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SKUL > SEC Filings for SKUL > Form 10-Q on 6-Nov-2013All Recent SEC Filings

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Form 10-Q for SKULLCANDY, INC.


6-Nov-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, Inc., a Delaware corporation (the "Company"), is the original lifestyle and performance audio brand inspired by the creativity and irreverence of youth culture. Skullcandy designs, markets and distributes audio and gaming headphones and other accessory related products under the Skullcandy, Astro Gaming and 2XL by Skullcandy brands. Skullcandy was launched in 2003 and quickly became one of the world's most distinct audio brands by bringing unique technology, color, character and performance to an otherwise monochromatic space; helping to revolutionize the audio arena by introducing headphones, earbuds and other audio and wireless lifestyle products that possess unmistakable style and exceptional performance. Our products are sold and distributed through a variety of channels in the U.S. and approximately 80 countries worldwide.
Our net sales are derived primarily from the sale of audio and gaming headphones and other accessory related products. 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, sporting goods and mobile phone retailers including Best Buy, Target and Dick's Sporting Goods. 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, Canada and Mexico (through our joint venture). The International segment primarily includes Skullcandy and Astro Gaming 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 audio and gaming headphones and other accessory related products under the Skullcandy, Astro Gaming and 2XL by Skullcandy brands. Amounts billed to retailers and distributors for shipping and handling are included in net sales. Sales are reported net of estimated product returns and pricing adjustments.


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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.
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, 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.
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 September 30,                  Nine Months Ended September 30,
                                 2013                    2012                     2013                     2012
Net sales                $ 50,004     100.0  %   $ 71,000     100.0  %   $ 137,843     100.0  %   $ 196,716     100.0  %
Cost of goods sold         27,573      55.1  %     37,315      52.6  %      76,141      55.2  %     102,208      52.0  %
Gross profit               22,431      44.9  %     33,685      47.4  %      61,702      44.8  %      94,508      48.0  %
Selling, general and
administrative
expenses                   21,917      43.8  %     23,065      32.5  %      72,179      52.4  %      70,687      35.9  %
Income (loss) from
operations                    514       1.0  %     10,620      15.0  %     (10,477 )    (7.6 )%      23,821      12.1  %
Other expense (income)        153       0.3  %        219       0.3  %         443       0.3  %         592       0.3  %
Interest expense              125       0.2  %        184       0.3  %         339       0.2  %         455       0.2  %
Income (loss) before
income taxes and
noncontrolling
interests                     236       0.5  %     10,217      14.4  %     (11,259 )    (8.2 )%      22,774      11.6  %
Income tax expense
(benefit)                    (842 )    (1.7 )%      3,782       5.3  %      (4,568 )    (3.3 )%       8,391       4.3  %
Net income (loss)           1,078       2.2  %      6,435       9.1  %      (6,691 )    (4.9 )%      14,383       7.3  %
Net income (loss)
attributable to
noncontrolling
interests                       1         -  %        (57 )    (0.1 )%         (86 )    (0.1 )%         (33 )       -  %
Net income (loss)
attributable to
Skullcandy, Inc.         $  1,077       2.2  %   $  6,492       9.1  %   $  (6,605 )    (4.8 )%   $  14,416       7.3  %

Three Months Ended September 30, 2013 Compared to Three Months Ended September 30, 2012
Net Sales
Net sales decreased $21.0 million, or 29.6%, to $50.0 million for the three months ended September 30, 2013 from $71.0 million for the three months ended September 30, 2012.
North America net sales decreased $22.6 million, or 39.4%, to $34.8 million, or 69.6% of our net sales for the three months ended September 30, 2013 from $57.4 million, or 80.9% of our net sales for the three months ended September 30, 2012. Contributing to the decrease in net sales is increased competition in the audio and gaming headphone markets. Additionally contributing to the decrease, and consistent with the strategy stated in previous quarters, we continued to scale back our sales to the off-price channel, which were down approximately $4.4 million, or 74.6%, compared with the three months ended September 30, 2012. We expect sales to the off-price channel to continue to be down more than 50% in the fourth quarter of 2013. There was also a decrease in net sales of $2.2 million as a result of the transition to a direct distribution model in Canada. We also actively stopped selling products to certain retailers and distributors that were violating our policies on minimum advertised prices which further contributed to the decrease in net sales.


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International net sales increased $1.6 million, or 11.9%, to $15.2 million, or 30.4% of our net sales for the three months ended September 30, 2013 from $13.6 million, or 19.1% of our net sales for the three months ended September 30, 2012. Included in the North America segment in the three months ended September 30, 2013 and 2012 are net sales of $0.9 million and $3.0 million, respectively, that were sold from the United States to customers with a "ship to" location outside of North America. Including these sales in the international segment, international net sales decreased 2.5%, and North America net sales decreased 37.8%.
Gross Profit
Gross profit decreased $11.3 million, or 33.4%, to $22.4 million for the three months ended September 30, 2013 from $33.7 million for the three months ended September 30, 2012. Gross margin was 44.9% for the three months ended September 30, 2013 compared to 47.4% for the three months ended September 30, 2012. North America gross margin was 43.4% for the three months ended September 30, 2013 compared to 46.6% for the three months ended September 30, 2012. International gross margin was 48.1% for the three months ended September 30, 2013 compared to 51.0% for the three months ended September 30, 2012. The decrease in gross margin was primarily attributable to increased allowances to the Company's retail customers and a shift to a lower margin product mix. 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.
Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses decreased $1.1 million, or 5.0%, to $21.9 million for the three months ended September 30, 2013 from $23.1 million for three months ended September 30, 2012. SG&A expenses in the third quarter of 2013 include $1.0 million in costs related to the closure of the San Clemente, California office. These costs include certain termination benefits, charges associated with subleasing the former office space, and the relocation of the marketing, creative, business development and legal departments, as well as certain sales and international personnel to the Company's headquarters in Park City, Utah. The Company continues to invest in marketing and demand creation efforts with an increase in expenses of $0.3 million compared to the same quarter of the prior year.
As a percentage of net sales, selling, general and administrative expenses increased 11.3% to 43.8% for the three months ended September 30, 2013 from 32.5% for the three months ended September 30, 2012. The increase in percentage was primarily due to lower net sales.
We expect to continue to make critical investments in the business to support long-term growth. These investments include demand creation efforts including point of sale merchandising, media campaigns and higher operating costs to support our gaming and international expansion. Income from Operations
As a result of the factors above, income from operations decreased $10.1 million to $0.5 million for the three months ended September 30, 2013 from $10.6 million for the three months ended September 30, 2012. Income from operations as a percentage of net sales decreased to 1.0% for the three months ended September 30, 2013 from 15.0% for the three months ended September 30, 2012. Other Expense
Other expense was $0.2 million for the three months ended September 30, 2013 which was related to foreign currency transaction losses.


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Interest Expense
Interest expense for the three months ended September 30, 2013 was consistent with interest expense for the three months ended September 30, 2012. Interest expense primarily includes the amortization of deferred financing fees and unused line fees associated with our credit facility. Income Taxes
The income tax benefit was $0.8 million for the three months ended September 30, 2013 compared to income tax expense of $3.8 million for the three months ended September 30, 2012. Our effective tax rate for the three months ended September 30, 2013 and September 30, 2012 was (358.3)% and 36.8%, respectively. During the three months ended September 30, 2013, we recorded a tax benefit primarily related to the stock option exchange program. The modification of our incentive stock options ("ISO's") caused the disqualification of the awards as ISO's. If ISO status is disallowed because of a disqualifying modification, then the award is treated as if it had been a non-qualified option since inception. As a result, a deferred tax benefit is recorded for all compensation cost recognized for the award through the modification date. During the three months ended September 30, 2013, a tax effected $1 million deferred tax benefit was recorded for the amount of ISO compensation expense previously recognized. Our 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
As a result of the factors above, net income was $1.1 million for the three months ended September 30, 2013 compared to net income of $6.4 million for the three months ended September 30, 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 September 30, 2013 and 2012 consists of income (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 $1.1 million and $6.5 million for the three months ended September 30, 2013 and 2012, respectively.
Nine Months Ended September 30, 2013 Compared to Nine Months Ended September 30, 2012
Net Sales
Net sales decreased $58.9 million, or 29.9%, to $137.8 million for the nine months ended September 30, 2013 from $196.7 million for the nine months ended September 30, 2012.
North America net sales decreased $65.1 million, or 38.9%, to $102.5 million, or 74.3% of our net sales for the nine months ended September 30, 2013 from $167.6 million, or 85.2% of our net sales for the nine months ended September 30, 2012. Contributing to the decrease in net sales is increased competition in the audio and gaming headphone markets. Additionally contributing to the decrease, and consistent with the strategy stated in previous quarters, we continued to scale back our sales to the off-price channel, which were down approximately $9.9 million, or 61.1%, compared with the nine months ended September 30, 2012. There was also a decrease in net sales of $5.1 million as a result of the transition to a direct distribution model in Canada. In addition, we stopped selling products to certain retailers and distributors that were violating our policies on minimum advertised prices.
International net sales increased $6.3 million, or 21.6%, to $35.4 million, or 25.7% of our net sales for the nine months ended September 30, 2013 from $29.1 million, or 14.8% of our net sales for the nine months ended September 30, 2012. Included in the North America segment in 2013 and 2012 are net sales of $4.9 million and $11.2 million, respectively, that were sold from the United States to customers with a "ship to" location outside of North America. Including these sales in the international segment, international net sales were relatively flat, and North America net sales decreased 37.6%. Gross Profit


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Gross profit decreased $32.8 million, or 35%, to $61.7 million for the nine months ended September 30, 2013 from $94.5 million for the nine months ended September 30, 2012. Gross margin was 44.8% for the nine months ended September 30, 2013 compared to 48.0% for the nine months ended September 30, 2012. North America gross margin was 43.8% for the nine months ended September 30, 2013 compared to 47.5% for the nine months ended September 30, 2012. International gross margin was 47.6% for the nine months ended September 30, 2013 compared to 51.3% for the nine months ended September 30, 2012. The decrease in gross margin was primarily attributable to increased allowances to the Company's retail customers and a shift to a lower margin product mix. Gross margin was also negatively impacted by certain sales allowances associated with the transition to a direct sales model in Canada and higher raw material costs. In addition, there was a write-off of $0.8 million of inventory related to end of life, or EOL, products that contributed to the decline in gross margin.
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.
Selling, General and Administrative Expenses Selling, general and administrative expenses increased $1.5 million, or 2.1%, to $72.2 million for the nine months ended September 30, 2013 from $70.7 million for nine months ended September 30, 2012. Selling, general and administrative expenses for the nine months ended September 30, 2013 includes $1.2 million in expenses associated with the departure of our former chief executive officer. We also recorded a loss of $2.0 million related to disposals of property and equipment for certain EOL products. Additionally, we recorded $2.1 million in costs related to the closure of the San Clemente, California office. These increases were offset by our cost control initiatives which included a reduction in travel related expenses of $1.4 million.
As a percentage of net sales, selling, general and administrative expenses increased 16.5% to 52.4% for the nine months ended September 30, 2013 from 35.9% for the nine months ended September 30, 2012. The increase in percentage was primarily due to lower net sales.
Income (loss) from Operations
As a result of the factors above, income (loss) from operations decreased $34.3 million to $(10.5) million for the nine months ended September 30, 2013 from $23.8 million for the nine months ended September 30, 2012. Income (loss) from operations as a percentage of net sales decreased to (7.6)% for the nine months ended September 30, 2013 from 12.1% for the nine months ended September 30, 2012.
Other Expense
Other expense was comparable for the nine months ended September 30, 2013 and 2012, and related to foreign currency transaction losses. Interest Expense
Interest expense for the nine months ended September 30, 2013 was consistent with interest expense for the nine months ended September 30, 2012. Interest expense primarily includes the amortization of deferred financing fees and unused line fees associated with our credit facility. Income Taxes
The income tax benefit was $4.6 million for the nine months ended September 30, 2013 compared to income tax expense of $8.4 million for the nine months ended September 30, 2012. Our effective tax rate for the nine months ended September 30, 2013 and September 30, 2012 was 40.9% and 36.8%, respectively. Our effective tax rate differs from the United States federal statutory rate of 35% mostly due to the effect on the provision for income tax expense due to the accounting treatment of the stock option exchange completed during the quarter ended September 30, 2013. Our 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.


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Net Income (Loss)
As a result of the factors above, net loss was $6.7 million for the nine months ended September 30, 2013 compared to net income of $14.4 million for the nine months ended September 30, 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 nine months ended September 30, 2013 and 2012 consists of income (losses) 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 $(6.6) million and $14.4 million for the nine months ended September 30, 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 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.
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):

                                                        Nine Months Ended September 30,
                                                           2013                 2012
Cash and cash equivalents at beginning of period    $        19,345       $        23,302
Net cash provided by (used in) operating activities          18,773               (11,278 )
Net cash used in investing activities                        (3,434 )              (7,796 )
Net cash used in financing activities                          (134 )              (2,404 )
Effect of exchange rate changes on cash and cash
equivalents                                                     147                    74
Cash and cash equivalents at end of period          $        34,697       $         1,898

Net Cash Provided by (Used in) Operating Activities. Cash from operating activities consists primarily of net income (loss) adjusted for certain non-cash items including depreciation and amortization expense, loss on disposal of property and equipment, 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 nine months ended September 30, 2013, net cash provided by operating activities was $18.8 million and consisted of a net loss of $6.7 million, plus $10.4 million of non-cash items, plus $15.1 million of working capital and other activities. Working capital and other activities consisted primarily of a decrease in accounts receivable of $34.2 million, a decrease in prepaid expenses and other current assets of $1.6 million, offset by an increase in inventory of $7.2 million and a decrease in accounts payable of $6.1 million and accrued liabilities of $7.4 million.
For the nine months ended September 30, 2012, net cash used in operating activities was $11.3 million and consisted of net income of $14.4 million plus $9.4 million of non-cash items, less $35.1 million of working capital and other activities. Working capital and other activities consisted primarily of a decrease in prepaid expenses and other current assets of $2.5 million, offset by increases in accounts receivable of $10.9 million, inventory of $11.4 million and decreases in accounts payable of $9.0 million, income taxes payable of $1.2 million and accrued liabilities of $5.1 million.
Net Cash Used in Investing Activities. Net cash used in investing activities relates to capital expenditures. Net cash used in investing activities was $3.4 million and $7.8 million for the nine months ended September 30, 2013 and 2012, respectively.


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Net Cash Used in Financing Activities. Net cash provided by financing activities was immaterial for the nine months ended September 30, 2013. For the nine months ended September 30, 2012, net cash used in financing activities was $2.4 million, which consisted of net repayments on the bank line of credit of $4.7 million offset by $1.8 million in proceeds from the exercise of stock options and a tax benefit of $0.5 million.
We believe that our cash, cash flow from operating activities and available borrowings under our credit facility will be sufficient to meet our capital requirements for at least the next twelve months. Indebtedness
On August 19, 2013, we entered into a new credit agreement and revolving line of credit, or the credit facility, with Wells Fargo Bank, National Association, as lender, which provides a line of credit of up to $50 million. As a subfeature, the credit facility provides for letters of credit up to $10.0 million. The credit facility is secured with a first-priority lien against substantially all of our Company assets.
The credit facility requires us to be in compliance with specified affirmative financial covenants, including (a) total liabilities divided by tangible net worth not greater than 1.5 to 1.0 as of the last day of each fiscal quarter; (b) asset ratio not less than 1.35 to 1.00 as of the last day of each fiscal quarter; (c) net income attributable to the Company, measured on a rolling 4-quarter basis for each fiscal quarter set forth in the table below, determined as of the last day of each such fiscal quarter, not less than the amount set forth opposite the relevant fiscal quarter: . . .

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