KOSS CORP 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The purpose of this discussion and analysis is to enhance the understanding and evaluation of the financial position, results of operations, cash flows, indebtedness, and other key financial information of the Company for fiscal years 2023 and 2022. 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. See also the “Cautionary Statement Regarding Forward-Looking Statements” on page 4 of this Report. Overview John C. Koss and the Company have been recognized as the creator of the personal listening industry. The Company initially developed the first Koss SP 3 stereo headphones in 1958 and has been an innovator in the field ever since. We market a complete line of high-fidelity headphones, wireless Bluetooth® headphones, wireless Bluetooth® speakers, computer headsets, telecommunications headsets, and active noise canceling headphones. Koss operates as one business segment, as its only business line is the design, manufacture and sale of stereo headphones and related personal listening accessories. The Company’s products are sold domestically and internationally through a variety of retailers and distributors, as well as directly to other manufacturers to include with their own products. Changes in sales volume are driven primarily by the addition or loss of customers, a customer adding or removing a product from its inventory, or changes in economic conditions. Sales levels are less impacted by seasonality or the traditional holiday shopping season. Although certain of the Company’s products could be viewed as essential by consumers for use with mobile phones and other portable electronic devices, many other models represent a more discretionary spend. The results of the Company’s operations are therefore susceptible to consumer confidence and adverse macroeconomic factors such as inflation, slower growth or recession, higher interest rates, and wage and commodity inflation. In addition, the economic sanctions imposed as a result of the Russia/Ukraine conflict have impacted certain of our customers in those markets and the surrounding regions. The impacts of COVID-19 have moderated since it was declared a global pandemic by the World Health Organization in March 2020. The Company continues to monitor any changes regarding the pandemic and any future impacts of COVID-19 on our business, operations, and financial results. Fiscal Year 2023 Summary  Net sales declined 26.0% to $13,099,651 due predominantly to weaker consumer demand led by constraints on consumer spending brought on by higher inflation and, as a result, lower disposable income. Over inventory positions at some U.S. distributors also contributed to the decline. Export sales fell 29% while domestic sales fell 25%.  Gross profit as a percentage of sales decreased 3.9 percentage points to 34.0%. The decrease was primarily due to fixed manufacturing expenses that do not flex with the lower sales volume. The favorable mix of higher margin direct-to-consumer (“DTC”) sales offset the year over year decline in higher margin domestic distributors.  Selling, general and administrative expenses increased significantly as a result of legal fees and expenses incurred in support of the Company’s patent defense litigation. Excluding the effect of these legal fees and expenses, selling, general and administrative expenses increased by approximately $1.3 million, or 24.9%. Bonus and profit-sharing expense as a consequence of the net income from licensing proceeds during the year also contributed to the increase.  Other income for the year ended June 30, 2023 consisted entirely of $33,000,000 in licensing proceeds received in the first quarter of the year.  Tax expense for the year ended June 30, 2023 was $317,377 as a direct impact of the licensing income earned during the year. ‎ 17 Table of Contents Consolidated Results The following table presents selected consolidated financial data for each of the past two fiscal years: Consolidated Performance Summary 2023 2022 Net sales $ 13,099,651 $ 17,705,519 Net sales decrease (26.0)% (9.4)% Gross profit $ 4,457,414 $ 6,715,630 Gross profit as % of net sales 34.0% 37.9% Selling, general and administrative expenses $ 29,358,466 $ 5,813,607 Selling, general and administrative expenses as % of net sales 224.1% 32.8% Interest income $ 520,809 $ 11,513 Other income $ 33,000,000 $ 362,390 Income before income tax provision $ 8,619,757 $ 1,275,926 Income before income tax provision as % of net sales 65.8% 7.2% Income tax provision $ 317,377 $ 7,517 Income tax provision as % of income before taxes 3.7% 0.6% 2023 Results of Operations Compared with 2022 Net sales for the fiscal year 2023 declined by 26.0% mainly as a result of lower sales to U.S. distributors coupled with a 28.9% drop in sales to the Company’s export markets. For the year ended June 30, 2023, domestic net sales decreased $3,284,378, or 25.0% to $9,848,521. Sales to U.S. distributors were impacted by an oversupply of inventory as a consequence of higher-level purchases during the pandemic followed by recent weakened consumer demand for our product due to inflation. While DTC sales, believed to be a significant approach to driving growth, remained stable year over year, it continued to represent the Company’s largest market class, growing from approximately 19% of total net sales during the twelve months ended June 30, 2022 to approximately 25% during the current fiscal year. Export net sales also saw a downturn during the current fiscal year, decreasing $1,321,490 or 28.9% to $3,251,130. The adverse impacts from the war between Russia and Ukraine, along with increasing inflation and higher energy costs, drove an approximately 27% decline in sales to export distributors in Europe by nearly $1,000,000 versus fiscal year 2022. Lost sales of approximately $600,000 to Russia and Ukraine made up the majority of the drop. A decrease in sales to distributors in Asia also contributed to the decline mainly behind a lack of sales to one of the Company’s non-retail original equipment manufacturers that utilizes Koss headphones in one of their products. Sales to this market were over $350,000 during the year ended June 30, 2022. Gross profit as a percentage of net sales decreased to 34.0% for the year ended June 30, 2023, compared to 37.9% for the prior fiscal year. Gross margins vary by customer, product, and markets and, as a result, any shifts in the mix can impact the overall gross margin. While the mix of higher margin DTC sales was favorable compared to the prior fiscal year, fixed manufacturing overhead expenses that don’t flex with sales negatively impacted the margins for the year. And while freight costs improved during the first half of the year and then stabilized in the back half, the movement of inventory received at the higher freight costs will continue to offset the reduced shipping costs. The Company renewed its contract with the freight forwarder, stabilizing contract rates and bringing them in line with market rates. UPS reached a tentative agreement for a new five-year national contract with the Teamsters on July 25, 2023, averting a potential crisis in small package shipping. The new agreement is likely to increase the Company’s future freight costs. Selling, general and administrative expenses for the year ended June 30, 2023 increased by approximately $23,545,000 to $29,358,000 compared to the prior year period. The significant change was predominantly a result of the increase of approximately $22,276,000 in legal fees and expenses incurred in support of the Company’s patent defense litigation. Excluding the effect of these legal fees and expenses, selling, general and administrative expenses increased by approximately $1.3 million, or 24.9%. Also, a bonus accrual of $334,000 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 fiscal year 2023 due mainly to the licensing proceeds received during the first quarter of 2023, partially offset by the aforementioned legal fees and expenses. During the year ended June 30, 2023, deferred compensation expense of $60,000 was recorded related to the change in the net present value of the future expected payments to a current officer as a result of an additional vesting year, which increased the future annual payments. This compares to $633,000 of income recorded in the prior fiscal year as a result of income of $473,000 recognized with the reversal of the deferred compensation liability for the Company’s founder who passed away in December 2021, offset by $71,250 of payments accrued and made to the former officer prior to his passing, and deferred compensation income of $231,000 recognized under the arrangement for the current officer as a result of increasing interest rates. Employer taxes on stock option exercises of approximately $28,000 were recorded in the current year compared to $134,000 in the prior year, a decrease of $106,000. 18 Table of Contents Other income for the year ended June 30, 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 fiscal year 2022 was $362,390. Interest income of $520,809 was recorded during the year ended June 30, 2023 for interest earned on U.S. Treasury securities that were purchased midyear to better secure the Company’s excess cash while earning a return. Interest income of $11,513 was earned on a money market account in the prior fiscal year. Income tax expense of $317,377 for the year ended June 30, 2023 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 $230,139 and $87,237, respectively. For the year ended June 30, 2022, there was no federal tax provision and a state tax provision of $7,517 was recorded. The effective tax rate was 3.7% for the fiscal year ended June 30, 2023 compared to less than 1% for the previous fiscal year. During the twelve months ended June 30, 2023, stock option exercises resulted in tax deductible compensation expense of approximately $368,000 and will offset some of the taxable income generated by the net licensing proceeds. Net operating loss carryforwards were also utilized to reduce the taxable income and, as such, th e remaining expected federal tax loss carryforward is expected to approximate $31,800,000 by the end of the fiscal year. The current fiscal year adjustment to the estimated tax loss carryforward decreased the deferred tax asset to approximately $8,200,000 as of June 30, 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. As previously reported, 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. The Company has recovered certain of the fees and costs that were involved with the underlying efforts to enforce this portfolio, as further described in the notes to the financial statements included in this Annual Report on Form 10-K. Part of the litigation related to this enforcement has been recently dismissed and the Company received non-recurring net proceeds of nearly $11,000,000 from the granting of licenses to certain of its patents. If the program continues to be successful with the remaining complaints, the Company may receive additional royalties, offers to purchase its intellectual property, or other remedies advantageous to its competitive position; however, there is no guarantee of a positive outcome from these efforts, which could ultimately be time consuming and unsuccessful. Additionally, the Company may owe all or a portion of any future proceeds arising from the enforcement program to third parties. The Company believes that its financial position remains strong. The Company had $3.1 million of cash and cash equivalents, $17.1 million of short-term investments and available credit facilities of $5.0 million on June 30, 2023. During fiscal 2023, inflation, rising interest rates and higher energy costs have impacted consumers’ discretionary spending and, as a result, the Company’s sales volumes. Inflationary cost increases have also had an impact on our commodities, packaging materials, labor costs, and transportation costs. Pricing actions implemented in the third quarter of fiscal year 2023 partially mitigated these increases and working with a dedicated freight forwarding partner has helped to minimize freight rate increases. The Company’s supply chain is primarily in southern China. While some issues related to the availability of containers and routings have subsided, the Company continues to monitor the situation closely and the supply chain team will modify business plans as necessary. This could include increasing the investment in inventory, being alert to potential short supply situations, assisting suppliers with acquisition of critical components and utilizing alternative sources and/or air freight. The invasion of Ukraine by Russia in February 2022 and the broad economic sanctions imposed in response to this conflict have increased global economic and political uncertainty. In accordance with Executive Order 14071 declared on April 6, 2022, the Company suspended sales into Russia. Given the humanitarian crisis in Ukraine and the population seeking refuge in other countries as a result of the ongoing conflict, sales to Ukraine were also impacted. Prior to the war, neither Russia nor Ukraine constituted a significant portion of the business, making up less than 3.4% of total net sales of the Company for the year ended June 30, 2022. There were no sales to Russia or Ukraine in the current fiscal year. We are uncertain, however, of the impact it will have on future operating results. 19 Table of Contents 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: Total cash provided by (used in): 2023 2022 Operating activities $ 10,735,649 $ (942,530) Investing activities (17,024,107) 1,810,139 Financing activities 171,350 1,390,346 Net (decrease) increase in cash and cash equivalents $ (6,117,108) $ 2,257,955 Operating Activities Cash provided by operating activities of the Company during the year ended June 30, 2023 was the result of the licensing proceeds received, partially offset by the payment of related legal fees and expenses, along with a second quarter profit-sharing payout. Additionally, the Company’s discipline around and the management of inventory purchases has led to a continued decline in inventory balances during the year. For the year ended June 30, 2022, the Company used cash of $942,530 for operating activities related to the deliberate investment in inventory to ensure adequate stock levels of critical products were available in case of potential supply chain disruption and delays. Investing Activities Cash used by investing activities for year ended June 30, 2023 was almost entirely related to the purchase of approximately $18,860,000 of U.S. Treasury securities at a discount. Purchases of equipment and leasehold improvements by the Company during the year ended June 30, 2023 was $98,441 compared to $108,158 spent for tooling and leasehold improvements in the prior year. Cash provided by investing activities for the year ended June 30, 2022 was the result of proceeds of a company-owned life insurance policy on the Company’s founder upon his passing on December 21, 2021, slightly offset by the fixed asset purchases. Capital expenditures for fiscal year 2024 are expected to be approximately $400,000 related to leasehold improvements. Financing Activities The cash generated from financing activities in the years ended June 30, 2023 and 2022 was solely driven by stock option exercises. As of June 30, 2023, the Company had no outstanding borrowings on its bank line of credit facility under the Credit Agreement (described below under “Credit Facility"). There were no purchases of common stock in 2023 or 2022 under the stock repurchase program. In the year ended June 30, 2023, there were stock option exercises of 87,000 shares generating $171,350 of cash. This compares to the exercise of 539,089 options during the year ended June 30, 2022, which generated cash of $1,390,346. Short Term Liquidity The Company anticipates funding its normal recurring trade payables, accrued expenses, ongoing R&D costs, and any potential interest payments, if it utilizes its line of credit facility, through existing working capital and funds provided by operating activities. The majority of the Company’s purchase obligations are pursuant to funded contractual arrangements with its customers. The Company believes its existing cash, cash equivalents, investments in short-term U.S. Treasury securities, cash provided by operating activities and borrowings under its credit facility, if any, will be sufficient to meet its anticipated working capital, and capital expenditure requirements during the next twelve months. There can be no assurance, however, that the Company’s business will continue to generate cash flow at current levels. If the Company is unable to generate sufficient cash flow from operations, then it may be required to sell assets, reduce capital expenditure, or draw on its credit facilities. Management is focused on increasing sales, especially in the U.S. distributor market, DTC, and the export markets, increasing new product introductions, 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 expenditure to ensure that it is effectively allocating resources in line with current market conditions. Long Term Liquidity The Company’s future capital requirements, to a certain extent, are also subject to general conditions in or affecting the electronics industry and are subject to general economic, political, financial, competitive, legislative, and regulatory factors that are beyond its control. Moreover, to the extent that existing cash, cash equivalents, cash from operations, and cash from its credit facilities are 20 Table of Contents insufficient to fund its future activities, the Company may need to raise additional funds through public or private equity or debt financing, subject to the limitations specified in the Credit Agreement (as defined below). In addition, the Company may also need to seek additional equity funding or debt financing if it becomes a party to any agreement or letter of intent for potential investments in, or acquisitions of, businesses, services, or technologies. 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 as well as 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 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 extends the maturity 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. The Company is currently in compliance with all covenants related to the Credit Agreement. As of June 30, 2023, and June 30, 2022, there were no outstanding borrowings on the facility. 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 approved increases in the amount authorized for repurchase under the program. As of June 30, 2023, the Board had authorized the repurchase of an aggregate of $45,500,000 of common stock under the stock repurchase program, of which $43,360,247 had been expended. No purchases were made during the years ended June 30, 2023 or 2022. There were no stock repurchases under the program in fiscal year 2023 or 2022. As such, as of June 30, 2023, the amount of common stock subject to repurchase by the Company under the Board of Director’s prior authorization remained $2,139,753 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, may occur either on the open market or through privately negotiated transactions and may be financed through the Company’s cash flow or by borrowing. 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 the former Chairman’s revocable trust and includes current stockholders of the Company. 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. ‎ 21 Table of Contents 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 have made estimates and 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, taking into consideration certain possible adverse impacts from inflation, the economic sanctions imposed on the international community as a result of the continued conflict between Russia and Ukraine, and any changes to the global economic situation as a consequence of the COVID-19 pandemic. Actual results may differ from these estimates. Below are the estimates that we believe are critical to the understanding of the Company’s results of operations and financial condition. Other accounting policies are described in Note 1, “Significant Accounting Policies” to the consolidated financial statements included in this Annual Report on Form 10-K. Revenue Recognition Revenues from product sales are recognized when the customer obtains control of the product, which typically occurs upon shipment from the Company’s facility. There are a very limited number of customers for which control does not pass until they have received the products at their facility. Revenue from product sales is adjusted for estimated warranty obligations and variable consideration, which are detailed below. The Company uses a five-step analysis to determine how revenue is recognized. The underlying principle is to recognize revenue when promised goods or services transfer to the customer. The amount of revenue recognized is to reflect the consideration expected to be received for those goods or services. See Note 3 to the Consolidated Financial Statements for additional information on revenue recognition. 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 an allowance for estimated credit losses. 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 collectability of the unsecured receivable is dependent upon the financial condition of an individual customer, which could change rapidly and without warning. Inventories The Company values its inventories using standard cost which approximates the lower of first in first out (“FIFO”) cost or net realizable value. Valuing inventories at the lower of cost or net realizable value requires the use of estimates and judgment. The Company continues to use the same techniques to value inventories that it has 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 net realizable value 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. When a reserve is established, it creates a new cost basis, which is not increased in the future. Product Warranty Obligations The Company offers a lifetime warranty to consumers in the United States and certain other countries. This lifetime warranty creates a future performance obligation. There are also certain foreign distributors that receive warranty repair parts and replacement headphones to satisfy warranty obligations in those countries. The Company defers revenue to recognize the future obligations related to these warranties. The deferred revenue is based on historical analysis of warranty claims relative to sales. This deferred revenue reflects the Company’s best estimates of the amount of warranty returns and repairs it will experience during those future periods. If 22 Table of Contents future warranty activity varies from the estimates, the Company will adjust the estimated deferred revenue, which would affect net sales and operating results in the period that such adjustment becomes known. Deferred Compensation The Company’s deferred compensation liability is for a current officer and is calculated based on various assumptions that may include compensation, years of service, expected retirement date, discount rates and mortality tables. The related expense is calculated using the net present value of the expected payments and is included in selling, general and administrative expenses in the Consolidated Statements of Operations. Management makes estimates of life expectancy and discount rates using information available from several sources. In addition, management estimates the expected retirement date for the current officer as that impacts the timing for expected future payments. See Note 10 for additional information on deferred compensation. Stock-Based Compensation The Company has a stock-based employee compensation plan, which is described more fully in Note 12 to the Consolidated Financial Statements. The Company accounts for stock-based compensation in accordance with ASC 718 "Compensation - Stock Compensation". Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the vesting period. The expected term of the options and volatility are estimated using historical experience for the options by vesting period. The risk-free interest rate is calculated based on the expected life of the options. The Company does not estimate forfeitures as they are recognized when they occur. Income Taxes We estimate a provision for income taxes based on the effective tax rate expected to be applicable for the 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 on Form 10-K and are incorporated herein by reference. ‎ 23 Table of Contents ITEM 7A. QUANTITATIVE AND QU ALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable . ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See the Consolidated Financial Statements included herewith. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None.