News Column


August 28, 2014

The purpose of this discussion and analysis is to enhance the understanding and evaluation of the results of operations, financial position, cash flows, indebtedness and other key financial information of the Company for fiscal years 2014 and 2013. Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.


The Company developed stereo headphones in 1958 and has intrinsically been a leader in the industry. We market a complete line of high-fidelity stereo headphones, speaker-phones, computer headsets, telecommunications headsets, active noise canceling stereo headphones, wireless stereo headphones and compact disc recordings of American Symphony Orchestras on the Koss Classics label. We operate as one business segment.

As headphones become more integral to use of music listening devices in the portable electronics market, the business volume becomes variable throughout the year. Changes in volume are more dependent on adding new customers or changes in economic conditions than they are on seasonality or the traditional holiday shopping season.

Many of the Company's products could be viewed as essential by the consumer and others are more of a discretionary spend. The results of the Company's operations are therefore susceptible to consumer confidence and macroeconomic factors. These economic factors have been evident in results during fiscal year 2014.

As a result of the unauthorized transactions that the Company previously reported, the Company has on-going activity to recover the amounts lost in the unauthorized transactions. These activities are explained in Note 2 to the Consolidated Financial Statements.

Fiscal Year 2014 Summary Net sales dropped 33.3% to $23,840,882 on volume declines at several major customers, most of which are export customers. Gross profit as a percent of sales declined 38.7% to (1.2)% due to the impairment charge to expense relating to capitalized software, tooling and inventory; operating costs in Mexico and impact of fixed costs on a lower sales amount. Selling, general and administrative spending was lower due to decrease in profit-based compensation, reduction in spending on product development, and the favorable impact of various cost reduction efforts. Unauthorized transaction related recoveries decreased primarily due to the fact that the $8,500,000 settlement of a third party lawsuit was recorded in the year ended June 30, 2013. Unauthorized transaction related costs decreased primarily due to contingent legal expenses in the year ended June 30, 2013, relating to the settlement of the third party lawsuit. 10


Consolidated Results

The following table presents selected consolidated financial data for each of the past two fiscal years:

Consolidated Performance Summary 2014 2013 Net sales $23,840,882$35,764,579 Net decrease % (33.3 )% (5.5 )% Gross profit (loss) $(281,819)$13,405,800 Gross profit (loss) as % of net sales (1.2 )% 37.5 % Selling, general and administrative expenses $10,468,708$13,350,456 Selling, general and administrative expenses as % of net sales 43.9 % 37.3 % Unauthorized transaction related costs $388,287$ 2,598,454 Unauthorized transaction related recoveries $(1,134,082)$(10,185,501) Unauthorized transaction related costs (recoveries), net $(745,795)$(7,587,047) Income (loss) from operations $(10,004,732)$7,642,391 Income (loss) from operations as % of net sales (42.0 )% 21.4 % Other income (expense) $49,589$56,090 Income tax provision (benefit) $(4,401,589)$2,270,766 Income tax provision (benefit) as % of income before taxes 44.2 % 29.5 % 2014 Results of Operations Compared with 2013

Net sales for 2014 declined primarily due to decreases in sales volume to several distributors in Europe, a manufacturer in Asia, and to two large retailers in the United Sates. The decline in sales to the European distributors reflected overstock of inventory held by the distributors leading to a decline in purchases, increased competition in the headphone market and political turmoil in a couple of Koss' major markets. The decrease in the U.S. retail market reflects the increased number of competitors in this space and decreased product placement at key retailers. New customers and introduction of new products throughout the year helped to reduce the sales declines.

Gross profit as a percent of sales in 2014 was (1.2)%, which was 38.7% lower than 2013. The decline in gross profit percentage was primarily due to the impairment charge related to the WiFi development and inventory. In 2014, the Company also incurred costs for the operations in Mexico that were operating at less than optimal levels due to the lower sales levels, especially for products in export markets. In addition, fixed costs were a higher percentage of net sales.

The Company took impairment charges for capitalized software, inventory and related items during the fiscal year ended 2014. It was determined during the three months ended December 31, 2013, that the capitalized software needed to be replaced by a new architecture currently under development. Further review later in the year determined that it was unlikely that products would be marketed and sold using the architecture as currently configured. The remaining inventory and tooling were charged to expense in the three months ended June 30, 2014. The Company still plans to develop the revised software platform and expects to launch new products using this technology, but has temporarily suspended this research and development effort until the base business is restored to more profitable levels. Software development expenditures incurred since December 31, 2013 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 costs for manufacturing operations in Mexico. During fiscal year 2014, the Company commenced manufacturing operations in Juarez, Mexico that focused on certain products aimed at our export markets. The large reduction in export sales did not allow the Company to experience an adequate return on its investment in the Mexican production facility. As a result, we have temporarily suspended production at the facility. The Company incurred approximately $1,523,000 of expense in fiscal year 2014 for the Mexican operations. We continue to believe that a manufacturing presence in Mexico has future strategic value and we may resume production there if key economic factors improve to justify it. 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 was the impact of a reduction in the Company's short and long term warranty reserve by approximately $389,000. 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 for fiscal year 2014 were $2,881,748 lower than for fiscal year 2013. The majority of this decrease was driven by lower profit-based compensation and spending for product development, which decreased by approximately $936,000 and $750,000, respectively. The product development costs decreased due to a change in direction on the development of the WiFi based product line. 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.

In fiscal year 2013, unauthorized transaction related costs were higher because the Company incurred higher legal fees that were contingent on the settlement of the third party lawsuit against the Company's former auditors and additional costs of pursuing certain actions against other third parties. Included in the unauthorized transaction related recoveries for 2013 was $8,500,000 of gross proceeds from the settlement of the lawsuit against the Company's former auditors.

The income from operations decreased in 2014 from 2013 primarily due to lower sales, the impairment charge and the 2013 income recorded from the settlement of the lawsuit against a third party.

In both 2014 and 2013, the Company decreased the interest it had accrued related to its tax reporting of the unauthorized transactions by $73,725 and $145,488, respectively. The Company reversed accrued interest related to the tax returns as they were filed and based upon the expiration of the statute of limitations for certain returns. These impacts are described further in Note 13 of the Notes to the Consolidated Financial Statements.

The effective income tax rate in 2014 was 44.2% which is comprised of the U.S. federal statutory rate of 34%, the effect of state income taxes, the decrease in unrecognized tax benefits and the recognition of some federal income tax credits during the year. It is anticipated that the effective income tax rate will be approximately 37% in 2015.

Liquidity and Capital Resources

Cash Flows

The following table summarizes our cash flows from operating, investing and financing activities for each of the past two fiscal years:

2014 2013 Total cash provided by (used in): Operating activities $ 3,591,432$ 3,496,217 Investing activities $ (779,808 )$ (914,759 ) Financing activities $ (1,771,849 )$ (1,771,849 )

Net increase in cash and cash equivalents $ 1,039,775$ 809,609

Operating Activities

During 2014, cash provided by operations stayed approximately the same as the prior year with favorable changes to operating assets and liabilities offsetting the decrease in net income. Accounts receivable decreased by $9,024,275 as of June 30, 2014 compared to June 30, 2013. The proceeds of $8,500,000 from the lawsuit settlement, received in July 2013, were in accounts receivable at June 30, 2013. In addition, there was a decrease in accounts receivable from customers caused by lower sales late in fiscal year 2014 compared to the same period in fiscal year 2013. The contingent legal fees, related to the lawsuit settlement, were $2,120,000 and were recorded in accrued liabilities as of June 30, 2013.



Investing Activities

Cash used in investing activities was lower for 2014 as the Company decreased spending on tooling and equipment compared to 2013. In 2015, the Company has budgeted $600,000 for tooling and leasehold improvements. The Company expects to generate sufficient funds through operations to fund these expenditures.

Financing Activities

Net cash used in financing activities were similar in 2014 because the Company paid the same amount in dividends as it did in 2013. At the Board of Directors meeting in May 2014, the Company determined that based on the financial results, the Company would 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. Dividends declared to stockholders decreased in 2014 but dividends paid stayed the same at $1,771,849 or $0.18 per share in 2014. As of June 30, 2014, the Company had no outstanding borrowings on its bank line of credit facility. On July 31, 2014, the Company had no outstanding borrowings on its bank line of credit facility and availability of approximately $5,000,000 under the credit agreement as amended on July 23, 2014.

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.


In addition to capital expenditures for tooling and investment in software development, the Company has interest payments when it uses its line of credit facility. The Company believes that cash generated from operations, together with borrowings available under its credit facility, should provide it with adequate liquidity to meet operating requirements, debt service requirements, and a reduced level of capital expenditures. Management is focusing on increasing sales especially in the export markets, reducing the amount of capital expenditures, increasing the generation of cash from operations, and improving the Company's overall earnings to help improve 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. Whether there is adequate liquidity to resume paying quarterly dividends, and if so, the amount per share of such dividends, will be dependent on an improvement of the Company's financial condition and liquidity.

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. On July 23, 2014, the Credit Agreement was amended to reduce the facility to $5,000,000 and to amend certain financial covenants. The Company and the Lender also entered into the 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. The balance on this facility was $0 as of June 30, 2014 and 2013.

Stock Repurchase Program

In April 1995, the Board of Directors approved a stock repurchase program authorizing the Company to purchase from time to time up to $2,000,000 of its common stock for its own account. Subsequently, the Board of Directors periodically has approved increases of between $1,000,000 to $5,000,000 in the stock repurchase program. As of June 30, 2014, the most recently approved increase was for additional purchases of $2,000,000, which occurred in October 2006, for an aggregate maximum of $45,500,000, of which $43,360,247 had been expended through June 30, 2014. The Company intends to effect all stock purchases either on the open market or through privately negotiated transactions and intends to finance all stock purchases through its own cash flow or by borrowing for such purchases.

There were no stock repurchases under the program in fiscal years 2014 and 2013. As of June 30, 2014, the Board of Directors has authorized the repurchase by the Company of up to $2,139,753 in Company common stock at the discretion of the Chief Executive Officer of the Company. Future stock purchases under this program are dependent on management's assessment of value versus market price.



Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements other than the lease for the facility in Milwaukee, Wisconsin. The Company leases the facility from Koss Holdings, LLC, which is wholly-owned by the Company's 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.

Critical Accounting Policies

Our discussion and analysis of financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continually evaluate our estimates and judgments, including those related to doubtful accounts, product returns, excess inventories, warranties, impairment of long-lived assets, deferred compensation, income taxes and other contingencies. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates.

Revenue Recognition

The Company recognizes revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; shipment and delivery has occurred; the seller's price to the buyer is fixed and determinable; and collectibility is reasonably assured. When these criteria are generally satisfied, the Company recognizes revenue. The Company also offers certain customers the right to return products that do not meet the standards agreed with the customer. The Company continuously monitors such product returns and cannot guarantee that they will continue to experience the same return rates that they have experienced in the past. Any significant increase in product quality failure rates and the resulting credit returns could have a material adverse impact on the Company's operating results for the period or periods in which such returns materialize.

The Company provides for certain sales incentives. The Company records a provision for estimated incentives based upon the incentives offered to customers on product related sales in the same period as the related revenues are recorded. The provision is recorded as a reduction of sales. The Company also records a provision for estimated sales returns and allowances on product related sales in the same period as the related revenues are recorded. These estimates are based on historical sales returns, analysis of credit memo data and other known factors. If the historical data the Company uses to calculate these estimates does not properly reflect future returns, adjustments may be required in future periods.

Accounts Receivable

The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history and the customer's current credit worthiness, as determined by the review of the customer's current credit information. The Company continuously monitors collections and payments from customers and maintains a provision for estimated credit losses based upon the Company's historical experience and any specific customer collection issues that have been identified. Accounts receivable are stated net of an allowance for doubtful accounts. The allowance is calculated based upon the Company's evaluation of specific customer accounts where the Company has information that the customer may have an inability to meet its financial obligations. In these cases, management uses its judgment, based on the best available facts and circumstances and records a specific reserve for that customer against amounts due to reduce the receivable to the amount that is expected to be collected. These specific reserves are re-evaluated and adjusted as additional information is received that impacts the amount reserved. However, the ultimate collectibility of the unsecured receivable is dependent upon the financial condition of an individual customer, which could change rapidly and without warning.




The Company values its inventories at the lower of cost or market. Cost is determined using the last-in, first-out ("LIFO") method. As of June 30, 2014 and 2013, 100% of the Company's inventory was valued using LIFO. Valuing inventories at the lower of cost or market requires the use of estimates and judgment. The Company continues to use the same techniques to value inventory as have been used in the past. Our customers may cancel their orders or change purchase volumes. This, or certain additional actions or market developments, could create excess inventory levels, which would impact the valuation of our inventories. Any actions taken by our customers or market developments that could impact the value of our inventory are considered when determining the lower of cost or market valuations. The Company regularly reviews inventory quantities on hand and records a provision for excess and obsolete inventory based primarily on historical and projected usage and production requirements. If the Company is not able to achieve its expectations of the net realizable value of the inventory at its current value, the Company would have to adjust its reserves accordingly.

Product Software Development Costs

Product software development costs consist of costs incurred by outside parties for the development of software embedded in or used to support new products. These assets have been evaluated to ensure that the capitalized costs do not exceed the estimated net realizable value of the related products. As part of the impairment analysis, we use an undiscounted cash flow model based on estimated net sales and gross profit to be derived in the future from the specific product and other estimated costs directly related to the product. Amortization was started in fiscal year 2012 with introduction of the first products at the end of April 2012. No amortization was recorded prior to the introduction of the new products.

Inherent in the operating results forecasts are certain assumptions regarding revenue growth rates, projected future costs, costs to complete and projected long-term growth rates. No impairment was recorded for the year ended June 30, 2013. The Company determined that the capitalized software needed to be replaced by a new architecture under development, which began in the three months ended December 31, 2013. As a result, the remaining value of the capitalized software was expensed during the three months ended December 31, 2013.

Product Warranty Obligations

Our products carry a lifetime warranty. We record accruals for potential warranty claims based on prior product returns experience. Warranty costs are accrued at the time revenue is recognized. These warranty costs are based upon management's assessment of past claims and current experience. However, actual claims could be higher or lower than amounts estimated, as the amount and value of warranty claims are subject to variation as a result of many factors that cannot be predicted with certainty.

Income Taxes

We estimate a provision for income taxes based on the effective tax rate expected to be applicable for the full fiscal year. If the actual results are different from these estimates, adjustments to the effective tax rate may be required in the period such determination is made. Additionally, discrete items are treated separately from the effective rate analysis and are recorded separately as an income tax provision or benefit at the time they are recognized.

Deferred income taxes are accounted for under the asset and liability method whereby deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred income tax assets and liabilities are measured using statutory tax rates. Deferred income tax provisions are based on changes in the deferred tax assets and liabilities from period to period. Additionally, we analyze our ability to recognize the net deferred income tax assets created in each jurisdiction in which we operate to determine if valuation allowances are necessary based on the "more likely than not" criteria.

New Accounting Pronouncements

Applicable new accounting pronouncements are set forth under Item 15 of this annual report and are incorporated herein by reference.



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Source: Edgar Glimpses

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