KOSS CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis supplements our management’s discussion and analysis for the year ended June 30, 2022 as contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on August 26, 2022, and presumes that readers have read or have access to such discussion and analysis. The following discussion and analysis should also be read together with the unaudited consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that reflect our plans and strategy for our business and involve risks and uncertainties. You should review the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended June 30, 2022, as updated by subsequent filings with the Securities and Exchange Commission, for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. You should carefully read “Cautionary Statement Regarding Forward-Looking Statements” in this Quarterly Report on Form 10-Q. Overview The Company initially developed stereo headphones in 1958 and has been recognized as a leader in the industry ever since. Koss markets a complete line of high-fidelity headphones, wireless Bluetooth® headphones, wireless Bluetooth® speakers, computer headsets, telecommunications headsets, and active noise canceling headphones. The Company operates as one business segment, as its principal business line is the design, manufacture and sale of stereo headphones and related accessories. Financial Results The following table presents selected financial data for the three and nine months ended March 31, 2023, and 2022: Three Months Ended Nine Months Ended March 31 March 31 Financial Performance Summary 2023 2022 2023 2022 Net sales $ 3,369,160 $ 4,634,552 $ 9,995,620 $ 13,415,506 Net sales (decrease) increase % from prior year period (27.3)% 16.2% (25.5)% (5.0)% Gross profit $ 1,292,678 $ 1,963,216 $ 3,605,063 $ 5,094,747 Gross profit as % of net sales 38.4% 42.4% 36.1% 38.0% Selling, general and administrative expenses $ 1,746,034 $ 1,566,430 $ 27,890,606 $ 4,576,521 Selling, general and administrative expenses as % of net sales 51.8% 33.8% 279.0% 34.1% Interest income $ 189,593 $ 3,578 $ 314,482 $ 7,837 Other income $ — $ 6,415 $ 33,000,000 $ 362,389 (Loss) income before income tax (benefit) provision $ (263,763) $ 406,779 $ 9,028,939 $ 888,452 (Loss) income before income tax as % of net sales (7.8)% 8.8% 90.3% 6.6% Income tax (benefit) provision $ (30,910) $ 3,575 $ 463,928 $ 5,638 Income tax (benefit) provision as % of (loss) income before income tax 11.7% 0.9% 5.1% 0.6% ‎ 14 Table of Contents Fiscal 2023 Period Results Compared with Fiscal 2022 Period (comments refer to the three and nine-month periods ended March 31 unless otherwise noted) Net sales for the quarter ended March 31, 2023 decreased by $1,265,000, or 27.3%, primarily due to reduced sales to certain of our distributors in the domestic market and online retailers, as well as lower sales in the European markets. For the nine-month period ended March 31, 2023, net sales decreased by $3,420,000, or 25.5%, with over 50% of the reduction due to a slowdown in certain of our domestic distributor sales. This was coupled with a continued decline in sales to our European and Asian markets. Net sales in the domestic market were approximately $2,717,000 in the three months ended March 31, 2023, compared to approximately $3,735,000 in the prior year period, a decrease of $1,018,000, or 27.3%. Domestic net sales for the nine months ended March 31, 2023 decreased from $9,781,000 in the prior year period to $7,589,000, a decline of $2,192,000, or 22.4%. A weakness in consumer demand and bloated customer inventory levels have resulted in a 38% decrease in net sales to certain of our domestic distributors, representing approximately 85% of the drop in domestic net sales. Growth in direct-to-consumer (DTC) sales of $214,000, or 8.7%, during the nine months ended March 31, 2023 over the same period in the prior year helped to slightly offset the decline. Export net sales for the three months ended March 31, 2023 decreased by $247,000, or 27.5%, compared to the three months ended March 31, 2022, behind a decrease in sales to our distributors in Russia and Ukraine due to the continued discord in that region. Export net sales were down $1,228,000, or 33.8%, in the nine months ended March 31, 2023 versus the same prior year period. The decline in overall sales during fiscal year 2023 heightened the impact of the drop-off in sales to the two distributors in Russia and Ukraine, representing nearly 50% of the decrease in export sales for the current year. The 12.4% and 34.7% reduction in sales to our European and Asian distributors, respectively, for the current nine-month period also contributed to the decline. Gross profit margin decreased to 36.1% for the nine months ended March 31, 2023, compared to 38.0% for the nine months ended March 31, 2022. As the Company sold off inventory brought in during the prior year at higher freight rates, the margins on those sales were adversely impacted. Margins were also negatively impacted by fixed manufacturing expenses that do not flex with sales volume. Favorability from lower freight costs during the current nine-month period, as a result of declining rates and a decreasing investment in inventory, provided some positive impact on the overall margin as a partial offset. Freight rates remained constant through the quarter ended March 31, 2023 and are expected to continue as general container demand remains stable and the partnership with a dedicated freight forwarder is maintained. Selling, general and administrative expenses for the three months ended March 31, 2023 were $1,746,000, a $180,000 or 11.5% increase over the same period in the prior year. The decrease in the discount rates used to calculate the deferred compensation liability resulted in an increase in the liability with a corresponding increase to expense. This, coupled with an increase in legal fees compared to the prior year, were the main factors for the increase. For the nine months ended March 31, 2023, selling, general and administrative expenses increased by approximately $23,314,000 to $27,891,000 compared to the prior year period. The significant increase was primarily a result of approximately $22,265,000 in legal fees and expenses incurred in support of the Company’s patent defense litigation. Also, increased expense related to a bonus accrual of $381,000 and a second quarter profit-sharing payout of $576,000 were recorded as a result of the increased net income before income taxes for the first nine months of fiscal year 2023 due mainly to the licensing proceeds received during the quarter ended September 30, 2022, partially offset by the aforementioned legal fees and expenses. A decrease of $108,000 in employer taxes on stock option exercises slightly offset the significant increase in expense for the current nine-month period. Other income for the nine months ended March 31, 2023 consisted entirely of $33,000,000 in licensing proceeds received in the first quarter. The Company received licensing proceeds of $100,000, which was also recorded as other income, in the first quarter of the prior year. Also, in December 2021, the Company recognized other income on the proceeds from a company-owned life insurance policy on its founder, who passed away on December 21, 2021. Total other income for the nine months ended March 31, 2022 was $362,000. An income tax benefit of approximately $31,000 was recorded during the third quarter of fiscal year 2023 as a result of the taxable loss for the period. Income tax expense for the nine months ended March 31, 2023 was approximately $464,000 and was comprised of the U.S. federal statutory rate of 21% and the blended state income tax rate of approximately 3.8%, offset by an adjustment to the valuation allowance for deferred tax assets. The utilization of net operating loss carryforwards significantly reduced the taxable income, resulting in federal and state tax provisions of $374,714 and $89,214, respectively. For the three and nine months ended March 31, 2022, a state tax provision of $3,575 and $5,638, respectively, was recorded. The federal income tax expense was zero for the three and nine months ended March 31, 2022. The effective tax rate was 5.1% in the nine months ended March 31, 2023 and less than 1% in the nine months ended March 31, 2022. It is anticipated that the effective rate in the current year and future years will be reduced by utilization of a portion or all of the federal net operating loss carryforwards that existed as of June 30, 2022. 15 Table of Contents In the nine months ended March 31, 2023, stock option exercises resulted in tax deductible compensation expense of approximately $332,000 and will offset some of the taxable income generated by the net licensing proceeds. Net operating loss carryforwards were utilized to reduce the taxable income and, as such, th e remaining expected federal tax loss carryforward is expected to approximate $32,600,000 by the end of the fiscal year. The quarterly adjustment to the estimated tax loss carryforward decreased the deferred tax asset to approximately $9,800,000 as of March 31, 2023, and the future realization of this continues to be uncertain. The valuation allowance was also increased to fully offset the deferred tax asset as there is sufficient negative evidence to support the maintaining of a full valuation allowance as, excluding unusual, infrequent items, a three-year cumulative tax loss occurred. The Company maintains a program focused on enforcing its intellectual property and, in particular, certain of its patent portfolio. The Company has enforced its intellectual property by filing complaints against certain parties alleging infringement on the Company’s patents relating to its wireless headphone technology. If efforts are successful, the Company may receive royalties, offers to purchase its intellectual property, or other remedies advantageous to its competitive position from time to time. However, there is no guarantee of a positive outcome from these efforts in the future, which could ultimately be time-consuming and unsuccessful. Additionally, all or portions of monetary awards or judgments received by the Company in connection with these complaints will be due to third parties. The Company believes that its financial position remains strong. The Company had $2.9 million of cash and cash equivalents, $12.0 million of short-term investments and available credit facilities of $5.0 million on March 31, 2023. Recent Events Recent events continuing to impact our business include COVID-19, the inflationary cost environment, disruption in our supply chain, the ongoing crisis in Eastern Europe, and the threatened rail strike in the U.S. As more fully described below, we expect each of these factors will impact our fiscal 2023 performance. While the impact of these factors remains uncertain, we will continue to evaluate the extent to which these factors will impact our business, financial condition, or results of operations. These and other uncertainties with respect to these recent events could result in changes to our current expectations. COVID-19: The Company continues to closely monitor the impact of COVID-19 (including the emergence of variants) to protect the health and safety of its employees and customers. Business plans are being continuously updated and executed to maintain supply of the Company’s products to our customers throughout the world. While we expect the impacts of COVID-19 on our business to moderate, there still remains uncertainty around the pandemic. As a result of the COVID-19 pandemic, uncertainty with respect to its economic effects has impacted not only our operating results but also the global economy. The extent and nature of government actions to ease restrictions vary based upon the current extent and severity of the COVID-19 pandemic within their respective countries and localities. Certain of the Company’s suppliers have been, and could continue to be, impacted by the COVID-19 pandemic, resulting in disruptions to inventory replenishment. The Company expects the negative sales impacts caused by governmental responses to COVID-19, and the disruption in certain retail businesses to continue so long as new variants of the virus continue to emerge and spread. The ultimate magnitude of the COVID-19 pandemic, including the extent of its impact on the Company’s business, financial position, results of operations or liquidity, cannot be reasonably estimated at this time due to the rapid development and fluidity of the situation. The Company's future results will be determined by the effectiveness of vaccines, rollout of vaccine boosters, the duration of governmental pandemic restrictions, the impact of variants, geographic spread, further business disruptions and the overall impact on the economy throughout the world. To protect the safety, health and well-being of employees, customers, and suppliers, the Company continues to maintain several preventive measures while also meeting the needs of global customers. These measures include increased frequency of cleaning and disinfecting of facilities, and may also include, as necessary, social distancing practices, some remote working, restrictions on business travel, continuing to hold certain events virtually and limitations on visitor access to facilities. The Company is committed to executing these plans and remains in close contact with its supply chain to monitor future possible implications, especially on production facilities. ‎ 16 Table of Contents Inflationary Cost Environment and Supply Chain Disruption - The Company continues to experience inflationary cost increases in our commodities, packaging materials, wages and higher energy and transportation costs. These increases have been partially mitigated by pricing actions implemented by the Company in the third quarter of the prior fiscal year, with another increase at the beginning of the third quarter of the current fiscal year. The Company also continues to work with a dedicated freight forwarding partner to minimize freight rate increases. The Company’s supply chain is primarily in southern China. Delays throughout the supply chain continue as a result of the persistence of COVID-19 in all parts of the world, however, the Company does not believe that these continuing delays will be material to the Company as the cadence of specific customers’ bookings have become more consistent. The Company is aware that with the easing of COVID-19 restrictions in China, manufacturing operations and major ports could continue to be impacted by an increase in COVID-19 illness, which could result in supply chain delays. As such, the Company continues to monitor the situation closely, and the supply chain team has modified business plans, which include, but are not limited to: (1) being alert to potential short supply situations; (2) assisting suppliers with acquisition of critical components; and (3) utilizing alternative sources and/or air freight. In April 2023, United Parcel Service (UPS) and the International Brotherhood of Teamsters Union started labor contract talks to negotiate better pay, no forced overtime and the elimination of a two tier pay system. Members of the union have stated that they are prepared to walk off the job if UPS fails to deliver a deal before the current contract expires at midnight on July 31, 2023. Also, since December 2022, when the U.S. government abated a threatened railroad strike and implemented a labor agreement that prohibited the workers from striking, some union leaders and railroad executives have voluntarily reopened the conversation around paid sick leave in hopes of negotiating an improvement. The Company continues to monitor both situations as ether strike in the U.S. could potentially exacerbate disruptions in the supply chain and impact product shipments from suppliers and to customers, resulting in increased operating costs and delays in product shipments. Russia’s Invasion of Ukraine - The ongoing Russia-Ukraine conflict and the sanctions imposed in response to this conflict have increased global economic and political uncertainty. In accordance with the Executive Order declared on April 6, 2022, the Company suspended sales into Russia. Also, given the continued humanitarian crisis in Ukraine as a result of the conflict, and the population seeking refuge in other countries, sales to Ukraine have also ceased. The lack of sales to Russia and Ukraine during the nine months ended March 31, 2023 compared to net sales of approximately $600,000, or 4% of total net sales for the same period in the prior year. The continuation of the conflict will have an impact on sales to the region in the future, however we are uncertain of what that impact will be on the results of operations. Liquidity and Capital Resources Cash Flows The following table summarizes cash flows from operating, investing and financing activities for the nine months ended March 31, 2023 and 2022: Total cash provided by (used in): 2023 2022 Operating activities $ 10,616,726 $ (672,895) Investing activities (17,040,594) 1,820,269 Financing activities 137,330 1,390,346 Net (decrease) increase in cash and cash equivalents $ (6,286,538) $ 2,537,720 Operating Activities A majority of the cash provided by operating activities during the nine months ended March 31, 2023 is the result of the licensing proceeds received, partially offset by the payment of related legal fees and expenses as well as the profit-sharing payout in the second quarter. Additionally, the continued reduction in inventory levels as the Company’s investment tapers off contributed to the cash provided by operating activities during the first nine months of the current fiscal year. The use of cash in the same nine-month period in the prior year was related to the impact of the deliberate investment in inventory to ensure adequate stock levels to mitigate the impact of potential supply chain delays. An increase in accounts payable and accrued liabilities as a result of the increased inventory investment and customer deposits from our European distributors provided cash from operating activities to partially offset the use. 17 Table of Contents Investing Activities Cash used by investing activities for the nine months ended March 31, 2023 was almost entirely related to the purchase of $17,300,000 of U.S. Treasury securities at a discount. The Company believes that its cash flow from operations and available cash and its credit facility is sufficient to fund any necessary tooling, leasehold improvement and capital expenditures. Financing Activities Cash provided by financing activities is due entirely to stock option exercises. In the nine months ended March 31, 2023, an aggregate of 69,000 shares of common stock were issued as a result of employee stock option exercises under the Company’s 2012 Omnibus Incentive Plan. The cash provided from these stock option exercises was approximately $137,000. During the nine months ended March 31, 2022, an aggregate of 539,089 shares of common stock were issued as a result of employee stock option exercises under the Company’s 2012 Omnibus Incentive Plan. The cash provided from these stock option exercises was approximately $1,390,000. As of March 31, 2023, the Company had no outstanding borrowings on its bank line of credit facility. There were no purchases of common stock in the three months ended March 31, 2023 or March 31, 2022 under the stock repurchase program. Liquidity The Company's capital expenditures are primarily for leasehold improvements and tooling. In addition, it has interest payments on its borrowings when it uses its line of credit facility. The Company believes that cash generated from operations, together with healthy cash reserves and available borrowings, provide it with adequate liquidity to meet operating requirements, debt service requirements and planned or necessary tooling, leasehold and other capital expenditures for the next twelve months following the date of this Quarterly Report on Form 10-Q and thereafter for the foreseeable future. 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 14, 2019, the Company entered into a secured credit facility (“Credit Agreement”) with Town Bank (“Lender”). The Credit Agreement provides for a $5,000,000 revolving secured credit facility letters of credit for the benefit of the Company of up to a sublimit of $1,000,000. There are no unused line fees in the credit facility. On January 28, 2021, the Credit Agreement was amended to extend the expiration date to October 31, 2022, and to change the interest rate to Wall Street Journal Prime less 1.50%. A Third Amendment to the Credit Agreement effective October 30, 2022 extended the expiration date to October 31, 2024. The Company and the Lender also entered into a General Business Security Agreement dated May 14, 2019 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 Credit Agreement contains certain affirmative and negative covenants customary for financings of this type. The negative covenants include restrictions on other indebtedness, liens, fundamental changes, certain investments, disposition of assets, mergers and liquidations, among other restrictions. As of March 31, 2023, the Company was in compliance with all covenants related to the Credit Agreement. As of March 31, 2023 and June 30, 2022, there were no outstanding borrowings on the facility. Contractual Obligation The Company leases the 126,000 square foot facility from Koss Holdings, LLC, which is controlled by five equal ownership interests in trusts held by the five beneficiaries of a former chairman’s revocable trust. On May 24, 2022, the lease was renewed for a period of five years, ending June 30, 2028, 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 has the option to renew the lease for an additional five years beginning July 1, 2028 and ending June 30, 2033 under the same terms and conditions except that the annual rent will increase to $397,000. The negotiated increase in rent slated for 2028 will be the first increase in rent since 1996. 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. Off-Balance Sheet Transactions At March 31, 2023, the Company did not have any transactions, obligations or relationships that could be considered off-balance sheet arrangements. ‎ 18 Table of Contents Item 3. Quantitative and Qualitative Disclosures About Market Risk Not applicable.