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SKUL > SEC Filings for SKUL > Form 10-Q on 9-May-2013All Recent SEC Filings

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Form 10-Q for SKULLCANDY, INC.


9-May-2013

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 Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission on March 13, 2013.

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 Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission on March 13, 2013, "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.

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 and Dick's Sporting Goods. Skullcandy products are sold in the United States and in approximately 80 other countries around the world.

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.

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. In addition, we rely on Target and Best Buy for a significant portion of our net sales. During the three months ended March 31, 2013, Target and Best Buy each 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 Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission on March 13, 2013 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.


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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 warehousing, warranty costs and depreciation on tooling assets held at our contract manufacturers. 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 table sets forth selected items in our statements of operations in
dollars and as a percentage of net sales for the periods presented:



                                                           Three Months Ended March 31,
                                                        2013                           2012
                                                                  (in thousands)
Net sales                                      $  37,050         100.0 %      $ 53,280         100.0 %
Cost of goods sold                                20,564          55.5          27,665          51.9 %

Gross profit                                      16,486          44.5          25,615          48.1 %
Selling, general and administrative
expenses                                          26,311          71.0          24,131          45.3 %

Income (loss) from operations                     (9,825 )       (26.5 )         1,484           2.8
Other expense (income)                               539           1.5             (48 )        (0.1 )
Interest expense                                     103           0.3             124           0.2

Income (loss) before income taxes and
noncontrolling interests                         (10,467 )       (28.3 )         1,408           2.6
Income tax expense (benefit)                      (3,387 )        (9.1 )           267           0.5

Net income (loss)                              $  (7,080 )       (19.1 )      $  1,141           2.1

Noncontrolling interests                              33           0.1             (24 )          -

Net income attributable to Skullcandy, Inc.    $  (7,047 )       (19.0 )%     $  1,117           2.1 %

Three Months Ended March 31, 2013 Compared to Three Months Ended March 31, 2012

Net Sales

Net sales decreased $16.2 million, or 30.4%, to $37.1 million for the three months ended March 31, 2013 from $53.3 million for the three months ended March 31, 2012.

North America net sales decreased $17.5 million, or 37.9%, to $28.7 million, or 77.4% of our net sales for the three months ended March 31, 2013 from $46.1 million, or 86.6% of our net sales for the three months ended March 31, 2012. The prior year's first quarter was aided by lower retail customer inventory coming out of the holiday season and a packaging change that led to higher sales. Further, the Company chose to scale back its sales to the highly discounted off-price channel with sales reduced by 66.6% for the three months ended March 31, 2013. This decrease was partially offset by an increase in gaming net sales of 43.8%.

International net sales increased $1.3 million, or 17.5%, to $8.4 million, or 22.6% of our net sales for the three months ended March 31, 2013 from $7.1 million, or 13.4% of our net sales for the three months ended March 31, 2012. Included in the North America segment in Q1 2013 and Q1 2012 are net sales of $2.1 million and $3.4 million, respectively, that were sold from North America to customers with a "ship to" location outside of North America. Adjusting these sales into the international segment, international net sales decreased 0.6%.

Gross Profit

Gross profit decreased $9.1 million, or 35.6%, to $16.5 million for the three months ended March 31, 2013 from $25.6 million for the three months ended March 31, 2012. Gross profit as a percentage of net sales, or gross margin, was 44.5% for the three months ended March 31, 2013 compared to 48.1% for the three months ended March 31, 2012. Certain reclassifications have been made to the 2012 balances to conform to the 2013 presentation so as to better reflect where these costs should reside in the statement of operations. For this reason, tooling depreciation and warranty related expenses are being included in cost of goods sold for all comparable periods.

North America gross profit as a percentage of net sales, or gross margin, was 43.5% for the three months ended March 31, 2013 compared to 47.1% for the three months ended March 31, 2012. The decrease in gross margin is primarily due to an increase in tooling depreciation and a write off of $0.8 million of inventory related to end of life products ("EOL").

International gross profit as a percentage of net sales, or gross margin, was 48.1% for the three months ended March 31, 2013 compared to 54.4% for the three months ended March 31, 2012. The decrease in gross margin is primarily due to lower sales to a significant customer in Europe and higher discounts.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $2.2 million, or 9.0%, to $26.3 million for the three months ended March 31, 2013 from $24.1 million for the three months ended March 31, 2012. Selling, general and administrative


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expenses for the three months ended March 31, 2013 include $1.2 million in expenses associated with the departure of our former Chief Executive Officer. During the three months ended March 31, 2013, we recorded a loss of $2.0 million related to disposals of property and equipment for certain EOL products. We expect to continue to make critical investments in the business to support long-term growth. These investments include demand creation efforts for our Crusher product launch, higher operating costs to support our gaming and international expansion. As a percentage of net sales, selling, general and administrative expenses increased 25.0 percentage points to 71.0% for the three months ended March 31, 2013 from 46.0% for the three months ended March 31, 2012. We expect this percentage to decrease in subsequent quarters in 2013.

Income (loss) from Operations

As a result of the factors above, income from operations decreased $11.3 million to ($9.8 million) for the three months ended March 31, 2013 from $1.5 million for the three months ended March 31, 2012. Income from operations as a percentage of net sales decreased to (26.5%) for the three months ended March 31, 2013 from 2.8% for the three months ended March 31, 2012.

Other Expense (Income)

Other expense was $0.5 million for the three months ended March 31, 2013 and related to foreign currency transaction losses. Other income for the three months ended March 31, 2012 was immaterial.

Interest Expense

Interest expense for the three months ended March 31, 2013 was consistent with the interest expense for the three months ended March 31, 2012. Interest expense primarily includes the amortization of deferred financing fees associated with our revolving credit facility.

Income Taxes

The income tax benefit was ($3.4 million) for the three months ended March 31, 2013 compared to income tax expense of $0.3 million for the three months ended March 31, 2012. Our effective tax rate for the three months ended March 31, 2013 and March 31, 2012 was 32.4% and 19.3%, respectively. The Company's effective tax rate differs from the United States federal statutory rate of 35% mostly related to incentive stock options as well as operating in countries that have different statutory rates than the United States. The Company's effective tax rate may fluctuate significantly on a quarterly basis dependent upon the proportionate levels of income in countries with lower statutory rates versus countries with higher statutory rates.

Net Income (Loss)

As a result of the factors above, net loss was $7.1 million for the three months ended March 31, 2013 compared to net income of $1.1 million for the three months ended March 31, 2012.

Noncontrolling Interest

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

Noncontrolling interest for the three months ended March 31, 2013 and 2012 consists of income from our Mexico joint venture that is attributable to the other partner in the joint venture.

Net Income (Loss) Attributable to Skullcandy, Inc.

As a result of the factors above, net income (loss) attributable to Skullcandy, Inc. was ($7.0 million) and $1.1 million for the three months ended March 31, 2013 and 2012, respectively.

Liquidity and Capital Resources

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


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

                                                                      Three Months Ended
                                                                          March 31,
                                                                    2013              2012
Cash and cash equivalents at beginning of period                  $  19,345         $ 23,302
Net cash provided by (used in) operating activities                  14,848           (1,643 )
Net cash used in investing activities                                  (712 )         (1,350 )
Net cash provided by (used in) financing activities                      25           (9,493 )
Effect of exchange rate changes on cash and cash equivalents              8               97

Cash and cash equivalents at end of period                        $  33,514         $ 10,913

Net Cash Provided by (Used in) Operating Activities. Cash from operating activities consists primarily of net income adjusted for certain non-cash items including depreciation and amortization expense, provision for doubtful accounts, deferred income taxes, non-cash interest expense, stock-based compensation expense and the effect of changes in working capital and other activities.

For the three months ended March 31, 2013, net cash provided by operating activities was $14.8 million and consisted of a net loss of $7.1 million plus $1.6 million for non-cash items, plus $20.3 million for working capital and other activities. Working capital and other activities consisted primarily of a decrease in accounts receivable of $41.0 million, a decrease in prepaid expenses and other current assets of $2.0 million, offset by increases in inventory of $9.6 million and decreases in accounts payable of $5.3 million and accrued liabilities of $7.7 million.

For the three months ended March 31, 2012, net cash used in operating activities was $1.6 million and consisted of net income of $1.1 million plus $2.2 million for non-cash items, less $5.0 million for working capital and other activities. Working capital and other activities consisted primarily of a decrease in accounts receivable of $11.3 million, a decrease in prepaid expenses and other current assets of $3.2 million, offset by increases in inventory of $7.1 million and decreases in accounts payable of $1.5 million, income taxes payable of $5.9 million and accrued liabilities of $5.2 million.

Net Cash Used in Investing Activities. Net cash used in investing activities relates to capital expenditures. Net cash used in investing activities was $0.7 million and $1.4 million for the three months ended March 31, 2013 and 2012, respectively.

Net Cash Used in Financing Activities. Net cash provided by financing activities was immaterial for the three months ended March 31, 2013. Net cash used in financing activities was $9.5 million for the three months ended March 31, 2012 and primarily resulted from repayment of revolving credit facility.

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

Indebtedness

On August 31, 2010, we entered into a revolving credit and security agreement, or the credit facility, with PNC Bank and UPS Capital Corporation, as lenders. The credit facility provides for revolving loans and letters of credit of up to $28.8 million (which may be increased to up to $50.0 million upon our request subject to certain conditions) and expires on August 31, 2013. The credit facility is secured by substantially all of our assets. The total amount of available borrowings is subject to limitations based on specified percentages of the value of eligible receivables and inventory. At March 31, 2013, there were no outstanding borrowings and we had $25.6 million of additional availability under the credit facility. We may request up to two increases in the total maximum available amount of the credit facility from the existing lenders, each in an amount not to exceed $10.6 million, such that the aggregate amount of the facility does not exceed $50.0 million. We are required to pay a commitment fee on any unused credit facility commitments at a per annum rate of 0.50%. The credit facility includes restrictions on, among other things, our ability to incur additional indebtedness, pay dividends or make other distributions, make investments, make loans and make capital expenditures, and requires that we maintain a Fixed Charge Coverage Ratio (as defined in the credit facility) of not less than 1.15 to 1.0, measured on a trailing 12-month basis. At March 31, 2013, we were in compliance with all financial covenants.

In October 2011, we entered into a first amendment and waiver to revolving credit and security agreement, or the amendment. The amendment increased the amount of allowable capital expenditures to $6.0 million annually and waived any past non-compliance with the capital expenditure covenant. Under the amendment, we may select from two interest rate


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options for borrowings under the credit facility: (i) Alternate Base Rate (as defined in the credit facility) plus 1.0% or (ii) Eurodollar Rate (as defined in the credit facility) plus 1.5%. The amendment also allows us to enter into foreign currency contracts with the lenders to hedge our foreign currency risk.

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

Contractual obligations

In the three months ended March 31, 2013, there were no material changes to our contractual obligations as discussed in our annual report on Form 10-K for the year ended December 31, 2012.

Off Balance Sheet Arrangements

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

Critical Accounting Policies and Estimates

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

Revenue Recognition and Sales Returns and Allowances

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

Accounts Receivable

Throughout the year, we perform credit evaluations of our retailers and distributors, and we adjust credit limits based on payment history and the retailer's or distributor's current creditworthiness. We continuously monitor our collections and maintain an allowance for doubtful accounts based on our historical experience and any specific customer collection issues that have been identified. The Company records a specific reserve for individual accounts when the Company becomes aware of a customer's likely inability to meet its financial obligations, such as in the case of bankruptcy filings or deterioration in the customer's operating results or financial position. If circumstances related to customer change, the Company would further adjust estimates of the recoverability of receivables. Bad debt expense is reported as a component of selling, general and administrative expenses. Historically, our losses associated with uncollectible accounts have been consistent with our estimates, but there can be no assurance that we will continue to experience the same credit loss rates that we have experienced in the past. Unforeseen, material financial difficulties of our retailers or distributors could have an adverse impact on our profits.

Inventories

We value inventories at the lower of the cost or the current estimated market value of the inventory. Substantially all of our inventory is comprised of finished goods. We regularly review our inventory quantities on hand and adjust inventory values for excess and obsolete inventory based primarily on estimated forecasts of product demand and market value. Demand for our products could fluctuate significantly. The demand for our products could be negatively affected by many factors, including the following:

unanticipated changes in consumer preferences;

weakening economic conditions;

terrorist acts or threats;


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reduced consumer confidence in the retail market; and

unseasonable weather.

Some of these factors could also interrupt the production and importation of our . . .

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