Koss Corp: Form 10-Q for the period ended Sep 30, 2024

The following discussion and analysis supplements our management’s discussion and analysis for the year ended June 30, 2024 as contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on August 30, 2024, 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, 2024, 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 months ended September 30, 2024 and 2023:

Fiscal 2025 Period Results Compared with Fiscal 2024 Period

(comments refer to the three-month periods ended September 30 unless otherwise noted)

Net sales for the three months ended September 30, 2024 were $3,201,868, down $172,070, or 5.1%, from $3,373,938 for the same three-month period in the prior year. A sizable custom order in the prior year’s first quarter did not repeat, causing a decline in the current quarter. Coupled with that, was an approximately 20% decline in sales to our U.S. distributors. Improved sales to our European markets and a near 18% increase in direct-to-consumer (“DTC”) sales did help to partially offset the decline.

In the domestic markets, net sales were down $435,794, or 16.7%, from $2,603,158 for the three months ended September 30, 2023 to $2,167,364 for the three months ended September 30, 2024. The decrease was driven by a non-recurring custom order from the prior year, a shortfall in U.S. distributor sales due to a missed shipment and timing of new orders. Sales to the Education and Music markets also dropped by 55% versus the prior year, contributing to the overall decline. The increase in DTC sales in the first quarter of fiscal year 2025 compared to the prior year moderately offset some of the domestic sales reduction.

Sales to the export markets were a highlight for the quarter as the Company’s two largest European distributors placed significant orders for a newly released product, resulting in an 86% increase over the sales to them in the first quarter of the prior year. Sales to a Georgian distributor were also up 100% versus the prior year and a Canadian retail account returned with a respectable new order after discontinuing the Company’s product line. As an offset to this favorability, the Ukrainian distributor has not yet reordered, thus resulting in a gap compared to the approximately $214,000 order received in the first quarter of fiscal year 2024.

Gross margins as a percentage of net sales of 36.6% for the three months ended September 30, 2024 was a 500-basis points improvement compared to 31.6% for the three months ended September 30, 2023. A favorable sales mix, made up of a higher percentage of higher margin DTC sales plus the sales of the newly released product to our European distributors, was only slightly offset by a lower percentage of higher margin U.S. distribution sales. Also contributing to the increased margin performance was the freight expense offset related to the capitalization of freight costs into inventory for the stock purchased to ensure appropriate levels for the new product launches. An increase to the excess and obsolete inventory reserve driven by inventory on some items in excess of two years’ sales had an adverse impact on the gross margins for the first quarter of fiscal year 2024.

Freight rates increased slightly throughout the quarter ended September 30, 2024, along with lead times, due to peak season and delays from the West Coast to the Midwest. Sixty percent of the Company’s shipments shipped under lower fixed rates that are accessible via the Company’s partnership with a dedicated freight forwarder. Market rates are expected to continue to rise into the next quarter due to increased U.S import demand during peak season and the significant challenges of shipping through the Red Sea and Suez Canal, causing major disruptions to global trade and increased costs. The Company also continues to monitor the sustained conflicts in Eastern Europe and the Middle East and is prepared to react as necessary if faced with supply chain disruptions.

Selling, general and administrative expenses for the three months ended September 30, 2024 increased by $273,780, or 17.8% from $1,536,279 to $1,810,059. The increase was almost entirely attributable to the increase in the deferred compensation liability as a result of the lower discount rates used in the calculation as well as an increase in expected payments due to an additional year of service. An increase in engineering expenses, mainly for new product testing and certification costs, was offset by a similar decline in legal expenses.

Interest income of $220,358 was recorded during the three months ended September 30, 2024 mainly due to interest earned on the U.S. Treasury investments held during the quarter in order to earn a return on the Company’s excess cash while maintaining a minimal risk profile. This compares to $212,859 of interest income earned in the same period in the prior fiscal year from these securities.

As a result of minimal or no taxable income after utilization of net loss carryforwards, no federal income tax expense was recorded for either of the three-month periods ended September 30, 2024 and 2023. State income tax expense of $2,760 was recorded for the three months ended September 30, 2024, reflecting the minimum required tax due plus a negligible net taxable income after considering NOLs. A state income tax expense of $1,879 was recorded in the first quarter of fiscal year 2024, which represented only the minimum required tax amounts due given no taxable net income. The effective tax rate was less than 1% for both three-month periods ending September 30, 2024 and 2023. 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 and state net operating loss carryforwards that existed as of June 30, 2024.

The Company’s remaining expected federal tax loss carryforward approximates $32,800,000 at the end of the first quarter of fiscal 2025. The small state taxable income after considering net operating losses decreased the net operating loss carryforward deferred tax asset to approximately $8,500,000 as of September 30, 2024. The valuation allowance was adjusted accordingly and still fully offsets the net 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, 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 $2.8 million of cash and cash equivalents, $9.1 million of short-term investments and available credit facilities of $5.0 million on September 30, 2024.

Recent Trends

Recent and ongoing macroeconomic and geopolitical conditions have impacted, and will continue to impact, our business. These include economic uncertainty from elevated inflation and interest rates, reduced consumer confidence, disruption in our supply chain and trade tensions with China, the ongoing crises in Eastern Europe, the continued conflict in the Middle East and increased risk of cyberattacks.

While the impact of these factors on our fiscal 2025 performance 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.

Inflationary Cost Environment and Reduced Consumer Confidence - Inflation, higher interest rates and higher energy costs continue to impact consumers’ discretionary spending and, in turn, the Company’s sales volumes. Inflation may impact customer demand for our products resulting from a slowdown in consumers’ willingness to spend as disposable income decreases due to rising prices of essential items, spend through of excess savings from earlier in the pandemic and leading indicators pointing to a softening in the labor market. While inflation rates have come down since the prior year, the Company is still experiencing higher costs of commodities, packaging materials, and wages, along with higher energy and transportation costs. The Company continues to monitor costs and will react with pricing actions as it deems necessary. The Company continues to work with a dedicated freight forwarding partner to minimize freight rate increases. Other risk factors further exacerbated by inflation include supply chain disruptions, increased oil and energy costs, risks of international operations and the recruitment and retention of talent.

Supply Chain Disruption and Trade Tensions with China - The Company relies on our third-party supply chain, primarily in southern China, and distribution networks and the availability of necessary components to produce a considerable number of our products. A reduction or interruption in supply, including interruptions due to pandemic related restrictions, geopolitical unrest, labor shortages or strikes, or a failure to procure adequate components, may lead to delays in manufacturing or increases in costs.

Many of the Company’s products are sourced from contract manufacturing facilities in the People’s Republic of China and Taiwan. There has been increasing geopolitical tension between China and Taiwan that may affect future shipments from Taiwan-based suppliers. Any other adverse changes in the social, political, regulatory or economic conditions in the countries could materially increase the cost of the products we buy from our foreign suppliers or delay shipments of products. There has also been increasing geopolitical tension between China and the United States. Sustained uncertainty about, or worsening of, economic relations and further escalation of trade tensions between the United States and China, or any other country in which the Company conducts business, could result in retaliatory trade restrictions that restrict our ability to source products from China or continue business in such other country. Any alterations to our business strategy or operations made in order to adapt to or comply with any such changes would be time-consuming and expensive, and the Company may not be able to pass along most increases in tariffs and freight charges to the Company’s customers, which would also directly affect profits.

On Monday, October 1, 2024, the International Longshoremen’s Association (the “ILA”) called a coast-wide strike, temporarily closing the U.S. East Coast and Gulf Coast ports, affecting the movement of import and export containers. On Thursday, October 3rd, the ILA and the United States Maritime Alliance, Ltd. (USMX) reached a tentative agreement on wages and to extend the Master Contract until January 15, 2025, to return to the bargaining table to negotiate all other outstanding issues. Work resumed at most ports along the US East and US Gulf coasts on Friday, October 4th. While some residual delays may occur as port operations gradually return to full capacity, the Company is aware that a final agreement will not be concluded until the end of the second quarter of the fiscal year and could still have a significant impact on its operations in the second half of the fiscal year. The Company will, however, continue to monitor this situation and others that may arise as the changes in the current labor landscape, the settlement of recent labor disputes, coupled with rising energy prices, could potentially exacerbate disruptions in the supply chain, delay product shipments and increase transportation costs.

Russia’s Invasion of Ukraine - Financial and credit markets around the world experienced volatility following the invasion of Ukraine by Russia in February 2022. In response to the invasion, the United States, United Kingdom, and European Union, along with others, imposed significant sanctions and export controls against Russia, Russian banks and certain Russian individuals and may implement additional sanctions or take further punitive actions in the future. In accordance with Executive Order 14071 signed on April 6, 2022, the Company suspended sales to Russia. While there is a humanitarian crisis in Ukraine created by the war and the population continues to seek refuge in other countries, the Company did receive a sizable order from their Ukrainian distributor in the first quarter of fiscal year 2024 with potential for more orders in the current year. During the three months ended September 30, 2024 and 2023, there were no sales to Russia.

Cyberattacks - Cyberattacks are a growing geopolitical risk, becoming larger, more frequent, more sophisticated and more relentless as technology has evolved, resulting in privacy, security, and compliance concerns. They are a significant threat to individual organizations and national security. High-profile security breaches at other companies and in government agencies have increased in recent years, and security industry experts and government officials have warned about the risks of hackers and cyberattacks targeting businesses. We rely on accounting, financial, and operational management information systems to conduct our operations. Any disruption in these systems could adversely affect our ability to conduct our business. Furthermore, as part of our normal business activities, we collect and store common confidential information about customers, employees, vendors, and suppliers. This information is entitled to protection under a number of regulatory regimes. Any failure to maintain the security of the data, including the penetration of our network security and the misappropriation of confidential and personal information, could result in business disruption, damage to our reputation, financial obligations to third parties, fines, penalties, regulatory proceedings and private litigation with potentially large costs, and also result in deterioration in customers confidence in us and other competitive disadvantages, and thus could have a material adverse impact on our financial condition and results of operations. While we devote resources to security measures to protect our systems and data, these measures cannot provide absolute security and there is a risk that these types of attacks could impact the entire supply and distribution chain for the Company’s product line. In a world that runs on the internet, the Company can only be as strong as its weakest link, whether as a financial service provider, third party distributor, reseller, transportation service provider, contract manufacturer, customer or consumer.

Liquidity and Capital Resources

Cash Flows

The following table summarizes cash flows from operating, investing and financing activities for the three months ended September 30, 2024 and 2023:

Operating Activities

The cash provided by operating activities during the three months ending September 30, 2024, was primarily a result of customer deposits for orders shipping in the next quarter. Also contributing to the positive cash flow was the refund of $362,000 by the Company’s payroll vendor relating to employee payroll taxes on the gains from the disqualifying dispositions of incentive stock options as the Company has now chosen to issue the checks directly to the employees. Cash outflow for the premium payments made for the annual renewal of the Company’s general insurance policies partially offset the cash that came in. During the three months ended September 30, 2023, the cash used in operating activities was due to payment of bonuses earned in the prior year, general insurance premiums and state income tax payments. The Company’s strict management of its inventory investment helped to retain some cash in the first quarter.

Investing Activities

Cash used by investing activities for the three months ended September 30, 2024 was related mostly to fixed asset expenditures, namely the replacement of a second roof section of the building, and the payment of the premiums on the company-owned life insurance policies on two of its executives. Proceeds of $5,034,000 received during the three months ended September 30, 2024 from the maturity of U.S. Treasury securities were mostly reinvested to purchase $5,057,000 of similar securities at a $58,000 discount. Cash used by investing activities for the three months ended September 30, 2023 was also related to fixed asset expenditures, predominantly the replacement of a roof section of the building for approximately $300,000. The Company also paid the premiums on the company-owned life insurance policies on two of its executives.

Financing Activities

Cash from the exercise of stock options during the three months ended September 30, 2024 provided the only cash from financing activities. An aggregate of 51,000 shares of common stock were issued as a result of employee stock option exercises under grants still outstanding from the Company’s 2012 Omnibus Incentive Plan. There were no stock option exercises in the first quarter of the prior fiscal year.

As of September 30, 2024 and June 30, 2024, 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 September 30, 2024 or 2023 under the stock repurchase program.

Liquidity

The Company believes its existing cash and 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 expenditures, or draw on its credit facilities. 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 for 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. A Fourth Amendment to the Credit Agreement effective October 30, 2024, extends the maturity date to October 31, 2026, and removes one of the covenants requiring submission of annual financial performance projections to the Lender. 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 September 30, 2024, the Company was in compliance with all covenants related to the Credit Agreement. As of September 30, 2024 and June 30, 2024, there were no outstanding borrowings on the facility.

Contractual Obligation

The Company leases its 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 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.

Critical Accounting Policies and Estimates

There have been no significant changes in our critical accounting policies and estimates from the information we provided in our Annual Report on Form 10-K for the fiscal year ended June 30, 2024.

Off-Balance Sheet Transactions

At September 30, 2024, the Company did not have any transactions, obligations or relationships that could be considered off-balance sheet arrangements.

Disclosure Controls and Procedures

Disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) are designed to ensure that: (1) information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms; and (2) such information is accumulated and communicated to management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.

The Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2024. The Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures as of September 30, 2024 were effective.

Changes in Internal Control Over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a–15(f) and 15d–15(f)) that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II

OTHER INFORMATION

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part 1. Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2024, as filed with the Securities and Exchange Commission on August 30, 2024. These factors could materially adversely affect our business, financial condition, liquidity, results of operations and capital position, and could cause our actual results to differ materially from our historical results or the results contemplated by any forward-looking statements contained in this report. There have been no material changes to the risk factors described under “Risk Factors,” included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2024.