News Column

KOSS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 15, 2014

Overview

The Company markets a complete line of high-fidelity headphones, speaker-phones, computer headsets, telecommunications headsets, active noise canceling headphones, wireless headphones and compact disc recordings of American Symphony Orchestras on the Koss Classics label. The Company operates as one business segment. In December 2009, the Company learned of significant unauthorized transactions, details of which have been disclosed in depth in the Company's previous periodic reports filed with the SEC. References to unauthorized transactions below should be read in conjunction with those reports. Results of Operations Summary



Net sales in the quarter ended March 31, 2014 decreased 48.2%, compared to

the same quarter last year, to $4,300,373 with decreased sales primarily

in export markets but also in certain mass and web retailer sales. Gross profit as a percent of sales decreased 14.4% to 25.4% for the quarter ended March 31, 2014, compared to 39.8% for the same quarter last



year. This decrease is primarily due to lower sales on fixed manufacturing

overhead costs as well as a large anticipated return from a customer.

Fixed manufacturing overhead costs increased due to manufacturing overhead

costs related to Mexico operations, which began in the fourth quarter of

fiscal year 2013. Removing those costs for comparison purposes, gross

profit as a percent of sales would have been 33.1% this quarter.

Selling, general and administrative spending was lower primarily due to

reduced software development expenditures, reduced expense for deferred

compensation, reduced sales commissions on lower sales, and reduced charitable donations. These lower expenses were partially offset by an increase in fees paid for celebrity product endorsements. Financial Results



The following table presents selected financial data for the three and nine months ended March 31, 2014 and 2013. Comparative figures are presented compared to the same period one year prior:

Three Months Ended Nine Months Ended March 31 March 31 Financial Performance Summary 2014 2013 2014 2013 Net sales $ 4,300,373$ 8,302,113$ 17,648,927$ 25,859,006 Net sales increase (decrease) % (48.2 )% 0.8 % (31.7 )% (4.1 )% Impairment of capitalized software, inventory and related items $ - $ - $ 4,535,747 $ - Gross profit $ 1,093,635$ 3,303,992$ 792,069$ 9,312,770 Gross profit as % of net sales 25.4 % 39.8 % 4.5 % 36.0 % Gross profit as % of net sales before impairment 25.4 % 39.8 % 30.2 % 36.0 % Selling, general and administrative expenses $ 2,354,337$ 3,111,919$ 7,925,186$ 9,134,158 Selling, general and administrative expenses as % of net sales 54.7 % 37.5 % 44.9 % 35.3 %



Unauthorized transaction related costs $ 86,391$ 180,295

$ 306,375$ 332,608 Unauthorized transaction related recoveries $ (317,553 )$ (28,294 )$ (1,134,082 )$ (1,375,678 ) Unauthorized transaction related costs and recoveries, net $ (231,162 )$ 152,001$ (827,707 )$ (1,043,070 ) Income (loss) from operations $ (1,029,540 )$ 40,072$ (6,305,410 )$ 1,221,682 Income (loss) from operations as % of net sales (23.9 )% 0.5 % (35.7 )% 4.7 % Other income (expense) $ 65,536$ 16,786$ 49,737$ (39,719 ) Income tax (benefit) provision $ (938,883 )$ (58,583 )$ (2,857,113 )$ 361,681 Income tax (benefit) provision as % of income before income tax (benefit) provision 97.4 % (103.0 )% 45.7 % 30.6 % 12



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2014 Results Compared with 2013



(comments refer to both the three and nine month periods unless otherwise

stated) Net sales decreased in both the three and nine months ended March 31, 2014, as sales to most export markets were much lower than last year. Net sales in our domestic markets decreased in the both the three and nine months ended March 31, 2014 with initial shipments to new customers and increases in certain markets partially offsetting declining sales at certain mass retailers. Export sales declined in the three and nine months ended March 31, 2014 compared to the same periods the prior year by approximately 61% and 50%, respectively. Certain key customers in Europe and Asia accounted for the majority of the decline in export sales. Management believes its customers in Europe are dealing with the impact of weak economies, which affect sell-through and their ability to properly balance inventories. Further, sales to two of our key export customers, one in Ukraine and another in Russia, have declined due to the political unrest in that region. The sales decline in Asia is the result of a specialty product which has experienced a decline in volume compared to the three and nine months ended March 31, 2013. Loss of space at a couple of retailers has negatively affected sales in the U.S. This appears to be changing with the introduction of the Fit Series product line which has gained placement at the retail level, and several new customers have been added due to this line. These sales were offset by a large anticipated return from a customer and reduced sales to a couple of new retail customers who last year had significant load-in sales. Overall the U.S. sales for the three and nine months ended March 31, 2014 were approximately 30% and 11%, respectively, less than in the same period the previous year. The Company took an impairment charge for capitalized software, inventory and related items in the three months ended December 31, 2013. It was determined during the three months ended December 31, 2013, that the capitalized software was being replaced by a new architecture currently under development. This review also indicated that certain inventory items were either obsolete or were in excess of what is forecast to be sold in the next two to three years. The Company still plans to develop the revised software platform and expects to launch new products using this technology. Software development expenditures incurred in the three months ended March 31, 2014 were expensed as incurred and future software development expenditures will be expensed as incurred as well. Gross profit prior to the impairment as a percent of sales was lower than last year. The lower gross profit margin was primarily the result of start up costs for manufacturing operations in Mexico. This new manufacturing facility started shipping headphones during the three months ended December 31, 2013. The gross profit margin was also negatively impacted by the fixed manufacturing costs on a lower sales base. Partially offsetting the negative impacts to gross profit margin is the impact of a reduction in our short and long term warranty reserve. Based on a review of both foreign and domestic sales compared to their respective warranty expense, the Company has adjusted the reserve commensurately. Selling, general and administrative expenses were lower than the same period last year. Deferred compensation expense has decreased to a credit as the result of changes to assumed retirement dates and an increase in the discount rate. Profit-based compensation decreased on the lower earnings in the nine months ended March 31, 2014. Legal fees have continued to decline in both the three and nine months ended March 31, 2014. During the three months ended December 31, 2013, the derivative liability was reversed since the associated shares subject to repurchase are insignificant. During the three months ended September 30, 2013, the Company received approximately $93,000 of proceeds from a customer account that had previously been written off. Additionally, the Company has reduced its spending on new product development directed at the STRIVA WiFi-based headphones and other WiFi-based products in the quarter ended March 31, 2014, due to a change in vendor and the related cost savings. The company has not reduced spending on new product offerings in the traditional wired headphone space. Several new headphone products have been introduced in the current fiscal year and more were unveiled at the annual Consumer Electronics Show (CES) in Las Vegas in January 2014.



Unauthorized transaction related recoveries were primarily from asset forfeitures and sale of items at auction. The Company believes that most of the proceeds from asset forfeitures have been received as of March 31, 2014.

The income (loss) from operations for the quarter ended March 31, 2014 decreased primarily due to the decline in net sales, the large return expected from a customer and the impact of start up costs for manufacturing in Mexico. These impacts were partially offset by lower selling, general and administrative expenses and increased recoveries from asset forfeitures. 13



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The effective income tax rate for the nine months ended March 31, 2014 was 45.1% which is comprised of the U.S. federal statutory rate of 34%, the effect of state income taxes and the decrease in unrecognized tax benefits during the quarter. It is anticipated that the effective income tax rate will be between 40 - 50% in the year ended June 30, 2014 due the decrease of unrecognized tax benefits. Liquidity and Capital Resources Cash Flows



The following table summarizes our cash flows from operating, investing and financing activities for the nine months ended March 31, 2014 and 2013:

Total cash provided by (used in): 2014 2013 Operating activities $ 3,942,251$ 2,543,954 Investing activities (723,796 ) (759,126 ) Financing activities (1,328,887 ) (1,328,887 )



Net increase in cash and cash equivalents $ 1,889,568$ 455,941

Operating Activities During the nine months ended March 31, 2014, cash provided by operations increased primarily due to receiving the proceeds of the settlement of the lawsuit against the Company's former auditors. Pursuant to the settlement, in July 2013, the Company received gross proceeds of $8,500,000, or $6,380,000 net of associated legal fees. During the quarter ended September 30, 2013, the Company paid approximately $2,000,000 for federal taxes.



Inventories were reduced by approximately $833,000 in the nine months ended March 31, 2014. This reduction was a result of the $1.8 million inventory impairment as part of the impairment of capitalized software, inventory and other items as detailed in Note 3, partially offset by a large return from a customer.

Investing Activities Cash used in investing activities was slightly higher for the nine months ended March 31, 2014 as the Company had higher capital expenditures for tooling related to new products. In addition, the Company had to purchase tooling for the Mexico operations. The capitalized software development expenditures decreased as a result of expensing on-going costs for the related products since the technology was launched during the year ended June 30, 2012. The Company anticipates it will incur expenditures of approximately $800,000 for tooling, leasehold capital expenditures for improvements and Mexico manufacturing equipment during the fiscal year ending June 30, 2014. The Company expects to generate sufficient cash flow through operations to fund these expenditures.



Financing Activities

The payment of quarterly dividends resulted in a net use of cash in the nine months ended March 31, 2014 and 2013. The Company intends to pay its quarterly dividend of $0.06 per share for the quarter ended March 31, 2014. At the Board of Directors meeting in May 2014, the Company determined that based on the financial results, the Company will not declare a quarterly dividend for the quarter ending June 30, 2014. The Company will determine whether to declare and the amount of any future dividends based upon its assessment of the Company's financial condition and liquidity, improvement in sales as a whole and in particular in the export markets, an increased generation of cash from operations, and the Company's earnings. As of March 31, 2014, the Company had no outstanding borrowings on its bank line of credit facility.



There were no purchases of common stock in 2014 or 2013 under the stock repurchase program. No stock options were exercised in 2014 or 2013.

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Liquidity

In addition to capital expenditures for tooling and Mexico manufacturing as well as continued investment in software and new product development, the Company has interest payments on its borrowings when it uses its line of credit facility, and has paid quarterly dividends for the past several years, but will not declare a dividend for the quarter ended June 30, 2014. The Company believes that cash generated from operations, together with cash reserves and borrowings available under its credit facility, provide it with adequate liquidity to meet operating requirements, debt service requirements, and planned capital expenditures for the next twelve months and thereafter for the foreseeable future. Whether there is adequate liquidity to resume paying quarterly dividends, and if so, the amount per share of such dividends, will be dependent on certain factors, including the Company's financial condition and liquidity, an improvement in sales as a whole and in particular in the export markets, an increased generation of cash from operations, and the Company's overall earnings. Management believes an improvement in sales and reducing the amount of capital expenditures are important factors for improving the Company's liquidity. The Company regularly evaluates new product offerings, inventory levels and capital expenditures to ensure that it is effectively allocating resources in line with current market conditions.



Credit Facility

On May 12, 2010, the Company entered into a secured credit facility with JPMorgan Chase Bank, N.A. ("Lender"). The Credit Agreement dated May 12, 2010 between the Company and the Lender ("Credit Agreement") provides for an $8,000,000 revolving secured credit facility and for letters of credit for the benefit of the Company of up to a sublimit of $2,000,000. On July 24, 2013, the Credit Agreement was amended to extend the expiration to July 31, 2015. The Company and the Lender also entered into a Pledge and Security Agreement dated May 12, 2010 under which the Company granted the Lender a security interest in substantially all of the Company's assets in connection with the Company's obligations under the Credit Agreement. There were no borrowings outstanding on the facility as of March 31, 2014 and June 30, 2013, respectively.



Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements other than the lease for the facility in Milwaukee, Wisconsin, which it leases from its Chairman. On May 15, 2012, the lease was renewed for a period of five years, ending June 30, 2018, and is being accounted for as an operating lease. The lease extension maintained the rent at a fixed rate of $380,000 per year. The Company is responsible for all property maintenance, insurance, taxes and other normal expenses related to ownership. The facility is in good repair and, in the opinion of management, is suitable and adequate for the Company's business purposes. 15



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