# Turtle Beach Corp (TBCH) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Turtle Beach Corp's 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1493761/000095017023010660/hear-20221231.htm
Accession: 0000950170-23-010660
Filing date: 2023-03-29
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/TBCH/
All MD&A years: /company/TBCH/mda/
Previous year: /company/TBCH/mda/fy2021/ (FY 2021)
Next year: /company/TBCH/mda/fy2023/ (FY 2023)

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three-year period ended December 31, 2022.

Turtle Beach Corporation (herein referred to as the “Company,” “we,” “us,” or “our”), headquartered in White Plains, New York, and incorporated in the state of Nevada in 2010, is a premier audio technology company with expertise and experience in developing, commercializing, and marketing innovative products across a range of large addressable markets under the Turtle Beach® and ROCCAT® brands.

•
Turtle Beach is a worldwide leader of feature-rich headset solutions for use across multiple platforms, including video game and entertainment consoles, handheld consoles, personal computers (“PC”), tablets and mobile devices.

•
ROCCAT is a gaming headsets, keyboards, mice, and other accessories brand focused on the personal computer peripherals market.

Business Trends

Console Headset Market

The global market for console headsets is estimated to be approximately $1.4 billion, in which we are the market leader. PlayStation and Xbox consoles continue to be dominant gaming platforms in North America and Europe for games that drive headset usage. This market experienced unprecedented growth in 2020 driven by the initial stay-at-home orders when new gamers entered the market, lapsed gamers started playing again, existing gamers played more, and non-gamers bought headsets for remote learning. In past couple years, this market experienced a decline relative to the 2020 surge due to weaker retail demand, a slower holiday season from disappointing AAA video game releases and console supply constraints.

Traditionally, the gaming market has grown as new gamers enter and existing gamers upgrade current gaming accessories. The emergence of battle royale games that are highly social, collaborative, and competitive, contributed to a higher growth in the video game industry and a higher proportion of gamers using headsets. And given that most of the gaming headset market is driven by replacement and upgrading, this large influx of new gaming headset users is expected to drive an increase in demand for gaming headsets in future years.

PC Accessories Market

The market for PC gaming headsets, mice, and keyboards is estimated to be approximately $3.2 billion. PC gaming continues to be a main gaming platform in the U.S. and internationally, driven by big AAA game launches, PC-specific esports leagues, popular teams and players, content creators and influencers and cross-platform play. While most games are available on multiple platforms, gaming on PC offers advantages including improved graphics, increased speed and precision of mouse/keyboard controls, and the ability for deeper customization. Gaming mice and keyboards are engineered to provide gamers with high-end performance and a superior gaming experience through features such as faster response times, improved materials and build quality, programmable buttons and keys, and software suites to customize and control devices and settings.

PC gaming mice come in a variety of different ergonomic shapes and sizes, are available in both wired and wireless models, offer options for different sensors (optical and laser) and responsiveness, and often feature integrated RGB LED lighting and software to unify the lighting with other devices for a visually consistent PC gaming appearance. Similarly, PC gaming keyboards often deliver a competitive advantage by offering options for mechanical and optical key switches that feel and sound different and offer customizable lighting.

Controllers and Gaming Simulation Markets

In 2022, Turtle Beach further expanded its gaming simulation and gaming controller product lines. For the flight simulation market, Turtle Beach launched the VelocityOneTM Pedals and VelocityOneTM Stand, which perfectly pair with the VelocityOne FlightTM simulation control system for the complete, most immersive flight simulation experience on the market. Turtle Beach also launched the VelocityOneTMFlightstick, which is a single stick joystick controller for air and space flight combat games. For the gamepads/controllers market, Turtle Beach added new colorways for its original Recon Controller, as well as launched the lower-cost REACT-R controller, and mobile-focused Recon Cloud and Atom controller offerings. These markets increase Turtle Beach’s total addressable market by $1 billion, with third-party game controllers at roughly $500 million and PC/console flight simulation hardware at roughly $500 million in the global market.

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Seasonality

Our gaming accessories business is seasonal with a significant portion of sales and profits typically occurring around the holiday period. Historically, more than 45% of revenues are generated during the period between September and December as new products are introduced and consumers engage in holiday shopping. In addition, launches of major new online multiplayer games, and specific retailer purchasing behavior, can drive significant revenue shifts between months and quarters in a given year. In the past few years, normal seasonal patterns have been significantly changed due to pandemic-driven shifts in consumer demand.

In connection with the seasonality of the business, historically the Company’s borrowings on the revolving credit facility increase as a result of the holiday inventory build leading up to year-end and decline on gross receipts during the first quarter of the following year.

Supply Chain and Operations

We have a global network of suppliers that manufacture products to meet the quality standards sought by our customers and our cost objectives. We have worked closely with component, manufacturing, and global logistic partners to build a supply chain that we consider dependable, scalable, and efficient to provide high-quality, reliable products employing leading cost management practices. The use of outsourced manufacturing facilities is designed to take advantage of specific expertise and allow for flexibility and scalability to respond to both seasonality and changing demands for our products.

We have experienced and may continue to experience increased freight costs and component availability challenges. Further, market conditions have significantly increased the lead time on many product components, causing us to purchase components earlier than normal to meet forecasted demand, which, in some cases, led to excess inventories of certain components ordered with long lead times ahead of shifting demand. We expect to continue to experience challenges impacting our supply chain and logistics operations. As a result, we continue to take proactive steps to limit the impact of these challenges and are working closely with our manufacturing and freight providers to reduce costs.

We believe we have strong, long-term relationships with our suppliers and that, subject to the discussion in Item 1A, “Risk Factors” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources,” we expect to continue to be able to obtain a sufficient supply of quality products on satisfactory terms.

Results of Operations

Management Overview

In 2022, we continued our position as the number one console gaming headset provider and, believe that the gaming market is a great market to be a leader in, despite the difficult year, driven by a slowdown in consumer demand, retail channel inventory reductions, heavy competitive discounting, a strong dollar and continued global logistics and supply chain challenges, including high freight rates. Against this backdrop, we delivered net revenue of $240.2 million, proactively reduced operating expenses by 7% and limited the net loss to $59.5 million, inclusive of $34.5 million related to certain non-recurring charges.

Despite the macro circumstances that impacted the industry throughout 2022, we are well-positioned for the inevitable market turnaround and remain encouraged as the global gaming market is projected to continue to add gamers. Our industry-leading console headsets continued to expand and perform well, as our Stealth 600 wireless headset was the best-selling headset series in 2022 per NPD, and we launched two new modes, the Vulcan 2 Mini and the Vulcan 2 Max, with groundbreaking first-to-market features, including the world's first dual LED smart keys, in the iconic Vulcan product line.

We exceeded 20% of our revenues in categories outside the console gaming headset category, in which we have been a leader for over ten years, and looking forward, will continue to enhance our PC gaming portfolio of headsets, keyboards, and mice to increase our share in the PC accessories market and grow the game controller and gaming simulation categories that we entered in 2021. As a result, we believe our brand leadership and diverse product portfolio positions us for continued success including growth and a return to positive EBITDA in 2023 as the gaming and macro environments continue to improve.

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Key Performance Indicators and Non-GAAP Measures

Management routinely reviews key performance indicators including revenue, operating income and margins, and earnings per share, among others. In addition, we believe certain other measures provide useful information to management and investors about us and our financial condition and results of operations for the following reasons: (i) they are measures used by our Board of Directors and management team to evaluate our operating performance; (ii) they are measures used by our management team to make day-to-day operating decisions; (iii) the adjustments made are often viewed as either non-recurring or not reflective of ongoing financial performance and/or have no cash impact on operations; and (iv) the metrics are used by securities analysts, investors and other interested parties as a common operating performance measure to compare results across companies in our industry by adjusting for potential differences caused by variations in capital structures (affecting relative interest expense), and the age and book value of facilities and equipment (affecting relative depreciation and amortization expense). These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America (“GAAP”) and given the limitations of these metrics as analytical tools, should not be considered a substitute for gross profit, gross margins, net income (loss) or other consolidated income statement data as determined in accordance with GAAP. We consider the following non-GAAP measures, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators:

•
Adjusted EBITDA is defined as net income (loss) before interest, taxes, depreciation and amortization, stock-based compensation (non-cash) and certain non-recurring special items that we believe are not representative of core operations.

•
Cash Margin is defined as gross margin excluding depreciation, amortization, and stock-based compensation.

Adjusted EBITDA

Adjusted EBITDA (and a reconciliation to net income, the nearest GAAP financial measure) for the years ended December 31, 2022, 2021 and 2020 are as follows:

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[[/GREPCENT_TABLE]]

Comparison of the Year Ended December 31, 2022 to the Year Ended December 31, 2021

Net loss for the year ended December 31, 2022 was $59.5 million, including the deferred tax asset valuation allowance of $18.4 million and after-tax non-recurring costs of $16.2 million, compared to a net income of $17.7 million in the prior year.

For the year ended December 31, 2022, Adjusted EBITDA was ($18.7) million compared to $36.6 million, for the year ended December 31, 2021. Net income (loss) and Adjusted EBITDA were losses compared to the prior years due to a decrease in revenue as a result of macroeconomic conditions, as well as increased freight costs and volume-driven fixed cost deleveraging, partially offset by lower operating expenses.

Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

Net income for the year ended December 31, 2021 was $17.7 million compared to net income of $38.7 million in the prior year.

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For the year ended December 31, 2021, Adjusted EBITDA was $36.6 million compared to $61.4 million, for the year ended December 31, 2020. Net income and Adjusted EBITDA decreased reflecting higher freight and supply chain costs, annualized run-rate increases in operating expenses due to larger size of the business, and growth investments.

Financial Results

The following table sets forth the Company’s statements of operations for the periods presented:

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[[/GREPCENT_TABLE]]

Net Revenue and Gross Profit

The following table summarizes net revenue and gross profit for the periods presented:

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[[/GREPCENT_TABLE]]

(1)
Excludes non-cash charges of $2.8 million for 2022, $1.9 million for 2021, and $3.3 million for 2020.

Comparison of the Year Ended December 31, 2022 to the Year Ended December 31, 2021

Net revenue for the year ended December 31, 2022 was $240.2 million, a $126.2 million, or 34.4%, decrease from $366.4 million in the record prior year period reflecting lower customer demand as a result of a challenging macroeconomic environment, channel inventory compression and increased promotional spend.

For the year ended December 31, 2022, gross profit as a percentage of net revenue decreased to 20.5% from 35.0% in the prior year. The decrease was primarily due to a $9.8 million charge for potential excess components and product inventory relating to pandemic driven supply chain and logistic impacts, higher freight and warehouse costs to ensure product supply, higher promotional spend driven by more aggressive competitive pricing actions to reduce channel inventory levels and volume-driven fixed cost deleveraging.

Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

Net revenue for the year ended December 31, 2021 increased $6.3 million, or 1.7% from 2020 driven by PC accessories growth and the entry into gaming controllers and flight simulation hardware, which offset the weaker console headset demand mostly due to weaker retail traffic, a slower holiday season from disappointing AAA video game releases and console supply constraints.

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For the year ended December 31, 2021, gross profit as a percentage of net revenue decreased to 35.0% from 37.2% in the prior year. The decrease was primarily due to higher freight costs and more normalized holiday promotional activity.

Operating Expenses

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[[/GREPCENT_TABLE]]

Selling and Marketing

Selling and marketing expense for the year ended December 31, 2022 totaled $47.1 million, or 19.6% as a percentage of net revenue, compared to $58.9 million, or 16.1% as a percentage of net revenue, for the prior year. This decrease was primarily due to lower revenue-based expenses, reduction of marketing initiatives to align with lower consumer demand and strategic priorities.

Selling and marketing expense for the year ended December 31, 2021 totaled $58.9 million, or 16.1% as a percentage of net revenue, compared to $46.8 million, or 13.0% as a percentage of net revenue, for the year ended December 31, 2020. This increase was primarily due to marketing initiatives to support product portfolio expansion, expansion of geographies, and entry into new product categories.

Research and Development

For the year ended December 31, 2022, we invested $19.1 million in research and development, as we continued to invest in new product categories and portfolio expansion to support strategic growth initiatives.

For the years ended December 31, 2021 and 2020, we expended $17.5 million and $12.3 million, respectively. For the year 2021, this increase was attributable to additional resources and infrastructure to support product expansion including new category introductions.

General and Administrative

General and administrative expenses for the year ended December 31, 2022 increased $1.1 million to $32.6 million compared to $31.5 million for the year ended December 31, 2021. Excluding certain non-recurring fees related to the proxy contest in both years with respect to the 2022 annual meeting of stockholders ($2.2 million) and other litigation costs, expenses decreased $1.1 million primarily due to lower personnel costs and professional fees.

General and administrative expenses for the year ended December 31, 2021 increased $6.5 million to $31.5 million compared to $25.0 million for the year ended December 31, 2020. The year-over-year increase was primarily due to increased professional fees and the inclusion of acquired Neat Microphones-related headcount, partially offset by lower variable compensation costs.

Income Taxes

Income tax expense for the year ended December 31, 2022 was $5.1 million at an effective tax rate of (9.4)% compared to income tax expense of $2.4 million for the year ended December 31, 2021 at an effective tax rate of 12.1%. The effective tax rate was primarily impacted by the establishment of a valuation allowance on our net U.S. deferred tax assets as well as state income tax.

Income tax expense for the year ended December 31, 2021 was $2.4 million at an effective tax rate of 12.1% compared to income tax expense of $13.7 million for the year ended December 31, 2020 at an effective tax rate of 26.1%. The effective tax rate was primarily impacted by tax benefits attributable to stock option exercises and restricted stock vestings, Research and Development (“R&D”) credits and the reduced tax rate on our Foreign Derived Intangible Income (“FDII”). These tax benefits were partially offset by the impact of disallowed compensation and state income tax expense. During 2021, we substantially completed a federal R&D study for the 2018-2020 tax years, recognizing tax

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benefits of $0.5 million net of reserves. An estimate of $0.2 million R&D credits, net of reserves, was included for 2021. In addition, we completed an analysis of our foreign sales and recognized a tax benefit of $1.0 million on our FDII.

Other Non-Operating Expense (Income)

Other non-operating expense totaled $1.8 million for the year ended December 31, 2022, due to negative effect of exchange rates as it relates to our European operations, compared to other non-operating income of $0.1 million for the year ended December 31, 2021, which included a $1.9 million fair value of contingent consideration reversal.

Other non-operating income totaled $0.1 million for the year ended December 31, 2021, including a $1.9 million fair value of contingent consideration reversal, compared to other non-operating income of $3.8 million for the year ended December 31, 2020, which included a $1.7 million acquisition-related settlement gain and $1.2 million fair value of contingent consideration reversal.

Liquidity and Capital Resources

Our primary sources of working capital are cash flow from operations and availability of capital under our revolving credit facility. We have funded operations and acquisitions in recent periods with operating cash flows and proceeds from debt and equity financings.

The following table summarizes our sources and uses of cash:

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[[/GREPCENT_TABLE]]

Operating activities

Cash used for operating activities for the year ended December 31, 2022 was $41.8 million, a decrease of $41.5 million as compared to cash used for operating activities totaling $0.3 million for the year ended December 31, 2021. The increase in the cash used for operations is primarily the result of lower gross receipts due to lower demand and retailers compressing channel inventories.

Cash used for operating activities for the year ended December 31, 2021 was $0.3 million, a decrease of $51.4 million as compared to cash provided by operating activities of $51.0 million for the year ended December 31, 2020. The decrease is primarily the result of lower operating results increased inventory levels in response to supply chain and logistic headwinds.

Investing activities

Cash used for investing activities was $3.5 million for the year ended December 31, 2022, which was related to certain capital investments, compared to $8.1 million in 2021, which included $2.5 million related to the Neat Microphones acquisition.

Cash used for investing activities was $8.1 million for the year ended December 31, 2021, which consisted of capital expenditures related to in-store advertising displays and new product manufacturing tooling, as well as $2.5 million related to the Neat Microphones acquisition, compared to $5.7 million in 2020, which consisted of capital expenditures primarily related to in-store advertising displays, new product manufacturing tooling and internal system upgrades.

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Financing activities

Net cash provided by financing activities was $19.7 million during the year ended December 31, 2022 compared to net cash used for financing activities of $0.1 million and net cash used for financing activities of $7.4 million during the years ended December 31, 2021 and 2020, respectively. Financing activities during the year ended December 31, 2022 consisted primarily of revolving credit facility borrowings.

Financing activities in 2021 included stock option exercise proceeds of $5.3 million and repurchases of common stock of $4.9 million.

Financing activities in 2020 included net repayments on our revolving credit facility of $15.7 million, offset by $4.3 million received from the sale of equity securities and proceeds from exercise of stock options of $4.2 million.

Management assessment of liquidity

Management believes that our current cash and cash equivalents, the amounts available under our revolving credit facility and cash flows derived from operations will be sufficient to meet anticipated short-term and long-term funding for working capital and capital expenditures including amounts to develop new products, fund future stock repurchases and to pursue strategic opportunities. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements.

In addition, the Company monitors the capital markets on an ongoing basis and may consider raising capital if favorable market conditions develop.

Foreign cash balances at December 31, 2022 and December 31, 2021 were $6.5 million and $10.2 million, respectively.

Revolving Credit Facility

On March 5, 2018, Turtle Beach and certain of its subsidiaries entered into an amended and restated loan, guaranty and security agreement (the “Credit Facility”) with Bank of America, N.A. (“Bank of America”), as administrative agent, collateral agent and security trustee for Lenders (as defined therein), which replaced the then existing asset-based revolving loan agreement. The Credit Facility was amended on each of December 17, 2018, May 31, 2019, and March 10, 2023. The Credit Facility, as amended, expires on April 1, 2025 and provides for a line of credit of up to $80 million inclusive of a sub-facility limit of $15 million for TB Europe, a wholly-owned subsidiary of Turtle Beach. In addition, the Credit Facility provides for a $40 million accordion feature.

On March 10, 2023, the Company entered into a Third Amendment to Amended and Restated Loan, Guaranty and Security Agreement (the “Third Amendment”), by and among the Company, VTB, TBC Holding Company LLC, TB Europe, VTBH, the financial institutions party thereto from time to time and Bank of America, as administrative agent, collateral agent and security trustee for the lenders.

The Third Amendment provides for, among other things: (i) extending the maturity date of the Credit Facility from March 5, 2024 to April 1, 2025; (ii) updating the interest rate and margin terms; (iii) removing the FILO Loan facility; (iv) updating the sub-facility limit for TB Europe to $15 million; (v) increasing our undrawn commitment fee by 0.125%; and (vi) transitioning the reference interest rates from LIBOR to BSBY, SONIA and EUIBOR, as applicable.

The maximum credit availability for loans and letters of credit under the Credit Facility is governed by a borrowing base determined by the application of specified percentages to certain eligible assets, primarily eligible trade accounts receivable and inventories, and is subject to discretionary reserves and revaluation adjustments. The Credit Facility may be used for working capital, the issuance of bank guarantees, letters of credit and other corporate purposes.

Amounts outstanding under the Credit Facility bear interest at a rate equal to (i) a rate published by Bank of America or the U.S. Bloomberg Short-Term Bank Yield Index (“BSBY”) rate for loans denominated in U.S. Dollars, (ii) the Sterling Overnight Index Average Reference Rate (“SONIA”) for loans denominated in Sterling, (iii) and the Euro Interbank Offered Rate (“EUIBOR”) for loans denominated in Euros, plus in each case, an applicable margin, which is between 0.50% to 2.50% for base rate loans and UK base rate loans, and 1.50% and 3.50% for U.S. BSBY rate loans, U.S. BSBY daily floating rate loans and UK alternative currency loans. In addition, Turtle Beach is required to pay a commitment fee on the unused revolving loan commitment at a rate ranging from 0.375% to 0.50%, and letter of credit fees and agent fees. As of December 31, 2022, interest rates for outstanding borrowings were 8.75% for base rate loans and 6.50% for LIBOR rate loans, which reference interest rates were still in effect prior to the Libor Transition Amendments discussed below.

The Company is subject to financial covenant testing if certain availability thresholds are not met or certain other events occur (as defined in the Credit Facility). The Credit Facility requires the Company and its restricted subsidiaries to maintain a fixed charge coverage ratio of at least 1.00 to 1.00 as of the last day of each fiscal quarter.

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The Credit Facility also contains affirmative and negative covenants that, subject to certain exceptions, limit our ability to take certain actions, including our ability to incur debt, pay dividends and repurchase stock, make certain investments and other payments, enter into certain mergers and consolidations, engage in sale leaseback transactions and transactions with affiliates and encumber and dispose of assets. Obligations under the Credit Facility are secured by a security interest and lien upon substantially all of the Company’s assets.

As of December 31, 2022, the Company was in compliance with all the financial covenants under the Credit Facility, as amended, and excess borrowing availability was approximately $36.8 million. As of December 31, 2022, there was $19.1 million in outstanding borrowings under the Credit Facility.

In 2017, the United Kingdom’s Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit LIBOR rates. LIBOR’s administrator ceased publishing one-week and two-month U.S. Dollar LIBOR immediately after the LIBOR publication on December 31, 2021, and is scheduled to cease publication of the remaining U.S. Dollar LIBOR tenors immediately after the publication on June 30, 2023. In January 2023, the Company and Bank of America entered into LIBOR Transition Amendments with respect to the Credit Facility, including the sub-facility for TB Europe. These amendments replaced applicable LIBOR rates for interest, fees, commissions and other amounts based on LIBOR with successor rates based on BSBY, SONIA and EURIBOR, as applicable.

Contractual Obligations

Our principal commitments primarily consist of obligations for minimum payment commitments to lessors for office space and the revolving credit facility. As of December 31, 2022, we had operating lease obligations totaling $10.3 million which represents our obligations to make payments under non-cancelable lease agreements for our facilities. See Part II, Item 7,“Management’s Discussion and Analysis of Financial Condition and Results of Operations –Liquidity and Capital Resources–Revolving Credit Facility” above for more information regarding obligations under our revolving credit facility.

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[[/GREPCENT_TABLE]]

(1)
Contractual obligations exclude tax liabilities of $3.0 million related to uncertain tax positions because we are unable to make a reasonably reliable estimate of the timing of settlement, if any, of these future payments.

(2)
Operating lease agreements represent obligations to make payments under non-cancelable lease agreements for its facilities.

(3)
The Credit Facility, as amended, expires on April 1, 2025 and provides for a line of credit of up to $80 million inclusive of a sub-facility limit of $15 million for TB Europe, a wholly-owned subsidiary of Turtle Beach. Interest payments are not reflected under the Credit Facility because the amount that will be borrowed in future years is uncertain.

Critical Accounting Estimates

Our discussion and analysis of our results of operations and capital resources are based on our consolidated financial statements, which have been prepared in conformity with GAAP. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and the disclosure of contingent assets and liabilities. Management bases its estimates, assumptions, and judgments on historical experience and on various other factors that it believes to be reasonable under the circumstances.

Different assumptions and judgments would change the estimates used in the preparation of the condensed consolidated financial statements, which, in turn, could change the results from those reported. Management evaluates its estimates, assumptions, and judgments on an ongoing basis.

Based on the above, we have determined that our most critical accounting policies are those related to revenue recognition and sales return reserve, inventory valuation, asset impairment, and income taxes.

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Revenue Recognition and Sales Return Reserve

Net revenue consists primarily of revenue from the sale of gaming headsets and accessories to wholesalers, retailers and to a lesser extent, on-line customers. Our products function on a standalone basis (in connection with a readily available gaming console, personal computer, or stereo) and are not sold with additional services or rights to future goods or services. Revenue is recorded for a contract through the following steps: (i) identifying the contract with the customer; (ii) identifying the performance obligations in the contract; (iii) determining the transaction price; (iv) allocating the transaction price to the performance obligations; and (v) recognizing revenue when or as each performance obligation is satisfied.

Each contract at inception is evaluated to determine whether the contract should be accounted for as having one or more performance obligations. Revenue is recognized when obligations under the terms of a contract with our customer are satisfied; generally, this occurs at a point in time when the risk and title to the product transfers to the customer. Our standard terms of delivery are included in our contracts of sale, order confirmation documents, and invoices. The Company excludes sales taxes collected from customers from “Net Revenue” in its Consolidated Statements of Operations.

Certain customers may receive cash-based incentives (including cash discounts, quantity rebates, and price concessions), which are accounted for as variable consideration. Provisions for sales returns are recognized in the period the sale is recorded based upon our prior experience and current trends. These revenue reductions are established by the Company based upon management’s best estimates at the time of sale following the historical trend, adjusted to reflect known changes in the factors that impact such reserves and allowances, and the terms of agreements with customers. We do not expect to have significant changes in our estimates for variable considerations.

Inventory Valuation

Inventories are valued at the lower of weighted average cost or market, at the individual item level. Market is determined based on the estimated net realizable value, which is generally the selling price. Inventory levels are monitored to identify slow-moving items and markdowns are used to increase sales of such products. Physical inventory counts are performed annually in January and estimates are made for any shortage between the date of the physical inventory count and the balance sheet date.

Asset Impairment

Historically, we have had significant long-lived tangible and intangible assets, including goodwill with indefinite lives, which are susceptible to valuation adjustments as a result of changes in various factors or conditions. We assess the potential impairment of intangible and fixed assets whenever events or changes in circumstances indicate that full recoverability of net asset balances through future cash flows is in question. Goodwill and indefinite-lived intangible assets are assessed at least annually, but also whenever events or changes in circumstances indicate the carrying values may not be recoverable. Factors we consider important, which could trigger an impairment of such assets include significant underperformance relative to historical or projected future operating results; significant changes in the manner of use of the acquired assets or the strategy for our overall business; significant negative industry or economic trends; significant decline in our stock price for a sustained period; and a decline in our market capitalization below net book value.

Management estimates future pre-tax cash flows based on historical experience, knowledge, and market data. Estimates of future cash flows require that we make assumptions and apply judgment, including forecasting future sales and expenses and estimating useful lives of the assets. These estimates can be affected by factors such as future product development and economic conditions that can be difficult to predict, as well as other factors such as those outlined in Item 1A, “Risk Factors.” If the expected future cash flows related to the long-lived assets are less than the assets’ carrying value, an impairment loss would be recognized for the difference between estimated fair value and carrying value.

There are inherent assumptions and estimates used in developing future cash flows requiring management judgment including projecting revenues, interest rates and the cost of capital. Many of the factors used in assessing fair value are outside our control and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments.

Income Taxes

We account for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying value of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates and laws expected to be in effect when the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. Inherent in the measurement of these deferred balances are certain judgments and interpretations of existing tax law and other published guidance as applied to our operations. Our effective tax rate considers our judgment of expected tax liabilities in the various jurisdictions within which we are subject to tax.

The determination of the need for a valuation allowance on deferred tax assets requires management to make assumptions and to apply judgment, including forecasting future earnings, taxable income, and the mix of earnings in the jurisdictions in which we operate.

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The tax effects of uncertain tax positions taken or expected to be taken in income tax returns are recognized only if they are “more likely-than-not” to be sustained on examination by the taxing authorities based on the technical merits as of the reporting date. The tax benefits recognized in the financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. We recognize estimated accrued interest and penalties related to uncertain tax positions in income tax expense.

There have been no material changes to the critical accounting policies and estimates. See Note 1, “Summary of Significant Accounting Policies,” in the notes to the consolidated financial statements for a complete discussion of recent accounting pronouncements. We are currently evaluating the impact of certain recently issued guidance on our financial condition and results of operations in future periods.

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