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ROCKY BRANDS, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

July 30, 2014

Creative Recreation

In December 2013, we completed the acquisition of certain assets of Kommonwealth, Inc. including the Creative Recreation trademark. Headquartered in Los Angeles, California, since 2002, Creative Recreation was first to create and market a versatile footwear brand that could easily transition between casual and more formal environments. Creative Recreation's collections of upscale sneakers quickly gained strong acceptance and support from a wide array of key influencers across multiple categories including music, sports, and acting. Creative Recreation's ability to successfully fuse style and versatility across a diversified assortment of products has created a wide target demographic and a strong distribution network that spans multiple channels and price points.

We believe by combining Rocky's strong operating platform and access to capital with Creative Recreation's design expertise we can strategically expand their business both domestically and overseas. At the same time, this transaction provides us with a compelling vehicle to penetrate the casual end of the market to complement our work, western and outdoor categories.

The total purchase price was approximately $8.7 million including cash and assumption of certain liabilities. The acquisition was funded by our existing cash balances and funds available under our existing revolving credit facility.

RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, information derived from our Interim Unaudited Condensed Consolidated Financial Statements, expressed as a percentage of net sales. The discussion that follows the table should be read in conjunction with our Interim Unaudited Condensed Consolidated Financial Statements. Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net Sales 100.0 % 100.0 % 100.0 % 100.0 % Cost Of Goods Sold 67.2 % 65.8 % 67.0 % 65.5 % Gross Margin 32.8 % 34.2 % 33.0 % 34.5 % Selling, General and Administrative Expenses 29.1 % 29.4 % 30.1 % 30.6 % Income From Operations 3.7 % 4.8 % 2.9 % 3.9 %



Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013

Net sales. Net sales for the three months ended June 30, 2014 were $68.8 million compared to $59.4 million for the same period in 2013. Wholesale sales for the three months ended June 30, 2014 were $56.7 million compared to $45.8 million for the same period in 2013. The $10.9 million increase in wholesale sales was the result of a $2.8 million increase in our lifestyle footwear category which was primarily the result of the additional sales from the Creative Recreation brand, a $2.2 million increase in our western footwear category, a $1.9 million increase in our outdoor footwear category, a $1.5 million increase in our commercial military footwear category and a $1.3 million increase in our work footwear category. Retail sales for the three months ended June 30, 2014 were $10.1 million compared to $9.8 million for the same period in 2013. Military segment sales for the three months ended June 30, 2014, were $2.0 million, compared to $3.8 million in the same period in 2013. We have received an order to fulfill a contract to the U.S. Military to produce "Hot Weather" combat boots. Shipment of the boots under this contract began in March 2013.

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Gross margin. Gross margin for the three months ended June 30, 2014 was $22.6 million, or 32.8% of net sales, compared to $20.3 million, or 34.2% of net sales, in the same period last year. Wholesale gross margin for the three months ended June 30, 2014 was $18.2 million, or 32.0% of net sales, compared to $15.2 million, or 33.2% of net sales, in the same period last year. The 120 basis point decrease was primarily due to product sale at reduced prices to a key retail partner that reduced margins in the quarter. The Retail gross margin for the three months ended June 30, 2014 was $4.2 million, or 41.3% of net sales, compared to $4.6 million, or 46.9% of net sales, for the same period in 2013. The 560 basis point decrease was largely due to lower average selling prices on our internet driven transactions than our mobile store transactions. Military gross margin for the three months ended June 30, 2014 was $0.3 million, or 13.3% of net sales, compared to $0.5 million, or 13.9% of net sales, for the same period in 2013.

SG&A expenses. SG&A expenses were $20.0 million, or 29.1% of net sales, for the three months ended June 30, 2014, compared to $17.4 million, or 29.4% of net sales for the same period in 2013. The $2.6 million increase primarily related to the additional expenses of $1.6 million related to the Creative Recreation business and higher compensation expenses of $0.9 million related to a new mid-year bonus program that wasn't in place in the prior year.

Interest expense. Interest expense was $0.2 million in the three months ended June 30, 2014, compared to $0.1 million for the same period in the prior year.

Income taxes. Income tax expense for the three months ended June 30, 2014 was $0.8 million, compared to $1.0 million for the same period a year ago. We provided for income taxes at effective tax rates of 35% in 2014 and 2013.

Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2013

Net sales. Net sales for the six months ended June 30, 2014 were $134.6 million compared to $113.1 million for the same period in 2013. Wholesale sales for the six months ended June 30, 2014 were $109.8 million compared to $87.8 million for the same period in 2013. The $22.0 million increase in wholesale sales was the result of a $6.5 million increase in our lifestyle footwear category which was primarily the result of the additional sales from the Creative Recreation brand, a $4.7 million increase in our work footwear category, a $3.7 million increase in our western footwear category, a $2.7 million increase in our outdoor footwear category, a $2.3 million increase in our commercial military footwear category and a $1.4 million increase in our duty footwear category. Retail sales for the six months ended June 30, 2014 were $21.2 million compared to $20.6 million for the same period in 2013. Military segment sales for the six months ended June 30, 2014, were $3.6 million, compared to $4.7 million in the same period in 2013. We have received an order to fulfill a contract to the U.S. Military to produce "Hot Weather" combat boots. Shipment of the boots under this contract began in March 2013.

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Gross margin. Gross margin for the six months ended June 30, 2014 was $44.4 million, or 33.0% of net sales, compared to $39.0 million, or 34.5% of net sales, in the same period last year. Wholesale gross margin for the six months ended June 30, 2014 was $34.8 million, or 31.7% of net sales, compared to $28.8 million, or 32.8% of net sales, in the same period last year. The 110 basis point decrease was primarily due to product sale at reduced prices to a key retail partner that reduced margins in the period. The Retail gross margin for the six months ended June 30, 2014 was $9.2 million, or 43.4% of net sales, compared to $9.6 million, or 46.4% of net sales, for the same period in 2013. The 300 basis point decrease was largely due to lower average selling prices on our internet driven transactions than our mobile store transactions. Military gross margin for the six months ended June 30, 2014 was $0.5 million, or 13.2% of net sales, compared to less than $0.7 million, or 13.9% of net sales, for the same period in 2013.

SG&A expenses. SG&A expenses were $40.6 million, or 30.1% of net sales, for the six months ended June 30, 2014, compared to $34.6 million, or 30.6% of net sales for the same period in 2013. The $6.0 million increase primarily related to the additional expenses of $3.3 million related to the Creative Recreation business and higher compensation expenses of $1.4 million related primarily to a new mid-year bonus program that wasn't in place in the prior year.

Interest expense. Interest expense was $0.4 million in the six months ended June 30, 2014, compared to $0.3 million for the same period in the prior year.

Income taxes. Income tax expense for the six months ended June 30, 2014 was $1.2 million, compared to $1.4 million for the same period a year ago. We provided for income taxes at effective tax rates of 35% in 2014 and 2013.

Liquidity and Capital Resources

Our principal sources of liquidity have been our income from operations and borrowings under our credit facility.

Over the last several years our principal uses of cash have been for working capital and capital expenditures to support our growth. Our working capital consists primarily of trade receivables and inventory, offset by accounts payable and accrued expenses. Our working capital fluctuates throughout the year as a result of our seasonal business cycle and business expansion and is generally lowest in the months of January through March of each year and highest during the months of May through October of each year. We typically utilize our revolving credit facility to fund our seasonal working capital requirements. As a result, balances on our revolving credit facility will fluctuate significantly throughout the year. Our capital expenditures relate primarily to projects relating to our property, merchandising fixtures, molds and equipment associated with our manufacturing operations and for information technology. Capital expenditures were $5.2 million for the first six months of 2014, compared to $3.7 million for the same period in 2013. Total capital expenditures for 2014 are anticipated to be approximately $8.4 million.

In October 2010, we entered into a financing agreement with PNC Bank ("PNC") to provide a $70 million credit facility. The term of the facility is five years and the current interest rate is generally LIBOR plus 1.50%.

Our credit facility contains a restrictive covenant which requires us to maintain a fixed charge coverage ratio. This restrictive covenant is only in effect upon a triggering event taking place (as defined in the credit facility agreement). At June 30, 2014, no triggering event had occurred and the covenant was not in effect.

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The total amount available under our revolving credit facility is subject to a borrowing base calculation based on various percentages of accounts receivable and inventory. As of June 30, 2014, we had total $43.4 million in borrowings under this facility and total capacity of $70.0 million.

We believe that our existing credit facility coupled with cash generated from operations will provide sufficient liquidity to fund our operations for at least the next twelve months. Our continued liquidity, however, is contingent upon future operating performance, cash flows and our ability to meet financial covenants under our credit facility.

Operating Activities. Cash provided by operating activities totaled $1.5 million for the six months ended June 30, 2014, compared to cash used in operating activities of $4.7 million in the same period of 2013. Cash provided operating activities for the six months ended June 30, 2014 was primarily impacted by increases in accounts payable, partially offset by increases in accounts receivable and inventory. Cash used in operating activities for the six months ended June 30, 2013 was primarily impacted by increases in inventory and accounts receivable, partially offset by increases in accounts payable.

Investing Activities. Cash used in investing activities was $5.2 million for the six months ended June 30, 2014, compared to $3.6 million in the same period of 2013. Cash used in investing activities reflects an investment in property, plant and equipment of $5.2 million in 2014 and $3.7 million in 2013. Our 2014 and 2013 expenditures primarily relate to investments in molds and equipment associated with our manufacturing operations and for information technology.

Financing Activities. Cash provided by financing activities for the six months ended June 30, 2014 was $3.5 million and was primarily related to a net increase under the revolving credit facility of $5.0 million, partially offset by the payment $1.5 million of dividends on common stock. Cash used in financing activities for the six months ended June 30, 2013 was $7.2 million, partially offset by the payment of $0.8 million of dividends on common stock.

Inflation



We cannot determine the precise effects of inflation; however, inflation continues to have an influence on the cost of materials, salaries, and employee benefits. We attempt to offset the effects of inflation through increased selling prices, productivity improvements, and reduction of costs.

Critical Accounting Policies and Estimates

"Management's Discussion and Analysis of Financial Condition and Results of Operations" discusses our interim condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these interim condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the interim condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. A summary of our significant accounting policies is included in the Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2013.

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Our management regularly reviews our accounting policies to make certain they are current and also to provide readers of the interim condensed consolidated financial statements with useful and reliable information about our operating results and financial condition. These include, but are not limited to, matters related to accounts receivable, inventories, intangibles and income taxes. Implementation of these accounting policies includes estimates and judgments by management based on historical experience and other factors believed to be reasonable. This may include judgments about the carrying value of assets and liabilities based on considerations that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Our management believes the following critical accounting policies are most important to the portrayal of our financial condition and results of operations and require more significant judgments and estimates in the preparation of our interim condensed consolidated financial statements.

Revenue recognition



Revenue principally consists of sales to customers, and, to a lesser extent, license fees. Revenue is recognized when the risk and title passes to the customer, while license fees are recognized when earned. Customer sales are recorded net of allowances for estimated returns, trade promotions and other discounts, which are recognized as a deduction from sales at the time of sale.

Accounts receivable allowances

Management maintains allowances for uncollectible accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The allowance for uncollectible accounts is calculated based on the relative age and size of trade receivable balances.

Sales returns and allowances



We record a reduction to gross sales based on estimated customer returns and allowances. These reductions are influenced by historical experience, based on actual customer returns and allowances. The actual amount of sales returns and allowances realized may differ from our estimates. If we determine that sales returns or allowances should be either increased or decreased, then the adjustment would be made to net sales in the period in which such a determination is made.

Inventories



Management identifies slow moving or obsolete inventories and estimates appropriate loss provisions related to these inventories. Historically, these loss provisions have not been significant as the vast majority of our inventories are considered saleable, and we have been able to liquidate slow moving or obsolete inventories through our factory outlet stores or through various discounts to customers. Should management encounter difficulties liquidating slow moving or obsolete inventories, additional provisions may be necessary. Management regularly reviews the adequacy of our inventory reserves and makes adjustments to them as required.

Intangible assets



Intangible assets, including goodwill, trademarks and patents are reviewed for impairment annually, and more frequently, if necessary. We perform such testing of goodwill and indefinite-lived intangible assets in the fourth quarter of each year or as events occur or circumstances change that would more likely than not reduce the fair value of the asset below its carrying amount.

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In assessing whether indefinite-lived intangible assets are impaired, we must make certain estimates and assumptions regarding future cash flows, long-term growth rates of our business, operating margins, weighted average cost of capital and other factors such as discount rates, royalty rates, cost of capital, and market multiples to determine the fair value of our assets. These estimates and assumptions require management's judgment, and changes to these estimates and assumptions could materially affect the determination of fair value and/or impairment for each of our other indefinite-lived intangible assets. Future events could cause us to conclude that indications of intangible asset impairment exist. Impairment may result from, among other things, deterioration in the performance of our business, adverse market conditions, adverse changes in applicable laws and regulations, competition, or the sale or disposition of a reporting segment. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.

Income taxes



Management has recorded a valuation allowance to reduce its deferred tax assets for a portion of state and local income tax net operating losses that it believes may not be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance; however, in the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made.

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.

Except for the historical information contained herein, the matters discussed in this Quarterly Report on Form 10-Qinclude certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. Those statements include, but may not be limited to, all statements regarding our and management's intent, belief, and expectations, such as statements concerning our future profitability and our operating and growth strategy. Words such as "believe," "anticipate," "expect," "will," "may," "should," "intend," "plan," "estimate," "predict," "potential," "continue," "likely" and similar expressions are intended to identify forward-looking statements. Investors are cautioned that all forward-looking statements contained in this Quarterly Report on Form 10-Q and in other statements we make involve risks and uncertainties including, without limitation, the factors set forth under the caption "Risk Factors" included in our Annual Report on Form 10-K for the year ended December 31, 2013, and other factors detailed from time to time in our other filings with the Securities and Exchange Commission. One or more of these factors have affected, and in the future could affect our businesses and financial results and could cause actual results to differ materially from plans and projections. Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, there can be no assurance that any of the forward-looking statements included in this Quarterly Report on Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. All forward-looking statements made in this Quarterly Report on Form 10-Q are based on information presently available to our management. We assume no obligation to update any forward-looking statements.

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