HAUP Hauppague Digital Inc (CE)

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Net sales for the three months ended March 31, 2014 decreased $4,587,706 compared to the three months ended March 31, 2013 as shown in the table below.

Increased competition, tepid economic conditions and a reduction in video gaming product sales, which management believes stemmed from the release of a new generation game players from Sony and Microsoft with recording capabilities, had a negative impact on sales.

Gross profit

Gross profit decreased $1,298,041 for the three months ended March 31, 2014 compared to the same quarter in the prior fiscal year. The decrease in gross profit was due to:

The increase in the gross profit percentage was due to:

Selling, general and administrative expenses

The chart below illustrates the components of selling, general and administrative expense.

Selling, general and administrative expense for the second fiscal quarter of fiscal 2014 decreased $894,783 from the prior year’s second fiscal quarter as follows:

Sales and marketing expenses decreased $631,342, driven primarily by $270,593 in lower commission and co-operative advertising expense, which declined due to lower sales, $46,319 in lower compensation costs due to personnel reductions and $314,430 in lower sales office expense due to closing and downsizing of sales offices.

The decrease in general and administrative expenses of $71,005 was mainly from lower compensation expense due to personnel reductions, lower depreciation expense and lower credit card processing fees due to the issuing of credit lines to certain customers who previously purchased product with credit cards. The decrease in the amortization of intangible assets was due to the write-off of the intangible asset to zero in the fourth quarter of fiscal 2013, which eliminated the need for further intangible asset amortization.

Research and development expenses

Research and development expenses for the second fiscal quarter of 2014 decreased $92,359 from the same quarter in the prior fiscal year. The decrease was mainly due to lower compensation and compensation related expenses of $11,906 and lower product development costs of $80,453.

Tax provision

Our tax provision for the three months ended March 31, 2014 and 2013 is as follows:

The deferred tax expense was primarily due to the utilization of net operating losses and the utilization of deferred timing differences related to its United States subsidiary. The Effective Tax Rate for the quarter is different than the statutory rate of 34% due to the royalty income charged from the U.S. Entity to the International Entities.

Summary of operations

We recorded a net loss of $640,084 for the three months ended March 31, 2014, which resulted in basic and diluted net loss per share of $0.06 on weighted average basic and diluted shares of 10,122,344, compared to a net loss of $533,392 for the three months ended March 31, 2013, which resulted in basic and diluted net loss per share of $0.05 on weighted average basic and diluted shares of 10,122,344.

Options to purchase 1,251,125 and 1,478,125 shares of common stock, at prices from $0.74 to $7.45 were outstanding for the three months ended March 31, 2014 and 2013, respectively, but were not included in the computation of diluted earnings per share because they were anti-dilutive.

Net sales for the six months ended March 31, 2014 decreased $10,048,605 compared to the six months ended March 31, 2013 as shown in the table below.

Increased competition, tepid economic conditions and a reduction in video gaming product sales, which management believes stemmed from the release of a new generation game players from Sony and Microsoft with recording capabilities, had a negative impact on sales. In addition, the first quarter of fiscal 2013 included the product rollout of the HD-PVR-2 gaming unit, which resulted in a concentration of sales for fiscal 2013 which did not repeat in fiscal 2014.

Gross profit

Gross profit decreased $4,178,520 for the six months ended March 31, 2014 compared to the same period in the prior fiscal year. The decrease in gross profit was due to:

The decrease in the gross profit percentage was due to:

Selling, general and administrative expenses

The chart below illustrates the components of selling, general and administrative expense.

Selling, general and administrative expense for the six months ended March 31, 2014 decreased $1,700,859 from the prior fiscal year as follows:

Sales and marketing expenses decreased $1,435,186 driven primarily by $706,131 in lower commission and co-operative advertising expense, which declined due to lower sales, $100,980 in lower compensation costs due to personnel reductions and $628,075 in lower sales office expense due to closing and downsizing of sales offices.

The decrease in general and administrative expenses of $97,794 was mainly from lower compensation expense due to personnel reductions, lower depreciation expense and lower credit card processing fees due to the issuing of credit lines to certain customers who previously purchased product with credit cards.

The decrease in the amortization of intangible assets was due to the write-off of the intangible asset to zero in the fourth quarter of fiscal 2013, which eliminated the need for further intangible asset amortization. Offsetting the decrease in expenses was the non-recurring reversal in the first quarter of fiscal 2013 for a severance accrual of $213,793 that had been set up in a prior fiscal year.

Research and development expenses

Research and development expenses for the six months ended March 31, 2014 decreased $107,504 from the prior fiscal year. The decrease was mainly due to lower compensation and compensation related expenses of $59,556 and lower product development costs of $234,852. Offsetting the decrease in expenses was the non-recurring reversal in the first quarter of fiscal 2013 for a severance accrual of $186,904 that had been set up in a prior fiscal year.

Tax provision

Our tax provision for the six months ended March 31, 2014 and 2013 is as follows:

The deferred tax expense was primarily due to the utilization of net operating losses and the utilization of deferred timing differences related to its United States subsidiary. The Effective Tax Rate for the six months ended March 31, 2014 is different than the statutory rate of 34% due to the royalty income charged from the U.S. Entity to the International Entities.

Summary of operations

We recorded a net loss of $1,023,294 for the six months ended March 31, 2014, which resulted in basic and diluted net loss per share of $0.10 on weighted average basic and diluted shares of 10,122,344, compared to net income of $756,694 for the six months ended March 31, 2013, which resulted in basic and diluted net income per share of $0.07 on weighted average basic and diluted shares of 10,122,344.

Options to purchase 1,251,125 and 1,478,125 shares of common stock, at prices from $0.74 to $7.45 were outstanding for the six months ended March 31, 2014 and 2013, respectively, but were not included in the computation of diluted earnings per share because they were anti-dilutive.

Seasonality

As our sales are primarily to the consumer market, we have experienced certain seasonal revenue trends. Historically, our peak sales quarter due to holiday season sales is our first fiscal quarter (October to December), followed by our second fiscal quarter (January to March). In addition, our international sales, mostly in the European market, were 37% of sales for fiscal year ended September 30, 2013 and 44% for the fiscal year ended September 30, 2012. Part of our third and fourth quarters (April through June and July to September) can be impacted by the reduction of activity experienced in Europe during the summer holiday period.

We target a wide range of customer types to attempt to moderate the seasonal nature of our retail sales.

Liquidity and capital resources

We had cash and cash equivalents as of March 31, 2014 of $1,460,505, a decrease of $22,061 from September 30, 2013.

The decrease in cash was due to:

Cash used in operating activities of $28,907 was due to an increase in accounts receivable of $212,772, the net loss adjusted for non-cash items of $560,500, a decrease in accounts payable of $644,067 and a decrease in accrued expenses of $636,300. Sources of cash came from a decrease in inventory of $1,959,230 and a decrease in prepaid expenses and other assets of $65,502.

The increase in accounts receivable was due to a high percentage of sales occurring in the last two months of the quarter. The decrease in accrued expenses was due to payments and adjustments made for licenses and year-end sales rebates. The decrease in accounts payable was due to lower purchases of inventory coupled with payment to suppliers. The decrease in inventory was due to the liquidation of inventory levels through sales and lowered production volume. We had a working capital deficit of $3,655,865 as of March 31, 2014 compared to a working capital deficit of $3,005,314 as of September 30, 2013.

Our cash requirements for the next twelve months will include, among other things, the cash to fund our operating and working capital needs. We rely exclusively upon cash generated from operations to fund these needs. We do not have a working capital line of credit or other borrowing facility in place to draw upon in the event that cash from operations is insufficient to fund our capital requirements to sustain operations. Our cash and cash equivalents as of March 31, 2014 and our internally generated cash may not be sufficient to fund our operating needs for the next twelve months and this gives rise to a substantial doubt regarding our ability to continue as a “going concern ”.

We have incurred operating losses for the last six fiscal years and in the six month period ended March 31, 2014. Those losses are primarily attributable to a continuing decline in sales. In the six months ended March 31, 2014, we experienced an approximate 45% drop in sales from prior fiscal year. We believe that our sales have declined for the following reasons, including, among other things:

Since the fourth quarter of fiscal 2011, we have been implementing expense reduction initiatives. We switched from air to ocean freight to reduce shipping costs, outsourced most of our shipping and logistics to a third party, reduced personnel, relocated certain facilities to smaller offices, renegotiated certain existing leases to reduce rent and closed certain sales offices. We believe that it may be increasingly difficult to make further material reductions in costs and maintain a viable operating plan.

The Company is working to develop a strategy to address our continuing operating losses and loss of sales, and during the latter part of fiscal 2013 retained Corporate Fuel Advisors, an investment bank and advisory firm, which assisted the Company in considering and pursuing strategic alternatives, including possible additional financing to fund its capital needs, expense reductions and the restructuring of its business.

The Company cannot assure that it will be able to develop and implement a plan that will enable it to successfully address its business and financial challenges. Among other things:

If any strategic or restructuring plan that we develop and implement is not successful, there is a substantial risk that we might not be able to sustain our operations at current levels, which would have a material adverse effect on our business, operating results and financial condition.

Future contractual obligations

The following table shows our contractual obligations related to lease obligations as of March 31, 2014:

Inflation

While inflation has not had a material effect on our operations in the past, there can be no assurance that we will be able to continue to offset the effects of inflation on the costs of our products or services through price increases to our customers without experiencing a reduction in the demand for our products; or that inflation will not have an overall effect on the computer equipment market that would have a material effect on us.

Recent Accounting Pronouncements

In February 2013, the FASB issued new accounting guidance which amended Accounting Standards Codification (“ASC”) 220, “Comprehensive Income.” The amended guidance required entities to provide information about the amounts reclassified out of accumulated other comprehensive income by component. Additionally, entities are required to present, either on the face of the financial statements or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, but only if the amount reclassified is required under U.S. generally accepted accounting principles (“GAAP”) to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures in the financial statements. The amended guidance does not change the current requirements for reporting net income or other comprehensive income. The amendments became effective for us in the first quarter of fiscal year 2014. As this is disclosure-only guidance, it did not have an impact on our consolidated financial results.

In July 2013, the FASB issued new accounting guidance which requires the netting of unrecognized tax benefits against a deferred tax asset for a loss or other carry forward that would apply in settlement of the uncertain tax positions. Under the new standard, unrecognized tax benefits will be netted against all available same-jurisdiction loss or other tax carry forwards that would be utilized, rather than only against carry forwards that are created by the unrecognized tax benefits. The new guidance is effective prospectively to all existing unrecognized tax benefits, but entities can choose to apply it retrospectively. The guidance will be effective for us in our first quarter of fiscal year 2015, with early adoption permitted. We are currently assessing the impact this guidance will have on our consolidated statements of financial position and cash flows.