KOSS CORP quarterly report, Q1 FY2012

Koss Corporation Form 10-Q Summary

Business Context and Reporting Period

Koss Corporation, a headphone and consumer audio products manufacturer, reported unaudited results for the three months ended September 30, 2011, compared with the three months ended September 30, 2010. The company is a smaller reporting company with 7,382,706 common shares outstanding at October 21, 2011.

Financial Performance and Position

Metric	Q1 FY2012	Q1 FY2011	Change
Net sales	$8.755 million	$10.032 million	Down 12.7%
Gross profit	$3.328 million	$4.362 million	Down 23.7%
Gross margin	38.0%	43.5%	Down 5.5 percentage points
Income from operations	$493,469	$990,661	Down 50.2%
Net income	$280,597	$562,859	Down 50.1%
Diluted earnings per share	$0.04	$0.08	Down $0.04
Operating cash flow	$(606,048)	$(1.070 million)	Improved by $464,279

Operating expenses declined to $2.835 million from $3.371 million, including a $50,414 net benefit from unauthorized-transaction recoveries versus a $266,284 net cost in the prior year.
Operating income excluding unauthorized-transaction-related items was $443,055, or 5.1% of sales, versus $1.257 million, or 12.5% of sales.
The effective income tax rate increased to 38.1% from 36.5%.
Cash and cash equivalents were $233,634 at September 30, 2011, compared with $160,542 at June 30, 2011.
Working capital was $9.399 million, compared with $7.943 million at June 30, 2011. Inventory increased $846,037 to $8.713 million for seasonal stocking ahead of the December quarter.
Total assets were $28.545 million and total liabilities were $13.137 million at September 30, 2011.
The secured revolving credit facility had $3.500 million outstanding, up from $1.400 million at June 30, 2011. The facility provides up to $8.0 million of revolving borrowings, expires July 31, 2013, and is secured by substantially all company assets.
Investing cash outflows were $977,898, including $420,433 for equipment and leasehold improvements, $210,192 for product software development, and $347,273 for life insurance premiums.
The company paid $442,962 in dividends and declared a quarterly dividend of $0.06 per share. Management stated that it intends to continue regular quarterly dividends for the foreseeable future.

Material Changes Versus the Prior Comparable Period

Sales declined primarily because of lower sales to an overseas distributor and a large U.S. mass retailer. Management also cited increased competition, store consolidation among movie-rental and book retailers, and insufficient replacement sales from new customers.
Gross margin contracted because of higher costs from China-based suppliers following wage increases in March 2011. Management is pursuing lower-cost sources, selective price increases, and new product introductions.
Selling, general and administrative expenses decreased because of lower general corporate and patent legal fees, profit-based compensation, and bad-debt expense, partly offset by higher new-product development costs.
Operating cash use improved year over year, but operations remained cash-flow negative. The improvement primarily reflected changes in accounts receivable, accrued liabilities, and other working-capital items.
The company implemented a new business system during the quarter. Management had not completed sufficient testing and therefore concluded that disclosure controls and procedures were not effective as of September 30, 2011.
Stock options granted increased to 415,000 during the quarter, bringing options outstanding to 1,749,308; no options were exercised.

Outlook, Risks, Contingencies, and Unusual Items

Management described the long-term outlook as positive and believes operating cash generation plus available credit should fund operating needs, debt service, planned capital expenditures, and dividends. No specific revenue or earnings guidance was provided.
Open commitments for software and new-product development were approximately $1.538 million at September 30, 2011.
The company continues to face risks from competition, customer concentration and order levels, consumer acceptance of new products, foreign manufacturing and sourcing, China-related cost inflation, pricing, borrowing costs, taxes, and pending litigation or investigations.
The company disclosed unauthorized transactions totaling approximately $31.5 million from fiscal 2005 through December 2009. Related costs and recoveries produced a $50,414 net benefit in the quarter, including $499,320 of insurance recoveries.
A shareholder class action settlement was reached in principle on October 24, 2011, subject to court approval, involving a $1.0 million payment funded by the company’s insurer. The SEC settlement announced the same day included injunctive relief but no financial penalty for the company; Michael J. Koss agreed to reimburse the company an additional $242,419.
Derivative shareholder litigation against the company’s director defendants was finally approved and dismissed in September 2011. Other claims against American Express, Grant Thornton, and Park Bank remained unresolved; the filing states that ultimate resolution is generally not determinable.
The company expects additional recoveries from the sale of assets seized from the former vice president of finance. Gross proceeds from earlier auctions were believed to be approximately $1.1 million, but the net amount and timing of future recoveries are uncertain.
A Wisconsin Department of Revenue examination remains open for July 2005 through June 2009. Unrecognized tax benefits totaled $599,938, and accrued interest related to the unauthorized transactions was $511,792 at September 30, 2011.
The company leases its Milwaukee facility from Chairman John C. Koss at fixed annual rent of $380,000. It also has a $125,000 derivative liability related to a potential repurchase of shares from the chairman’s estate.

Important Facts for Investors to Verify

Whether declining sales and the 5.5-point gross-margin contraction persist, particularly in U.S. retail and overseas distribution channels.
The company’s ability to generate positive operating cash flow while funding inventory, product development, capital expenditures, dividends, and debt service.
Available borrowing capacity, compliance with the secured credit facility’s financial covenants, and the effect of increased borrowings and interest rates.
The final approval and funding of the $1.0 million class action settlement and the status of remaining third-party litigation and insurance recoveries.
The amount and timing of additional restitution and asset-forfeiture proceeds related to the former finance executive’s unauthorized transactions.
Completion and testing of the new business system and remediation of ineffective disclosure controls.
Whether supplier cost increases can be offset through sourcing changes, pricing, and new products without further damaging demand or margins.