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TMCNet:  INFOSONICS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[November 14, 2012]

INFOSONICS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements, Safe Harbor Statement and Other General Information This discussion and analysis of financial condition and results of operations should be read in conjunction with the accompanying unaudited consolidated financial statements and condensed notes thereto and other information included in this report and our Annual Report on Form 10-K for the year ended December 31, 2011 (including our 2011 audited consolidated financial statements and related notes thereto and other information). Our discussion and analysis of financial condition and results of operations are based upon, among other things, our unaudited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of financial statements in conformity with GAAP requires us to, among other things, make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosures of contingent liabilities as of the date of our most recent balance sheet, and the reported amounts of revenues and expenses during the reporting periods. We review our estimates and assumptions on an ongoing basis. Our estimates are based on our historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results are likely to differ from these estimates under different assumptions or conditions, but we do not believe such differences will materially affect our financial position or results of operations, although they may. Our critical accounting policies, the policies we believe are most important to the presentation of our financial statements and require the most difficult, subjective and complex judgments are outlined in "Critical Accounting Policies" in our Annual Report on Form 10-K. All references to results of operations in this discussion generally are to results from continuing operations, unless otherwise noted.



This report contains "forward-looking statements," including, without limitation, statements about customer relationships, marketing of our verykool® products, sales levels, cost reductions, operating efficiencies, profitability and adequacy of working capital, that are based on current management expectations and which involve certain risks and uncertainties. These risks and uncertainties, in whole or in part, could cause such expectations to fail to be achieved and have a material adverse effect on our business, financial condition and results of operations, and include, without limitation: (1) intense competition internationally, including competition from alternative business models, such as manufacturer-to-carrier sales, which may lead to reduced prices, lower sales, lower gross margins, extended payment terms with customers, increased capital investment and interest costs, bad debt risks and product supply shortages; (2) the ability of our China R&D group to develop new verykool® handsets and successfully introduce them into new emerging markets; (3) extended general economic downturn in world markets; (4) inability to secure adequate supply of competitive products on a timely basis and on commercially reasonable terms; (5) foreign exchange rate fluctuations, devaluation of a foreign currency, adverse governmental controls or actions, political or economic instability, or disruption of a foreign market, including, without limitation, the imposition, creation, increase or modification of tariffs, taxes, duties, levies and other charges and other related risks of our international operations which could significantly increase selling prices of our products to our customers and end-users; (6) the ability to attract new sources of profitable business from expansion of products or services or risks associated with entry into new markets, including geographies, products and services; (7) an interruption or failure of our information systems or subversion of access or other system controls may result in a significant loss of business, assets, or competitive information; (8) significant changes in supplier terms and relationships or shortages in product supply; (9) loss of business from one or more significant customers; (10) customer and geographical accounts receivable concentration risk and other related risks; (11) rapid product improvement and technological change resulting in inventory obsolescence; (12) uncertain political and economic conditions internationally, including terrorist or military actions; (13) the loss of a key executive officer or other key employees and the integration of new employees; (14) changes in consumer demand for multimedia wireless handset products and features; (15) our failure to adequately adapt to industry changes and to manage potential growth and/or contractions; (16) seasonal buying patterns; (17) the resolution of any litigation for or against the Company; (18) the ability of the Company to have access to adequate capital to fund its operations; and (19) the ability of the Company to generate taxable income in future periods. Reference is also made to other factors detailed from time to time in our periodic reports filed with the Securities and Exchange Commission. These forward-looking statements speak only as of the date of this release and we undertake no obligation to publicly update any forward-looking statements to reflect new information, events or circumstances after the date of this release. We have instituted in the past, and continue to institute, changes to our strategies, operations and processes to address risks and uncertainties and to mitigate their impacts on our results of operations and financial condition. However, no assurances can be given that we will be successful in these efforts. For a further discussion of significant risk factors to consider, see "Risk Factors" below in this report and "Item 1A. Risk Factors" of our Annual Report on Form 10-K. In addition, other risks or uncertainties may be detailed from time to time in our future SEC filings.

12-------------------------------------------------------------------------------- Table of Contents Overview We are a provider of wireless handsets and accessories to carriers, distributors and original equipment manufacturers ("OEMs") in Latin America, Asia Pacific, Europe and Africa. We design, develop, source and sell our proprietary line of products under the verykool® brand and on a private label basis to certain customers (collectively referred to as our "verykool® products"). We first introduced our verykool® brand in 2006 and verykool® products include entry-level, mid-tier and high-end products.

Prior to March 2012 and for the past five years before then, there were essentially two ways through which we provided wireless handsets and accessories: (1) through the distribution of wireless handsets supplied by major manufacturers, primarily Samsung, and (2) through the provision of our proprietary verykool® phones that we originally sourced from independent design houses and original design manufacturers ("ODMs"). Our annual revenue peaked in 2006 when we recorded approximately $241 million of net sales. In 2009, more than 95% of our net sales of approximately $231 million were derived from distribution sales of Samsung products to carriers in Argentina. In late 2009, however, a stiff import tariff on certain electronic devices, including wireless handsets, was enacted in Argentina. The tariff had a significant negative impact on our sales beginning in the first quarter of 2010, and ultimately resulted in a decrease of 69% of our sales volume in 2010 compared to 2009. Then, in February 2011, Argentina enacted a further import regulation effective March 6, 2011 which signaled the closing stage of our distribution business. Our distribution agreement with Samsung expired on March 31, 2012. Since then and going forward, our business has been and will be centered on our verykool® product line. Our goal is to eventually replace the lost gross profit from distribution revenues with higher margin verykool® sales through the expansion of our product portfolio and entry into new geographic markets in Latin America, Asia Pacific, Europe and Africa.

The verykool® brand is now our flagship product. In order to better control the roadmap for this product line, in April 2010 we established an in-house design center in Beijing, China where we are now designing a number of phones in our product portfolio. We continue to source many of our phones from independent design houses, but expect that eventually the majority of our phones will come from our own design center as our team expands and increases its capacity. We contract with electronic manufacturing services ("EMS") providers to manufacture all of our verykool® products, and maintain personnel in China to oversee production and conduct quality control.

Industry and Market Trends and Risks The wireless business is extremely competitive. The industry is characterized by rapid technological development driven by faster and more capable chipsets, innovative software features and applications and faster networks provided by wireless carriers. In this environment, it is extremely difficult to differentiate our products, and price pressure is constant.

Over the past several years, our business has been concentrated in countries in Latin America. In addition, during that time, the majority of our revenue was derived from distribution sales of Samsung products in Argentina, typically at very thin margins. As mentioned above, in late 2009, Argentina enacted a significant import tariff on certain electronic devices, including wireless handsets, that threatened our distribution business and largely eroded our sales during 2010 and 2011.

In late 2010, we expanded sales of our verykool® products into the Asia Pacific market with initial sales to customers in both China and India, and in 2011, we added customers in Western Europe, Russia, Singapore, Africa and certain other Southeast Asian countries. The economic profile of the consumer markets in both Latin America and Asia Pacific are similar in that they are extremely price sensitive. As a consequence, unlike the U.S. domestic market that is dominated by large providers, these markets are more open to smaller providers such as InfoSonics who are able to supply more competitively priced handsets with similar features. We expect 13 -------------------------------------------------------------------------------- Table of Contents this situation to continue for the foreseeable future. The Latin America and Asia Pacific markets are also more attractive to us because the current level of cellular customer penetration is significantly lower in most countries in these regions in comparison to North America and Western Europe.

Results of Operations The following table sets forth certain items from our consolidated statements of operations as a percentage of net sales for the periods indicated: Three months ended Nine months ended September 30, September 30, 2012 2011 2012 2011 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of sales 78.8 % 83.0 % 78.9 % 87.2 % Gross profit 21.2 % 17.0 % 21.1 % 12.8 % Operating expenses: Selling, general and administrative 33.6 % 17.5 % 20.4 % 17.3 % Research and development 9.8 % 5.4 % 5.9 % 4.9 % 43.4 % 22.9 % 26.3 % 22.2 % Operating loss from continuing operations (22.2 %) (5.9 %) (5.2 %) (9.4 %) Other income (expense): Other income (expense) - 0.0 % 0.0 % 0.1 % Interest, net 0.1 % - 0.0 % 0.0 % Loss from continuing operations before income taxes (22.1 %) (5.9 %) (5.2 %) (9.3 %) Provision for income taxes - - 0.0 % 0.0 % Loss from continuing operations (22.1 %) (5.9 %) (5.2 %) (9.3 %) Income from discontinued operation, net of tax - 0.1 % - - Net loss (22.1 %) (5.8 %) (5.2 %) (9.3 %) Three months ended September 30, 2012 compared with three months ended September 30, 2011 Net Sales For the three months ended September 30, 2012, our net sales amounted to $5.4 million, a decrease of $1.8 million, or 25%, from $7.2 million in the same period last year. The decrease was due to a softening of demand at a number of our larger customers, primarily in Guatemala and the Latin American open market (non-carrier), as well as a decline of $1.2 million in distribution sales as a consequence of the termination of our Samsung distribution agreement at the end of the first quarter of 2012 and the absence of Samsung sales during the third quarter of 2012. Excluding the decline in distribution sales, net sales of verykool® products declined 10% during the third quarter of 2012 compared to the third quarter of the prior period. Sales of verykool® products to customers in Latin America declined 18% from $5.7 million to $4.7 million, but was partially offset by $0.4 million of incremental private label sales to customers in Western Europe, Russia, Africa and Asia Pacific. In total, we shipped 22% more verykool® handsets during the quarter than in the prior year, but the average selling price declined 26% due to a shift in product mix driven by the popularity of lower-priced phones in our Latin American markets and a lowering of our sales prices during the third quarter of 2012 to spur sales.

We believe that the softening of our sales in the third quarter of 2012 reflects a general weakness of consumer demand that was experienced across a number of different industry sectors. We are encouraged by the firming of customer orders we are experiencing mid-way through the fourth quarter of 2012 and believe that our fourth quarter results will show meaningful improvement over the third quarter.

Cost of Sales, Gross Profit and Gross Margin For the three months ended September 30, 2012, our gross profit amounted to $1,139,000, a decrease of $79,000, or 7%, from $1,218,000 in the same period last year, as a result of the decreased sales volume of our proprietary verykool® products and the absence of Samsung distribution revenues. Our gross profit margin for the three months ended September 30, 2012 rose to 21.2% from 17.0% in the same period last year, due primarily to the absence of low margin distribution sales in the third quarter of 2012. For the three months ended September 30, 2012, substantially all of our net sales were generated by verykool® products, compared to 83% in the same period last year.

14-------------------------------------------------------------------------------- Table of Contents Operating Expenses For the three months ended September 30, 2012, total operating expenses amounted to $2.3 million, an increase of 42% compared to $1.6 million in the same period last year. The increase in expenses in combination with the decline in net sales resulted in an increase in operating expenses as a percentage of net sales to 43.4% in the three months ended September 30, 2012, compared with 22.9% for the same period last year. Selling, general and administrative expenses for the three months ended September 30, 2012 amounted to $1.8 million, an increase of $548,000, or 44%, compared to $1.3 million in the prior year quarter. The increases were primarily related to increases in marketing, our annual sales meeting and increased compensation expense for new employees and contractors.

R&D expenses for the three months ended September 30, 2012 amounted to $527,000, an increase of $143,000, or 37%, compared to $384,000 in the prior year quarter.

The increase was primarily due to increased compensation expense from expansion of our development team.

Other Income (Expense) Other income (expense) was not significant for the three months ended September 30, 2012 or 2011.

Provision for Income Taxes Because of our prior operating losses and lack of carry-back ability, we had no provision for income taxes for the three months ended September 30, 2012 and 2011.

Income from Discontinued Operations (net of tax) The discontinuance and closure of our operations in the U.S. and Mexico that began in the second quarter of 2008 was completed as of December 31, 2011.

During the three months ended September 30, 2011, we reported net income from discontinued operations of $7,000.

Nine months ended September 30, 2012 compared with nine months ended September 30, 2011 Net Sales For the nine months ended September 30, 2012, our net sales amounted to $25.8 million, an increase of $2.9 million, or 13%, from $23.0 million in the same period last year. The increase reflects a significant increase in sales of our proprietary verykool® handsets. Net sales of verykool® products during the nine months ended September 30, 2012 amounted to $23.1 million, an increase of $10.1 million, or 78%, from $13.0 million in the same period last year. We shipped 114% more verykool® handsets during the first nine months of 2012 than in the first nine months of the prior year, and the average selling price declined by 17% primarily due to a shift in product mix to lower priced phones that are popular in Latin America.

Partially offsetting the increase in sales of our proprietary verykool® handsets was a decline in Samsung distribution sales reflecting the wind down of our Samsung distribution business. Distribution sales during the nine months ended September 30, 2012 amounted to $2.7 million, a decrease of $7.2 million, or 73%, from $9.9 million in the same period last year.

Cost of Sales, Gross Profit and Gross Margin For the nine months ended September 30, 2012, our gross profit amounted to $5.5 million, an increase of $2.5 million, or 86%, from $2.9 million in the same period last year. The significant increase reflects the combined effect of the increased level of sales during the period and the higher mix of sales this year of our proprietary verykool® products compared to our distribution revenues. Our gross profit margin for the nine months ended September 30, 2012 was 21.1% of net sales, a 65% increase from the gross margin of 12.8% in the same period last year. For the nine months ended September 30, 2012, net sales of verykool® products represented 89% of our total sales, compared to 57% in the same period last year.

Operating Expenses For the nine months ended September 30, 2012, total operating expenses amounted to $6.8 million, an increase of 33% compared to $5.1 million in the same period last year. Operating expenses as a percentage of net sales increased to 26.3% in the nine months ended September 30, 2012, compared with 22.2% for the same period last year, as expenses increased at a faster pace than net sales.

Selling, general and administrative expenses for the nine months ended September 30, 2012 amounted to $5.3 million, an increase of $1.3 million, or 33%, compared to $4.0 million for the same period last year. This increase is primarily related to an increase of $225,000 in our bad debt reserve, increased compensation expense for new employees and contractors, sales commissions on increased sales, increased marketing and annual sales meeting expenses and increased homologation expenses to prepare new phone models for sale and use on carrier networks. Research and development expenses for the nine months ended September 30, 2012 amounted to $1.5 million, an increase of $388,000, or 33%, compared to $1.1 million for the same period last year. The increase is primarily related to compensation expense from expansion of our development team and prototyping and abandoned tooling expense.

15-------------------------------------------------------------------------------- Table of Contents Other Income (Expense) For the nine months ended September 30, 2012, other income (expense) included $65,000 of expense comprised of $48,000 of foreign exchange losses and a $17,000 loss on disposal of fixed assets. We also recorded $53,000 of interest income primarily related to financed customer receivables. For the nine months ended September 30, 2011, we recorded $30,000 of other income relating principally to the gain on sale of fixed assets in connection with the closure of our Miami warehouse on March 31, 2011 and $11,000 of interest income earned on an income tax refund.

Provision for Income Taxes Because of our operating losses and lack of carry back ability, our tax provisions for the nine month periods ended September 30, 2012 and 2011 were nominal and consisted only of state and local taxes.

Liquidity and Capital Resources Historically, our primary sources of liquidity have been cash generated from operations, lines of credit (bank and vendor) and, from time to time, the sale and exercise of securities to provide capital needed to support our business.

However, we have incurred losses for the last three fiscal years and negative cash flow from operations in one of those years. In the nine months ended September 30, 2012, we used $1.9 million in cash for operations. Primary uses of cash included a $2.4 million increase in inventories due primarily to the slowing of sales in the third quarter of 2012, a $1.4 million decrease in accounts payable and accruals, and a $0.6 million net loss before non-cash charges. Primary sources of cash included a $1.7 million reduction in accounts receivable, a $0.8 million decrease in prepaids and other assets. Although we do not currently have a bank credit line, we believe that our current cash resources and working capital are sufficient to fund our operations for the foreseeable future.

Critical Accounting Policies There have been no material changes to our critical accounting policies and estimates affecting the application of those accounting policies since our Annual Report on Form 10-K for the year ended December 31, 2011.

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