, to $21.4 million from $11.3 million in 2010.

Cost of Sales, Gross Profit and Gross Margin



                                    For the Year
                                 Ended December 31,                  Increase
                             2011                   2010            (Decrease)
                            (Dollar amounts in thousands)
        Net sales       $        34,884         $      72,530             (51.9 %)
        Cost of sales            30,344                67,734             (55.2 %)

        Gross profit    $         4,540         $       4,796              (5.3 %)

        Gross margin               13.0 %                 6.6 %            97.0 %

For the year ended December 31, 2011, cost of sales was $30.3 million, 87.0% of net sales, and gross margin was 13.0%, compared to cost of sales of $67.7 million, 93.4% of net sales, and a 6.6% gross margin for the year ended December 31, 2010. In 2011, our gross profit amounted to $4.5 million, a decrease of 5.3% from $4.8 million in 2010. The dramatic improvement in our gross margin is largely a result of the shift in the mix of sales to a lower concentration of distribution sales and a higher concentration of branded sales. Sales of our verykool® branded products typically result in higher gross margins than our distribution sales. In 2010, distribution sales comprised 84% of total revenues, with only 16% represented by branded sales. In 2011, distribution sales fell to 38% of total revenues, with 62% coming from branded sales.

Operating Expenses and Operating Loss from Continuing Operations

For the year ended December 31, 2011, operating expenses of $7.1 million decreased by $1.7 million, or 19.9%, from $8.8 million in 2010. Selling, general and administrative ("SG&A") expenses declined by $2.3 million, but this reduction was partially offset by an increase in R&D spending of $0.6 million related to our new development team in Beijing that was established in April 2010 to focus on our verykool® products. The majority of the SG&A decrease was related to reduction of expenses that were variable with sales volume, which decreased 52% in 2011 compared to 2010. Although we made reductions in other expenses as well, such reductions were not proportionate to the decline in sales. We significantly reduced marketing and legal expenses in 2011 compared to 2010 and reduced occupancy expenses through the closure of our Miami distribution center in March 2011. As a percentage of net sales, total operating expenses increased to 20.2% in 2011 compared to 12.1% in 2010, primarily due to the reasons outlined above.

For the year ended December 31, 2011, we sustained an operating loss from continuing operations of $2.5 million compared to an operating loss of $4.0 million for the year ended December 31, 2010. The 38% reduction in the operating loss in 2011 was achieved despite a 52% reduction in net sales. We generated slightly less gross profit, more than doubled our gross profit margin percentage and reduced operating expenses.


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Interest Expense and Other Income

During the year ended December 31, 2011, we had no bank borrowings and consequently no interest expense. Interest expense in 2010 of $23,000 related to borrowings under our bank revolving line of credit in the first half of the year. The line of credit was terminated on September 22, 2010. In 2011 we had $11,000 of interest income on a tax refund and $30,000 of other income consisting primarily of gain on sale of fixed assets.

Loss from Continuing Operations

For the year ended December 31, 2011, we sustained a loss from continuing operations of $2.5 million compared to a loss of $3.6 million in 2010. The 2010 loss from continuing operations benefited from a tax refund of $423,000 from the carry back of net operating losses in 2007 and 2008 to prior years.

Income (Loss) from Discontinued Operations

During the second quarter of 2008, we assessed opportunities in the United States and Mexico and decided to implement actions necessary to close sales operations in both of those countries, which we substantially completed in the second half of 2009, although we generated $44,000 in income from discontinued operations during 2010 from the salvage sale of remaining inventories. The discontinuation was completed in 2011 without any further income or loss.

Net Loss

Because the results of discontinued operations in both 2011 and 2010 were minimal, our net losses in both years were substantially equivalent to the losses from continuing operations for the respective years.

Financial Condition, Liquidity and Capital Resources

Historically, we have used cash from our sale of products and lines of credit (bank and vendor) to provide the capital needed to support our business. In late 2011 we added a new foreign exchange ("FX") hedging facility with our bank as a tool to hedge our exposure to changes in certain foreign currency exchange rates. We electively terminated this facility in the first quarter of 2013 and the restricted cash supporting it was returned to our general cash reserves.

The primary drivers affecting our cash and liquidity are net income (losses) and working capital requirements. Capital equipment is not significant in our business, and at December 31, 2012 we did not have any material commitments for capital expenditures. Our largest working capital requirement is for accounts receivable, and, to a lesser extent, inventory, as we strive to minimize our inventory levels. We typically bill customers on an open account basis subject to our standard credit quality and payment terms ranging between net 30 and net 60 days. If our net revenue increases, it is likely that our accounts receivable balance will also increase. Our accounts receivable could further increase if customers delay their payments or if we grant them extended payment terms.

As of December 31, 2012, we had $6.2 million of cash, cash equivalents and restricted cash and $16.3 million of working capital compared to $12.4 million of cash, cash equivalents and restricted cash and $18.6 million of working capital as of December 31, 2011. As of December 31, 2012 and 2011, we had no bank debt.

As of December 31, 2012, cash and cash equivalents consisted of cash on hand and in bank accounts.

Operating Activities

Net cash used by operating activities for the year ended December 31, 2012 amounted to $5.9 million compared to $0.1 million of cash provided by operations for the year ended December 31, 2011. Although the net


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loss of $2.5 million in 2012 was equal to the $2.5 million loss in 2011, our business contracted significantly in 2011 compared to 2010 and the reduction in receivables in 2011 was the largest factor in the stabilization of cash that year.

In 2012, we used $4.4 million of cash to fund our net working capital requirements. This included a $1.9 million increase in trade accounts receivable, reflecting a larger share of our fourth quarter sales to carrier customers who traditionally pay slower on purchases they make during the holiday season. Days sales outstanding in receivables at December 31, 2011 was 109 days, which was significantly greater than the 65 days at December 31, 2011. We also used $1.4 million to increase our inventory levels, although this was partially offset by a $1.1 million reduction in prepaid inventories. An additional $1.9 million was used to reduce payables and accruals and $0.3 million for other assets.

In 2011, we generated $1.6 million of positive cash flow from a reduction in net working capital. This consisted primarily of a $3.7 million reduction in trade accounts receivable, reflecting the 51.9% drop in annual revenue for the year, and $0.5 million from a reduction in other receivables. Days sales outstanding in receivables at December 31, 2011 was 65 days, which was a significant . . .

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