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SKUL > SEC Filings for SKUL > Form 10-Q on 9-May-2014All Recent SEC Filings

Show all filings for SKULLCANDY, INC.

Form 10-Q for SKULLCANDY, INC.


9-May-2014

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, 2013 filed with the Securities and Exchange Commission on March 14, 2014. 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, 2013 filed with the Securities and Exchange Commission on March 14, 2014, "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
We are the original performance and lifestyle audio brand inspired by the creativity and irreverence of youth culture. We design, market and distribute audio and gaming headphones, earbuds, speakers and other accessories under the Skullcandy, Astro Gaming and 2XL by Skullcandy brands. We launched in 2003 and quickly became an international audio brand by bringing innovation, bold color, character and performance to an otherwise monochromatic audio space. Our products are sold and distributed through a variety of channels in the U.S. and approximately 80 countries worldwide. We offer a wide array of styles and price points and are expanding into complementary audio products and categories such as sports performance, women's and wireless offerings, as well as partnerships with leading manufacturers to license our brand and enhance audio quality. We pioneered the distribution of headphones in specialty retailers focused on action sports and the youth lifestyle, such as Tilly's, Zumiez 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 leading consumer electronics, sporting goods, mobile phone and big box retailers such as Best Buy, Dick's Sporting Goods, AT&T Wireless and Target.
We also produce and market gaming headphones. We acquired Astro Gaming in April 2011 as part of our strategy to position ourselves in the premium end of the gaming category with a leading, authentic brand. Astro Gaming is based in San Francisco, California and develops and markets high-performance, feature-rich products to dedicated gamers, through both the direct-to-consumer channel and through a growing global network of retailers.
We were incorporated in Delaware in 2003. Our principal executive offices are located at 1441 West Ute Boulevard, Suite 250, Park City, Utah 84098, and our telephone number is (435) 940-1545. Our principal website address


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is www.skullcandy.com. Information contained on our website does not constitute part of, and is not incorporated by reference into, this annual report. Segment Information
We operate exclusively in the consumer products category in which we develop and distribute headphones and other audio accessories. We 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.
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, legal and professional fees, depreciation and amortization, travel expenses, information technology expenses, commissions to outside sales representatives, research and development expenses, utilities and other facility related costs, such as rent. The primary components of our marketing and advertising expenses include in-store advertising, point of sale 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 March 31,
                                                        2014                      2013
Net sales                                      $ 39,080       100.0  %   $ 37,050       100.0  %
Cost of goods sold                               20,917        53.5  %     20,564        55.5  %
Gross profit                                     18,163        46.5  %     16,486        44.5  %
Selling, general and administrative expenses     22,080        56.5  %     26,311        71.0  %
Loss from operations                             (3,917 )     (10.0 )%     (9,825 )     (26.5 )%
Other expense                                       170         0.4  %        539         1.5  %
Interest expense                                     11           -  %        103         0.3  %
Loss before income taxes and noncontrolling
interests                                        (4,098 )     (10.5 )%    (10,467 )     (28.3 )%
Income tax benefit                                 (706 )      (1.8 )%     (3,387 )      (9.1 )%
Net loss                                         (3,392 )      (8.7 )%     (7,080 )     (19.1 )%
Net income (loss) attributable to
noncontrolling interests                            (71 )      (0.2 )%         33         0.1  %
Net loss attributable to Skullcandy, Inc.      $ (3,463 )      (8.9 )%   $ (7,047 )     (19.0 )%

Three Months Ended March 31, 2014 Compared to Three Months Ended March 31, 2013 Net Sales
Net sales increased $2.0 million, or 5.5%, to $39.1 million for the three months ended March 31, 2014 from $37.1 million for the three months ended March 31, 2013. The increase in net sales was primarily attributable to gaming and international sales.
North America net sales increased $0.4 million, or 1.3%, to $29.0 million, or 74.3% of our net sales for the three months ended March 31, 2014 from $28.7 million, or 77.4% of our net sales for the three months ended March 31, 2013.


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International net sales increased $1.7 million, or 19.7%, to $10.0 million, or 25.7% of our net sales for the three months ended March 31, 2014 from $8.4 million, or 22.6% of our net sales for the three months ended March 31, 2013. Included in the North America segment in the three months ended March 31, 2014 and 2013 are net sales of $600,000 and $2.1 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 increased 1.2%, and North America net sales increased 7.2%, compared to the same quarter in the prior year.
Gross Profit
Gross profit increased $1.7 million, or 10.2%, to $18.2 million for the three months ended March 31, 2014 from $16.5 million for the three months ended March 31, 2013. Gross margin was 46.5% for the three months ended March 31, 2014 compared to 44.5% for the three months ended March 31, 2013. The increase in gross margin was primarily attributable to a shift in product sales mix into higher margin products, decreases in shipping related costs, and reductions in warranty related costs.
North America gross margin was 47.0% for the three months ended March 31, 2014 compared to 43.5% for the three months ended March 31, 2013.
International gross margin was 44.9% for the three months ended March 31, 2014 compared to 48.1% for the three months ended March 31, 2013. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses decreased $4.2 million, or 16.1%, to $22.1 million for the three months ended March 31, 2014 from $26.3 million for three months ended March 31, 2013.
As a percentage of net sales, SG&A expenses decreased 14.5% to 56.5% for the three months ended March 31, 2014 from 71.0% for the three months ended March 31, 2013.
The decrease in SG&A expenses is primarily due to a decrease in write-downs of tooling, fixtures and furniture, reduced severance, and a reduction in performance-based compensation.
We expect to continue to make critical investments in the business to support long-term growth. In particular, we continue to invest in marketing and demand creation efforts at the same level compared to the same quarter of the prior year, with an increased focus on in-store displays and presence. Loss from Operations
As a result of the factors above, loss from operations decreased $5.9 million to $3.9 million for the three months ended March 31, 2014 from $9.8 million for the three months ended March 31, 2013. Loss from operations as a percentage of net sales increased to 10.0% for the three months ended March 31, 2014 from 26.5% for the three months ended March 31, 2013. Other Expense
Other expense was $0.2 million for the three months ended March 31, 2014 which related to foreign currency transaction losses. Interest Expense
Interest expense for the three months ended March 31, 2014 was consistent with interest expense for the three months ended March 31, 2013. 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 $0.7 million for the three months ended March 31, 2014 compared to income tax expense of $3.4 million for the three months ended March 31, 2013. Our effective tax rate for the three months ended March 31, 2014 and March 31, 2013 was 17.2% and 32.4%, respectively, which decreased on a quarterly basis due to proportionately higher levels of income in countries with lower statutory tax rates. In addition, the exchange offer of incentive stock options, or ISO's in the quarter ended September 30, 2013 reduced the permanent difference for stock compensation in 2014, causing further decrease


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of the effective tax rate between these comparative quarters. Our effective tax rate may fluctuate significantly on a quarterly basis dependent on our levels of taxable income in the countries with lower statutory tax rates versus countries with higher statutory tax rates, which is difficult to predict. Net Loss
As a result of the factors above, net loss was $3.4 million and $7.1 million for the three months ended March 31, 2014 and 2013, respectively. 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, 2014 and 2013 consists of income (losses) from our Mexico joint venture that are attributable to the other partner in the joint venture. Net Loss Attributable to Skullcandy, Inc. As a result of the factors above, net loss attributable to Skullcandy, Inc. was $3.5 million and $7.0 million for the three months ended March 31, 2014 and 2013, 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. This source 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):

                                                         Three Months Ended March 31,
                                                           2014                 2013
Cash and cash equivalents at beginning of period    $        38,835       $        19,345
Net cash provided by operating activities                     9,587                14,848
Net cash used in investing activities                        (1,608 )                (712 )
Net cash provided by financing activities                     1,454                    25
Effect of exchange rate changes on cash and cash
equivalents                                                    (103 )                   8
Cash and cash equivalents at end of period          $        48,165       $        33,514

Net Cash Provided by 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 three months ended March 31, 2014, net cash provided by operating activities was $9.6 million and consisted of a net loss of $3.4 million, offset by $4.8 million of non-cash items, plus $8.2 million of working capital and other activities. Working capital and other activities consisted primarily of a decrease in accounts receivable of $20.8 million, an increase in prepaid expenses and other current assets of $2.1 million, offset by an increase in inventory of $2.5 million and a decrease in accounts payable of $1.7 million and accrued liabilities of $6.3 million.
Net Cash Used in Investing Activities. Net cash used in investing activities relates to capital expenditures. Net cash used in investing activities was $1.6 million and $0.7 million for the three months ended March 31, 2014 and 2013, respectively.
Net Cash Provided by Financing Activities. Net cash provided by financing activities primarily related to proceeds from exercise of stock options for the three months ended March 31, 2014.
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.


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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:

                                                                Net income attributable
                       Fiscal Quarter                             to Skullcandy, Inc.
The fiscal quarters ending March 31, 2014, June 30, 2014 and
September 30, 2014                                              $           2,500,000
The fiscal quarters ending December 31, 2014, March 31, 2015,
June 30, 2015 and September 30, 2015                                        5,000,000
The fiscal quarters ending December 31, 2015, March 31, 2016,
June 30, 2016 and September 30, 2016                                        7,500,000
The fiscal quarters ending December 31, 2016 and each fiscal
quarter thereafter                                              $          10,000,000

(d) net income attributable to the Company, measured on a rolling 4-quarter basis for each fiscal quarter ending after August 19, 2013 and on or prior to December 31, 2013 in which an advance under the Line of Credit is made, determined as of the last day of each such fiscal quarter, not less than zero. Our credit facility also contains certain financial covenants and other restrictions that limit the our ability, among other things, to: (a) make fixed asset purchases in any fiscal year greater than $12 million in aggregate; (b) incur operating lease expenses in any fiscal year greater than $3 million in aggregate; and (c) create, incur, assume or permit to exist any indebtedness or liabilities resulting from borrowings, loans or advances, whether secured or unsecured, matured or unmatured, liquidated or unliquidated, joint or several, except (1) the liabilities of the Company and each of its subsidiaries to Wells Fargo, (2) permitted investments, (3) uncapped permitted indebtedness, and (4) capped permitted indebtedness up to $2 million in the aggregate outstanding at any one time. Additional covenants and other restrictions exist that limit our ability, among other things, to: undergo a merger or consolidation, sell certain assets, create liens, guarantee certain obligations of third parties, make certain investments or acquisitions, and declare dividends or make distributions. The credit facility carries interest based on the 3-month LIBOR, resetting daily (floating), plus applicable margin. Applicable margin is determined by our (total liabilities / tangible net worth) quarterly as follows: (a) < 0.25:1.00 Applicable Margin to be 1.30%; (b) > = 0.25:1.00 Applicable Margin to be 1.50%. We may borrow, partially or wholly repay our outstanding borrowings, and reborrow, subject to all of the limitations, terms and conditions of the note, during the term of the note. The credit facility expires on August 19, 2018. At March 31, 2014 and December 31, 2013 we had no borrowings outstanding. To the extent that our rolling four quarter net income is less than the threshold stated in the covenants above, our ability to draw upon the line of credit may be limited. Subsequent to period end, the Company entered into an amendment of its credit agreement and revolving line of credit on April 29, 2014. The amendment reduced the line of credit to $10,000,000 and letters of credit to $5,000,000 and also included the following changes to the financial covenants:
1. Removed the net income requirement;

2.Revised the total liabilities divided by tangible net worth ratio to not greater than 1.1 : 1.0 as of the last day of each fiscal quarter;
3.Revised the current ratio to not less than 2.0 : 1.0 as of the last day of each fiscal quarter; and
4.Included an EBITDA coverage ratio of not less than 2.0 : 1.0 as of the last day of each quarter. Contractual obligations In the three months ended March 31, 2014, 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, 2013. Off-Balance Sheet Arrangements


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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.
Long-Lived Assets Including Goodwill and Intangible Assets We review property and equipment and certain identifiable intangible assets, excluding goodwill, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If property, plant and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair market value.
Prior to the acquisitions of Astro Gaming in April 2011 and Kungsbacka 57 AB in August 2011, we did not have goodwill. We do not amortize goodwill and intangible assets with indefinite useful lives, rather such assets are required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. We perform our goodwill and intangible asset impairment tests in the fourth quarter of each fiscal year. We did not recognize any goodwill impairment charges in the three months ended March 31, 2014. We did record a $688,000 impairment charge related to our indefinite lived intangible trademarks and domain names in the three months ended March 31, 2014.


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We amortize our intangible assets with definite lives over their estimated useful lives and review these assets for impairment. We are currently amortizing our acquired intangible assets with definite lives over periods ranging between three to eight years.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred income tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities at tax rates expected to be in effect when such assets or liabilities are realized or settled. Deferred income tax assets are reduced by valuation allowances when necessary.
Assessing whether deferred tax assets are realizable requires significant judgment. We consider all available positive and negative evidence, including historical operating performance and expectations of future operating . . .

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