10-K 1 form10k.htm HEELYS INC 10-K 12-31-2011 form10k.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
  Washington, D.C. 20549
 

 
FORM 10-K
 
(Mark One)
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2011
Or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                to
 
Commission file number: 001-33182
 

 
HEELYS, INC.
(Exact name of Registrant as specified in its charter)

Delaware
 
75-2880496
(State of incorporation)
 
(I.R.S. Employer Identification No.)
 
3200 Belmeade Drive, Suite 100
Carrollton, Texas 75006
 (Address of principal executive offices)      (Zip Code)
 
(214) 390-1831
 (Registrant's telephone number, including area code)
 

 
 Securities registered pursuant to Section 12(b) of the Act:

Title of each class
 
Name of each exchange on which registered
Common Stock, par value $0.001
  The Nasdaq Stock Market LLC
 
Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
  
Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
  
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x No  o
 


 
 

 
  
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
  
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
  
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of " large accelerated filer," “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company x
        (Do not check if a smaller reporting company)    
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes  o No  x
  
As of June 30, 2011, the last business day of the registrant's most recently completed second fiscal quarter, the aggregate market value of the registrant's common stock held by non-affiliates was approximately $37.4 million (based upon the closing price for the registrant's common stock on The Nasdaq Stock Market of $2.28 per share). For the purpose of the foregoing calculation only, all directors and executive officers of the registrant and owners of more than 5% of the registrant's common stock are assumed to be affiliates of the registrant. This determination of affiliate status is not necessarily conclusive for any other purpose.
 
As of March 12, 2012, there were 27,571,052 shares of the registrant's common stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
The information required by Part III of this Report, to the extent not set forth herein, is incorporated herein by reference from the registrant's definitive proxy statement relating to the Annual Meeting of Stockholders to be held in 2012, which definitive proxy statement shall be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this Report relates.
 
 
2

 
 

PART I
       
Item 1.
   
4
Item 1A.
   
10
Item 1B.
   
20
Item 2.
   
20
Item 3.
   
21
Item 4.
   
21
PART II
       
Item 5.
   
21
Item 6.
   
23
Item 7.
   
23
Item 7A.
   
35
Item 8.
   
35
Item 9.
   
35
Item 9A.
   
36
Item 9B.
   
36
PART III
       
Item 10.
   
37
Item 11.
   
37
Item 12.
   
37
Item 13.
   
37
Item 14.
   
37
PART IV
       
Item 15.
   
37
     
42
 
 
3

 
Cautionary Note Regarding Forward-Looking Statements
 
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the "Securities Act," and Section 21E of the Securities Exchange Act of 1934, as amended, or the "Exchange Act," that are based on information currently available to management as well as management's assumptions and beliefs. When used in this document and in documents incorporated by reference, forward-looking statements include, without limitation, statements regarding financial forecasts or projections, and our expectations, beliefs, intentions or future strategies that are signified by terminology such as "subject to," "believes," "anticipates," "plans," "expects," "intends," "estimates," "may," "will," "should," "can," the negatives thereof, variations thereon, similar expressions, or discussions of strategy. These forward-looking statements reflect our current views with respect to future events, based on what we believe are reasonable assumptions; however, such statements are subject to certain risks and uncertainties. In addition to the specific uncertainties discussed elsewhere in this Annual Report on Form 10-K, the risk factors set forth in Part I, "Item 1A. Risk Factors," in this report may affect our performance and results of operations. Those risks, uncertainties and factors include, but are not limited to, the fact that substantially all of our net sales are generated by one product, our intellectual property may not restrict competing products that infringe on our patents from being sold, continued changes in fashion trends and consumer preferences and general economic conditions, we depend on our relationships with retail customers and independent distributors with whom we do not have long term contracts, we outsource all of our manufacturing to, and rely on, a limited number of independent manufacturers, our distribution model and recent moves in select markets to take over distribution of our products directly to customers contains inherent risks, we are subject to the risks of conducting business internationally, foreign exchange rate fluctuations could harm our results of operations, we have expanded our product offering to mass merchants which may affect our brand image and reputation, we may not be able to successfully introduce new product categories and the other factors described in Part I, “Item 1A. Risk Factors” and in our other filings with the Securities and Exchange Commission. Investors are urged to consider these risks, uncertainties and factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may differ materially from those in the forward-looking statements. We disclaim any intention or obligation to update or review any forward-looking statements or information, whether as a result of new information, future events or otherwise.
 
  PART I
 
Item 1. 
 
Throughout this report, references to the "Company," "we," and "our" refer to Heelys, Inc. and its consolidated subsidiaries, unless the context indicates otherwise.
 
Overview
 
We are a designer, marketer and distributor of innovative, action sports-inspired products primarily under the HEELYS brand targeted to the youth market. Our primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user to seamlessly transition from walking or running to rolling by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. We believe our distinctive product offering and our HEELYS brand is synonymous with a popular lifestyle activity. In Europe, during the third and fourth quarters of 2011, we began to distribute brands other than HEELYS. These brands include Airbak backpacks, Tony Hawk skateboards, Blazer Pro scooters and accessories and District scooters.

We were initially incorporated as Heeling, Inc. in Nevada in 2000 and were reincorporated in Delaware in August 2006 and changed our name to Heelys, Inc. Through our general and limited partner interests, we own 100% of Heeling Sports Limited, a Texas limited partnership, which was formed in May 2000. In February 2008, we formed Heeling Sports EMEA SPRL, a Belgian corporation and indirect wholly-owned subsidiary, to manage our operations in Europe, the Middle East and Africa. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011.
 
We are subject to the informational requirements of the Exchange Act, and, accordingly, file reports, proxy statements and other information with the Securities and Exchange Commission (the "SEC"). We maintain a website on the World Wide Web at www.heelys.com. We make available, free of charge through our website, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, including exhibits thereto, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after the reports are electronically filed with, or furnished to, the SEC. Our reports that are filed with, or furnished to, the SEC are also available at the SEC's website at www.sec.gov, which contains material regarding issuers that file electronically with the SEC. You may also obtain copies of any of our reports filed with, or furnished to, the SEC, free of charge, at the SEC's public reference room at 100 F Street, N.E., Washington, DC 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.
 
 
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Our Business
 
We currently offer HEELYS-wheeled footwear in the United States and certain other countries. Heelys-wheeled footwear is protected by numerous patents and trademarks. In 2011, approximately 98% of our net sales were derived from the sale of our HEELYS-wheeled footwear. The remainder of our net sales were derived from the sale of our Nano™ inline footboard and branded accessories, such as replacement wheels, and the distribution of other brands besides HEELYS in Europe.
 
We sell our products through distribution channels that generally merchandise our products in a manner that we believe enhances and protects our HEELYS brand image. Domestically, our products can be purchased from full-line sporting goods retailers such as Academy and Big 5; and specialty apparel and footwear retailers such as Skechers, Footaction and Journeys. Our products can also be purchased from select online retailers such as Zappos.com and Amazon.com. In 2011, approximately 37% of our consolidated net sales were derived from retailers in the United States.
 
Historically, our products have been sold internationally through independent distributors with exclusive rights to specified international markets. Since 2008, however, we have expanded our international opportunities through our Belgian subsidiary by working more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products directly to retail customers. We took over the distribution of our products in the German market effective April 1, 2008 and in the French market effective May 1, 2008. We began to sell directly to retailers in Italy during the fourth quarter of 2009, and directly to retailers in Spain and Portugal in 2011, through our Belgian subsidiary. In Europe our products can be purchased in sporting goods retailers such as Decathlon (France), Sportland S.R.L. (Italy) and Sport Scheck (Germany); footwear retailers such as Bocci Sport (Italy) and Trops SPA (Italy); and through online retailers such as Amazon and Vente-Privee (France). As part of an initiative to improve efficiency and reduce costs, we began taking steps in the first quarter of 2012 to close our office in Brussels, Belgium and transition our business operations conducted through that office to our French and German offices. We ended our distributor agreement with our Japanese distributor in February 2011 and we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011. Our largest Japanese customer is Toys”R”Us.

During the second quarter of 2010, we began selling certain styles of our products through our website at www.heelys.com.
 
Target Market
 
The growth and longstanding popularity of skateboarding, inline skating, roller skating and scooter riding reflect consumers' interest in wheeled sports activities. For example, skateboarding and inline skating have remained a part of youth culture for more than 40 and 25 years, respectively. Our HEELYS-wheeled footwear, which we believe has broad patent protection relative to other wheeled sports products, appeals to many of these same consumers.
 
We believe our products appeal to a broad range of young, active consumers around the world who enjoy wheeled sports activities. The primary market for HEELYS-wheeled footwear is five to fourteen year-old boys and girls.
 
Products
 
Our primary product is HEELYS-wheeled footwear, patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user to seamlessly transition from walking or running to rolling by shifting weight to the heel. Users can remove the wheel to transform HEELYS-wheeled footwear into street footwear. HEELYS-wheeled footwear is offered in more than 20 styles, incorporating various comfort and performance features and colors at multiple retail price points. We traditionally offer a new line of HEELYS-wheeled footwear twice each year for the spring/summer selling season and the back-to-school/holiday selling seasons.
 
HEELYS-wheeled footwear can be classified into the following three categories:
 
Single-Wheel.     Our single-wheel HEELYS-wheeled footwear has one detachable wheel and are available in various sizes for men, women and children. We offer wheels of various performance capabilities in order to appeal to beginners and advanced users. In addition to offering standard styles, we may collaborate with certain of our retail customers to develop HEELYS-wheeled footwear styles that these retail customers have the exclusive rights to sell. These special make-up programs enable these retail customers to differentiate their HEELYS-wheeled footwear product offerings and allow us to broaden our product range.
 
 
5

 
Two-Wheel.     Our two-wheel HEELYS-wheeled footwear includes two detachable wheels, are designed for novice users and are offered only in children's sizes. The two-wheel HEELYS-wheeled footwear has been sold primarily in Japan; however, in 2010 we started selling this product domestically through key retailers and through our website.
 
Grind-and-Roll.     Grind-and-roll HEELYS-wheeled footwear represents our highest performance category and are preferred by enthusiasts seeking a challenging and exciting action sports experience. This category features a single detachable wheel and a patented, hard nylon plate in the arch, enabling the consumer to slide, or "grind," on hand railings and other similar surfaces. Consumers can use our grind-and-roll HEELYS-wheeled footwear to perform distinctive maneuvers, similar to those performed by skateboarders and inline skaters.

In 2011, we introduced Sidewalk Sports™ wheeled footwear. The Sidewalk Sports™ branded products will be sold in markets in which we lack protection of our intellectual property or where the level of expendable income of the average consumer does not support the purchase price of our HEELYS-wheeled footwear. We also plan to sell the product in the U.S., Japan and Europe in traditional mass retailers. In the fourth quarter of 2011, the two-wheeled Sidewalk Sports™ product was sold in the U.S. exclusively at Kmart stores. That exclusivity ended January 1, 2012.  

Product Design and Development
 
We attempt to update and refine our product offerings in response to evolving consumer preferences. We believe that introducing new products, performance features and designs better positions us to achieve targeted price points, drive incremental consumer demand for our products and encourage repeat purchases. We attempt to monitor changing consumer trends and identify new product opportunities through contact with our target consumers and dialogue between our sales representatives and our retail customers.
 
Our product development efforts include both incremental improvements to our existing products and entirely new technologies aimed at increasing the overall visual appeal and product function while simultaneously lowering our production costs.
 
Sales
 
We control the distribution of our products in an effort to protect our HEELYS brand and maintain our targeted price points. We sell our products domestically directly to retail customers. Internationally, while we have traditionally sold our products through independent distributors, since 2008, we have expanded our international opportunities through our Belgian subsidiary by working more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers. We began taking steps in the first quarter of 2012 to close our office in Brussels, Belgium and transition our business operations conducted through that office to our French and German offices. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011.
 
During the second quarter of 2010, we began selling certain of our products directly to consumers through our website at www.heelys.com.
 
Currently, we do not sell, other than the limited amount of sales through our website, directly to consumers. We sold certain styles to select discount retailers in order to reduce our inventory levels and dispose of excess inventory in 2009. Sales to discount retailers declined in 2010 and 2011 due to our lower inventory levels.
 
 Domestic Sales
 
Our products are sold through retail customers, including a variety of full-line sporting goods retailers, specialty apparel and footwear retailers, family footwear stores and select online retailers. We attempt to choose retail customers who appeal to our target market and who are able and willing to merchandise our products in a manner we believe is consistent with our brand message and positioning. Academy, Big 5, Kids Footlocker, Journeys, Kmart, Finish Line, Shoe Carnival, Zappos.com and Amazon.com are examples of our domestic retail customers. In 2011 and 2010, our domestic net sales were $11.9 million and $8.6 million, respectively, representing 37.2% and 28.4% of our consolidated net sales, respectively.
 
We actively manage our domestic distribution by controlling the number of stores in which HEELYS-wheeled footwear is sold.
 
We are committed to providing the highest levels of service to our retail customers. Historically, our domestic retail accounts have been served by a national sales force of sales representatives employed by independent sales agencies, with each independent sales agency being assigned an exclusive territory and compensated on a commission basis. In 2011, our domestic retail accounts were served by a national sales force of sales representatives employed by a single independent sales agency. Our external sales force is responsible for substantially all of our domestic sales.
 
 
6

 
International Sales
 
As of December 31, 2011, we offered our products internationally through 23 independent distributors, each of which has exclusive rights to a designated territory. We select our independent distributors based on their relationships with appropriate retailers, their ability to effectively represent the HEELYS brand and their execution of our distribution strategy. In order to maintain a consistent brand image throughout the world, we provide marketing, distribution and product training support to our independent distributors. Each distributor must generally meet minimum sales goals and is responsible for funding its local marketing campaigns, maintaining its own inventory and providing sufficient sales, distribution and customer service infrastructure.
 
During the first quarter of 2008, we formed a Belgian subsidiary, with offices in Belgium, Germany and France, to focus on expanding our international opportunities by working more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers. We took over the distribution of our products in Germany and Austria (the “German market”), effective April 1, 2008, and in France, Monaco and Andorra (the “French market”), effective May 1, 2008. In 2011, our German and French markets accounted for approximately 6.8% and 17.0% of our consolidated net sales, respectively. In 2010, our German and French markets accounted for 12.4% and 21.4% of our consolidated net sales, respectively.

During the fourth quarter of 2009, we began to sell directly to retailers in Italy through our Belgian subsidiary. In 2011 and 2010, our Italian market accounted for approximately 19.6% and 8.4% of our consolidated net sales, respectively.

During 2011, we began to sell directly to retailers in Spain and Portugal also through our Belgian subsidiary. For 2011 and 2010, sales in these markets have been limited.
 
We began taking steps in the first quarter of 2012 to close our office in Belgium and transition our business operations conducted through that office to our French and German offices.

In 2010, our largest international territory managed by an independent distributor was Japan, which accounted for 17.7% of our consolidated net sales. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011. In 2011, sales in our Japanese market accounted for approximately 5.9% of our consolidated net sales.
 
In 2011 and 2010, our international net sales were $20.1 million and $21.8 million, respectively, accounting for 62.8% and 71.6% of our consolidated net sales, respectively. The decline in sales in our international markets is primarily attributable to a decrease in sales in our Japanese market.

We believe international distribution represents a growth opportunity for us that we intend to take advantage of by encouraging our existing distributors to expand their market presence, by establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers.
 
In our international markets we employ third party distributors in most countries and those distributors have their own direct and independent sales representatives. In our German, French, Italian and Spain/Portugal markets, where we sell directly to retailers, we sell our products through independent sales representatives. In our Japanese market, where we began to sell directly to retailers effective March 1, 2011, we sell our products through employed sales staff.
 
 Principal Customers
 
In 2011 and 2010, Oxylane Group accounted for 11.7 % and 11.9% of our consolidated net sales, respectively. Oxylane Group is a French sporting goods retail chain operating under the name Decathlon.

In 2010, Privee AG Corporation accounted for 17.7% of our consolidated net sales. Privee AG Corporation (“Privee”) was the Company's independent distributor in Japan. On February 28, 2011 our distributor agreement with Privee was terminated. Sales to Privee decreased $2.2 million, or 29.4%, to $5.4 million in 2010, from $7.6 million in 2009. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011.
 
No other retail customer or independent distributor accounted for 10% or more of our net sales in either of fiscal years 2011 or 2010.
 
 
7

 
Marketing
 
Our marketing strategy is to position our products and the HEELYS brand to represent a lifestyle that allows our consumers to have Freedom and Fun with the sense that they are Fearless, providing them a sense of excitement and individuality. We utilize a multi-faceted strategy to promote awareness of, and generate demand for, the HEELYS brand. This strategy includes a mix of mass advertising, point-of-purchase, or "POP," displays, product placement, targeted licensing agreements and partnerships, public relations, celebrity/influential product trials and experiential marketing activities. While we fund the cost of these activities domestically, as well as in our direct distribution international markets, our international independent distributors are solely responsible for these costs in their respective markets.
 
Television Advertising
 
Television advertisements have traditionally been an important and effective tool for increasing awareness of our brand and products among our target consumers because these advertisements allow us to show consumers HEELYS-wheeled footwear in action. Advertisements have aired nationally and in selected regions of the United States, Europe and Japan during our primary selling seasons. As part of our regional television advertising strategy, we typically feature the name of a local retail customer at the end of our television advertisements. This tactic is intended to drive consumers to specific retail customers and allow us to evaluate the effectiveness of our advertising.
 
Point-of-Purchase Displays
 
Many of our retail customers have committed valuable floor space to HEELYS branded POP displays. When the opportunity presents itself, we supply custom POP solutions that best fit both our needs and those of our retail customers. Through the use of these POP displays, we are able to present the HEELYS brand message to consumers in a consistent manner and sometimes increase our shelf space in our retail customers' locations. POP displays are used in those markets where we sell directly to retailers. Our POP displays are scalable, to give a consistent look while adhering to the size differences at individual retail locations.
 
Product Placement
 
Kids, Tweens and Teens look to celebrities, musicians and other stars for inspiration and fashion cues. Therefore, we identify and secure, through our agency relationships, "product-in-use" opportunities for our domestic and international markets ranging from feature films to television and celebrity endorsement. We believe product placement activities enable us to build awareness of, and demand for, our products in a cost-effective manner.
 
Targeted Licensing Agreements and Partnerships
 
As our target demographic looks for inspiration from the celebrity world, our consumers are also fans of sporting teams and other corporations that market their products to our same customer. Partnerships and licensing agreements allow us to communicate with consumers, along with other non-competing brands, in an effort to establish a broader relationship with the consumer. It also allows us to get the most of our marketing funds by working with other brands that want to send the same or similar message.
 
 Cooperative Marketing
 
In partnership with our retailers to whom we sell direct to, whether it be domestic or international, we offer cooperative marketing support. Our cooperative marketing initiatives are aimed at increasing overall demand for HEELYS, as well as driving HEELYS sales to our key retail partners. Examples of cooperative marketing include company-approved POP display materials, television, radio, print and web-based advertising, gift with purchase promotions and customized event marketing demonstrations. We will continue to collaboratively work with our retail partners in an effort to drive the overall awareness and demand for HEELYS.
 
Website
 
We recently redesigned and upgraded the www.heelys.com website to provide a more interesting, informative and fun site for the online community of HEELYS users. The redesigned website allows HEELYS to have an on-line store for select products. In addition, the redesigned and upgraded website allows us to advertise one main URL to have a global look and feel, allowing our international offices to modify language and specific product information while keeping the same branded look that allows our consumers to choose their country and language.
 
 
8

 
Manufacturing and Sourcing
 
We do not own or operate any manufacturing facilities and we purchase our products as finished goods from independent manufacturers. We do not have any long-term manufacturing contracts, choosing instead to retain the flexibility to change our manufacturing sources if necessary. We believe alternate manufacturing or supply sources are available at comparable costs to those we currently utilize.
 
We monitor all aspects of the production of our HEELYS-wheeled footwear, including the development and manufacturing of prototypes, initial production runs and final product manufacturing. We perform an array of inspection procedures at various stages of the production process, including examination and testing of raw materials and components prior to manufacture, work-in-process at various stages of production and finished goods prior to shipment. Historically, our defective return rate has been less than 1.0% of our net sales.
 
In May 2010, we entered into an agreement with TGB, LLC, a New Jersey limited liability company (“TGB”), under which TGB acted as the exclusive sourcer of our shoe products. In April 2011, we reached an agreement to terminate our sourcing agreement with TGB. From and after the termination of that sourcing agreement, we were not required to (and did not) purchase any other products from TGB under the sourcing agreement and, instead, we purchased products directly from our independent manufacturers.
 
Order Fulfillment and Inventory Management
 
Our products are inspected, bar coded and packaged by our independent manufacturers. Our independent manufacturers mark, label and pre-ticket our products for certain of our larger retail customers. The product is then transported either to the port in Long Beach, California, to a third-party distribution facility in Belgium, to a third-party distribution facility in Tokyo, or directly to the customer.
 
For products shipped to the United States, after the products clear U.S. customs, we use an independent freight forwarder and customs broker to ship them via rail by container to our distribution center located in Carrollton, Texas or directly to our retail customers. Upon receipt at our warehouse, merchandise is inspected and recorded in our management information systems and packaged for delivery. We maintain electronic data interchange, or "EDI," connections with many of our larger retail customers in order to automate order tracking and inventory management.
 
 Before establishing our Belgian subsidiary, substantially all of our products destined for international distribution were sent directly by our independent manufacturers to our independent distributors. Through our Belgian subsidiary, we have expanded the use of a third-party distribution facility in Belgium to help facilitate fulfillment of orders to international customers, and some products destined for sale through our Belgian subsidiary are sent to this third-party distribution facility.
 
In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011. We use a third-party distribution facility in Japan to help facilitate fulfillment of orders to our retail customers in Japan.
 
To allow us to better plan our production volume with our manufacturers, we offer our retail customers discount incentives to place advance orders. Historically, we received most of our orders three to four months in advance of the scheduled delivery dates. Our retail customers have been, and continue to be, cautious when placing orders and have shifted towards shorter lead times and at-once inventory purchases. This has transferred more of the risk of purchasing and carrying inventory to us. We seek to manage our inventory risk by monitoring available sell-through data and seeking input on anticipated consumer demand from our retail customers.
 
Intellectual Property—Patents and Trademarks
 
We have both domestic and international patent coverage for the technology incorporated in our HEELYS-wheeled footwear and own more than 84 issued patents and pending patent applications in more than 25 countries, of which more than 55 are related to wheeled footwear. Our first patent was a method patent that was issued in June 2002 and includes coverage for wheeled footwear, including HEELYS-wheeled footwear, with a wheel in the heel that allows the user to transition from walking or running to rolling by shifting weight to at least one wheel in the heel. We also own a variety of trademarks, with more than 109 registered and pending trademarks with rights in more than 60 countries.
 
We have vigorously enforced, and expect to continue to vigorously enforce, our intellectual property rights against infringers domestically and internationally. Despite the challenges inherent in combating infringers in international jurisdictions that may not protect intellectual property rights to the same extent as the United States, we have cooperated with the appropriate authorities and they have conducted successful raids, customs seizures and product confiscations of products that infringe our intellectual property rights in various countries. We have obtained agreements from importers and retailers to cease and desist all infringing activities and, in some cases have been paid monetary compensation. We have also successfully asserted our patent rights against manufacturers of infringing products.
 
 
9

 
Seasonality
 
Similar to other vendors of footwear products, sales of our products are subject to seasonality. There are three major buying seasons in footwear: spring/summer, back-to-school and holiday. We offer two primary lines: spring/summer and a combined back-to-school/holiday line. A few new styles will typically be added for the holiday season. Shipments for spring/summer take place during the first quarter and early weeks of the second quarter, shipments for back-to-school generally begin in May and finish in late August and shipments for the holiday season begin in October and finish in early December. Historically, we have experienced greater revenues in the second half of the year than those in the first half due to a concentration of shopping around the back-to-school and holiday seasons.
 
Employees
 
As of December 31, 2011, we employed a total of 47 full-time employees. We are not a party to any labor agreements and none of our employees are represented by a labor union.
 
 Insurance and Product Liability
 
We purchase insurance to cover standard risks associated with our business, including policies to cover commercial general liability and other casualty and property risks. Our insurance rates depend upon our safety record as well as trends in the insurance industry.
 
We face an inherent risk of exposure to personal injury or product liability claims if, among other things, use of our products results in injury, disability or death. We believe our insurance coverage is sufficient for the risks relating to our products. Our coverage involves retentions with primary and excess liability coverage above the retention amount.
 
We retain certain property and casualty risks based on our analysis of the risk, the frequency and severity of a loss and the cost of insurance for the risk. We believe the risk we have assumed through retention is not significant and payments of retained claims will not have an adverse impact on our performance.
 
Information Technology Systems
 
Our information technology systems are designed to provide us with, among other things, comprehensive order processing, production, accounting and management information for the sourcing, importing, distribution and marketing aspects of our business. We maintain an EDI system that provides a computer link between us and certain of our customers, which enables us to monitor their purchases, inventory and retail sales and also improves our efficiency in responding to their needs. Although we believe our information technology systems are sufficient to meet our current needs, in June 2011 we migrated our information technology systems, located in our Texas headquarters, from Microsoft Solomon to Microsoft Navision. Our Belgian subsidiary’s operations are currently, and our operations in Japan will be, operating on the Microsoft Navision platform. We believe having all of our operations on the same platform will allow for more seamless sharing of information and implementation of standardized best practices for our industry and software platform. However, we will continue to assess the need to expand and upgrade our information technology systems to support actual or expected future needs.
 
Competition
 
We compete with companies that focus on the young consumer across a number of markets, including footwear, sporting goods and recreational products. Many of these companies have substantially greater financial, distribution and marketing resources than we have. Product design, performance, styling, comfort, quality, brand awareness, timeliness of product delivery and pricing are all important elements of competition in the markets for our products. We believe the strength of our HEELYS brand, the intellectual property related to the design of HEELYS-wheeled footwear, the quality of our products and our relationships with retailers and distributors allow us to compete effectively in the markets we serve. In certain international markets, where enforcing our intellectual property rights is more difficult than in the United States, and occasionally in the domestic market, we compete against counterfeit, knockoff and infringing products, which typically are offered at lower prices.
 
Backlog
 
Historically, we received most of our orders three to four months prior to the date the products were shipped to customers. At December 31, 2011, our backlog was approximately $5.4 million, compared to approximately $4.9 million at December 31, 2010. Although generally these orders are not subject to cancellation prior to the date of shipment, cancellations have and may continue to occur. In the current economic environment, our retail customers are being cautious when placing orders and have shifted towards shorter lead times and at-once inventory purchases. For a variety of reasons, including the timing of release dates for our product offerings, shipments, order deadlines and receipt of orders, backlog may not be a reliable measure of future sales and may not be comparable from one period to another.
 
Item 1A. 
  
Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described below in addition to the more detailed description of our business and other cautionary statements and risks described elsewhere, and the other information contained in this Annual Report on Form 10-K and in our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks or uncertainties actually occurs with material adverse effects on us, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock will likely decline, and you may lose all or part of your investment. Our business, prospects, financial condition or results of operations could be materially and adversely affected by the following:
 
 
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We depend primarily upon sales from a single product line and the absence of continued demand for our products would have a material adverse effect on our net sales and results of operations.
 
In both 2011 and 2010, we generated approximately 98% of our consolidated net sales from our HEELYS-wheeled footwear and we expect to continue to depend upon HEELYS-wheeled footwear for substantially all of our consolidated net sales in the foreseeable future. Because we are currently dependent on a single line of products, factors such as changes in consumer preferences may have a disproportionately greater impact on us than if we offered multiple product categories. If consumer interest in HEELYS-wheeled footwear or wheeled sports activity products in general continues to decline, we would likely experience a further loss of sales, cancellation of orders from customers, loss of customers, excess inventories, higher reserves for marketing discretionary fund assistance, increased reserves for inventory returns, inventory markdowns and discounts to our retail customers, deterioration of our brand image, and lower revenues and gross and operating margins as a result of price reductions and may be forced to liquidate excess inventories at a discount, any or all of which would have a material adverse impact on our business and operations. There can be no assurance our products will hold long-term consumer appeal.
 
If we are unable to enforce our patents, trademarks and other intellectual property rights, competitors may be able to sell products that are substantially similar to our products, which could adversely affect our sales and damage our brand image.
 
We believe our trademarks, trade names, copyrights, trade secrets, issued and pending patents, trade dress and designs are valuable and integral to our success. The costs associated with obtaining and maintaining our intellectual property rights and protecting our HEELYS brand are significant. Further, we do not know whether our pending or future patent applications will result in the issuance of patents. Even if patents are issued in the future, we cannot predict how the patent claims will be construed and such patents may not provide us with the ability to prevent the development, manufacturing or marketing of infringing products. Enforcement of our patents and other intellectual property rights is often met with defenses, counterclaims and countersuits attacking the validity and enforceability of our patents and other intellectual property rights. The validity and enforceability of our patents may be challenged by third parties for many different reasons, including for example, prior art, prior disclosure, prior offers to sell, incorrect inventorship, prior invention by another, patent misuse, antitrust violations, laches and estoppel.
 
In addition, we may not be able to detect infringement of our intellectual property rights quickly or at all, and at times in the past we have not been, and we may not be, successful combating counterfeit, infringing or knockoff products, thereby damaging our competitive position. For example, on many occasions, we have identified knockoff products sold by others we believe may infringe upon our intellectual property rights. Knockoff products often are sold under a brand name that is the same as or substantially similar to the HEELYS name. Knockoff and counterfeit products may continue to emerge, as others seek to trade on the goodwill of the HEELYS name and benefit from consumer demand for our products. We may not be able to detect all knockoff and counterfeit products and may lose our competitive position in a given geographic market before we become aware of any such infringement.
 
To protect our HEELYS brand, we have already spent significant resources and may be required to spend significantly greater resources in the future to monitor and police our intellectual property rights. If we are unsuccessful in enforcing our intellectual property rights, sales of counterfeit, knockoff or infringing products by others could harm our HEELYS brand and adversely affect our business, financial condition and results of operations. Even if we successfully enforce our intellectual property rights, the presence in the market of counterfeit, knockoff or infringing products of poor quality for even a short time period could have a detrimental impact on our HEELYS brand.
 
We may not be able to obtain and maintain patent, trademark or other intellectual property rights protection in some foreign countries, which could result in us being unable to prevent others from using our HEELYS mark and product, which could have a material adverse effect on our business.
 
We depend upon the laws of the countries where our products are sold to protect our intellectual property. Intellectual property rights may be unavailable or limited in some countries because patent laws and standards of patentability vary internationally. Consequently, in certain foreign jurisdictions, we have elected not to apply for patents or trademark registrations. Further, patent and trademark protection may not be available for the HEELYS mark and product in every country where our products are sold. While we generally apply for patents and trademarks in most countries where we intend to sell patented products, we may not accurately predict all of the countries where patent or trademark protection will ultimately be desirable. If we fail to timely file a patent or trademark application in any such country, we will likely be precluded from doing so at a later date. Failure to adequately pursue and enforce our patent and trademark rights could damage our HEELYS brand, enable others to compete with us and impair our ability to compete effectively.
 
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In some countries where we have sought patent protection, third parties have challenged the validity, enforceability and scope of our patent rights. Patent laws, and standards of patentability and validity, vary from one country to the next. Patent validity challenges are commonly filed as counterclaims in patent litigation proceedings. There can be no assurance that we will prevail against any challenges. Our HEELYS brand, business, financial condition and results of operations could be adversely affected if we fail to obtain and maintain intellectual property right protection in foreign countries where we derive a large amount of our net sales.
 
A downturn in the economy and adverse trends in retailing could have a material adverse effect on our results of operations.
 
In the current economic environment, consumer confidence is low resulting in a reduction in discretionary consumer spending. When discretionary consumer spending is reduced, purchases of our products may decline. We have noticed caution from our retail customers and this may continue to result in lower than expected orders by some of our customers. Continued uncertainties regarding future economic prospects could have a material adverse effect on our results of operations. An economic slowdown in any of our major markets could adversely affect the demand for our products and pressure our gross margins due to, among other potential factors, higher promotional spending, recessionary economic cycles, higher interest borrowing rates, higher fuel and other energy costs, inflation, increases in commodity prices, higher levels of unemployment, higher consumer debt levels, higher tax rates and other changes in tax laws or other economic factors that may affect consumer spending or buying habits. Reduced sales by some of our retail customers or independent distributors, along with the possibility of their reduced access to, or inability to access, the credit markets, may result in various retailers or independent distributors experiencing significant financial difficulties. Financial difficulties of retail customers could result in reduced sales to those customers or could result in store closures, bankruptcies or liquidations. Higher credit risk relating to receivables from retail customers experiencing financial difficulty may result. An economic downturn in any of our major markets or continued uncertainties regarding future economic prospects could have a material adverse effect on our results of operations.

 Particularly in Europe, the current sovereign debt crisis affecting Greece, Ireland, Italy, Portugal and Spain, and related European financial restructuring efforts, may cause the value of the European currencies, including the Euro, to further deteriorate, which in turn could adversely impact our Euro-denominated sales and working capital. In addition, the European crisis may contribute to instability in global credit markets, and further economic deterioration in Europe could adversely impact demand for our products and product pricing.

Because we are a consumer products company, if we fail to accurately forecast consumer demand and trends in consumer preferences, our HEELYS brand, net sales, customer relationships and results of operations may be adversely affected.
 
Demand for our products, and for consumer products in general, is subject to rapidly changing consumer demand and trends in consumer preferences. Therefore, our success depends upon our ability to:
 
 
identify, anticipate, understand and respond to these trends in a timely manner;
 
 
design our HEELYS-wheeled footwear to appeal to a wider range of consumers; and

 
introduce appealing new products and performance features on a timely basis.
 
We generally must make decisions regarding product designs several months before our products are available for sale, and it can take us up to six months to achieve full production of certain models. Accordingly, at the time we have to make decisions that determine our inventory levels, we cannot be certain that our product offerings will be well received by consumers, in which case we may be forced to liquidate excess inventories at a discount. In addition to offering our standard styles, we may collaborate with certain of our retail customers to develop HEELYS-wheeled footwear styles that these retail customers have the exclusive rights to sell. If these retail customers are unable to sell through these footwear styles we may agree to provide marketing discretionary fund assistance or to accept return of this inventory. Because these styles have been specifically designed for a particular customer, we may not be able to sell the returned inventory or may not be able to sell the returned inventory at or above cost. Conversely, if we underestimate consumer demand for our products, we could have inventory shortages, which would result in lost sales, delays in shipments to retail customers and independent distributors, strains on our relationships with retail customers and independent distributors and diminished brand loyalty. Even if we introduce appealing new styles and products on a timely basis, we may set prices for our products too high to be successful. A decline in demand for our products, or any failure on our part to satisfy increased demand for our products, could adversely affect our net sales and results of operations.
 
 
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Our operations are dependent upon the strength of our relationships with our retail customers and independent distributors and their success in selling our products, and a small number of retail customers and independent distributors are responsible for a significant percentage of our net sales.
 
Our success is dependent upon the willingness and ability of our retail customers to market and sell our products to consumers, as well as the success of our independent distributors in developing foreign markets for our products. For the years ended December 31, 2011 and December 31, 2010, Oxylane Group accounted for approximately 11.7% and 11.9% of our consolidated net sales, respectively. Oxylane Group is a French sporting goods retail chain operating under the name Decathlon. For the year ended December 31, 2010, Privee AG Corporation (formerly AG Corporation) accounted for approximately 17.7% our consolidated net sales. Privee AG Corporation was the Company's independent distributor in Japan. No other retail customer or independent distributor accounted for 10% or more of our consolidated net sales in either of these periods. If any of these, or our other significant retail customers or independent distributors, were to experience financial difficulties, reduce the quantity of our products it sells, discount the retail sales price, request markdown assistance or additional marketing assistance, or stop selling our products, our financial condition and results of operations could be adversely affected.
 
On November 25, 2010, we notified Privee AG Corporation we would not be renewing our distributor agreement with Privee AG Corporation, which terminated on February 28, 2011. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011.
 
We do not have long-term contracts with any of our retail customers or independent distributors, and the loss or material reduction in their business with us could result in reduced sales of our products.
 
Our retail customers and independent distributors generally purchase products from us on a purchase order basis and do not have long-term contracts with us. Consequently, with little or no notice and without penalty, our retail customers and independent distributors may terminate their relationship with us or materially reduce the level of their purchases of our products. For example, in 2007 one of our then large retail customers determined that it would no longer sell HEELYS-wheeled footwear. This customer accounted for 7.2% of our total net sales for the year ended December 31, 2007. If this were to occur with more retail customers or independent distributors who purchase significant quantities of our products, it may be difficult for us to establish substitute relationships in a timely manner, which could have a material adverse effect on our financial condition and results of operations.
 
Changes in the manner in which, or mix of retail customers to whom, we distribute our products could impact our gross margin and brand image, which could have a material adverse effect on our results of operations.
 
We sell our products through a mix of retail customers. Our Sidewalk Sports™ brand utilizes lower-cost materials and basic designs and sells for less than our other wheeled products. This brand will be sold domestically and in certain international markets.  Depending on the reaction to the brand, we may experience a change in the mix of our retail customers. Any material changes in the distribution to, or mix of, our retail customers could adversely affect our gross margin, and these changes, as well as the introduction of the Sidewalk Sports™ brand to our line of products, may negatively affect both our brand image and our reputation with our consumers. A negative change in our gross margin or our brand image and acceptance could have a material adverse effect on our results of operations and financial condition. Our sales of products directly to consumers via our website, which we began in the second quarter of 2010, and the introduction of our Sidewalk Sports™ brand, may alienate certain of our retail customers and result in reduced sales to these customers. Reduced sales to our retail customers could have an adverse impact on our financial condition and results of operations.
 
We may be adversely affected by the financial condition of our retailer customers.
 
Some of our retail customers have experienced financial difficulties in the past. A retail customer experiencing such difficulties will generally not purchase and sell as many of our products as it would under normal circumstances and may cancel orders. In addition, a retail customer experiencing financial difficulties generally increases our exposure to the risk of uncollectible receivables. We extend credit to our retail customers based on our assessment of such customer's financial condition, generally without requiring collateral. While such credit losses have historically been within our expectations and reserves, we cannot assure you that this will continue. Financial difficulties on the part of our retail customers could have a material adverse effect on our results of operations and financial condition.
 
Because we outsource all of our manufacturing to a limited number of independent manufacturers, we may face challenges in maintaining a sufficient supply of products to meet demand for our products or experience interruptions in our supply chain. Any shortfall in the supply of our products may decrease our net sales and have an adverse impact on our customer relationships and results of operations.
 
All of our products are produced by independent manufacturers with which we do not have long-term contracts. As such, any of our manufacturers could unilaterally terminate its relationship with us or increase the prices it charges us at any time. A limited number of independent manufacturers produce all of our HEELYS-wheeled footwear. Consequently, if any such manufacturers close, stop producing merchandise for us or greatly increase prices, these actions could result in delayed deliveries to our retail customers, could adversely affect our revenue and results of operations, and could require the establishment of new manufacturing relationships, which could require significant additional time and expense.
 
 
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Our business could suffer if our independent manufacturers violate legal requirements or fail to conform to generally accepted ethical standards.
 
We expect our independent manufacturers to comply with applicable legal requirements and generally accepted ethical standards for working conditions and other matters. However, we do not control our independent manufacturers or their business practices. If any of our manufacturers were to use forced or indentured labor or child labor, fail to pay compensation in accordance with local law, fail to operate in compliance with local safety regulations or diverge from other applicable legal requirements or business practices generally accepted as ethical, we would take appropriate action, which could result in an interruption in our product supply. In addition, we could suffer negative publicity and damage to our reputation and the value of our HEELYS brand, which would adversely affect our business and results of operations.
 
If our independent manufacturers are unable to obtain raw materials, our costs could increase or the delivery of our products could be delayed, which could adversely affect our net sales and results of operations.
 
The production capacity of our independent manufacturers is dependent, in part, upon the availability of raw materials. Our manufacturers may experience shortages of raw materials, which could result in increased costs to us or delays in deliveries of our products from our manufacturers. As a result, we could experience cancellation of orders, refusal to accept deliveries or a reduction in our sales prices and profit margins, any of which could harm our net sales and results of operations.
 
Our distribution efforts internationally, including our recent efficiency and cost reduction initiative with respect to our Belgian office, involve inherent risks which could result in harm to our business.
 
During 2008, we opened an office in Brussels, Belgium, with branch offices in Germany and France, to focus on expanding our international opportunities by working more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers. As part of an initiative to improve efficiency and reduce costs, we began taking steps in the first quarter of 2012 to close our office in Brussels and transition our business operations conducted through that office to our French and German offices. We cannot assure you that we will be able to implement this initiative successfully, and we anticipate incurring additional expenses, some of which may be material in the period in which those expenses are incurred. Even if we are successful with this initiative, we may not be able to translate all of the cost savings from this initiative into increased earnings and may face other risks associated with the initiative, including, among other things, declines in employee morale and interruptions in our European business operations. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011.

Our ability to meet customer expectations, manage inventory, complete sales and achieve objectives for operating efficiencies depends upon the proper operation of our distribution model (taking into account the absorption by our French and German offices of business operations conducted through our Belgian office) and the development of additional distribution capabilities. This distribution model is subject to a number of risks, including greater difficulties in staffing and managing foreign operations, unexpected changes in regulatory practices and tariffs, longer collection cycles, seasonality, potentially subjecting our operations to taxes in additional jurisdictions, potential changes in export and tax laws and other risks and uncertainties inherent in doing business outside of the United States. Any of these risks could have an adverse impact on our results of operations. This distribution model may also adversely impact our relationship with our independent distributors.
 
Our takeover of distribution in Japan and the March 2011 earthquake and tsunami-related events in the region could have a material adverse effect on our results of operations.
 
In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary of the Company, with offices in Tokyo, to manage our operations in Japan and to take over distribution of our products in that country effective March 1, 2011. Prior to March 1, 2011, our products were distributed in Japan through an independent wholesale distributor. Sales to this independent distributor in Japan accounted for 17.7% of our consolidated net sales for the year ended December 31, 2010. We face risks related to the Company’s takeover of distribution of its products in Japan, including our capacity to efficiently distribute our products and the potential for lack of realization of inventory values. Further, the March 2011 earthquake in Japan and related tsunami, nuclear and other disasters, including the impact of infrastructure and other damages and disruptions on retailers, manufacturers and other market participants throughout the region, such as reduced customer spending, have impacted, and may continue to impact, the demand for, and pricing elements of, our products and, as a result, may adversely affect our results of operations.
 
 
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Because our products are manufactured in Asia, because we operate offices internationally, and because a portion of our sales activities occur outside of the United States, we are subject to international business, political, operational, financial and economic risks that could adversely affect our net sales and results of operations.
 
Conducting business internationally entails numerous risks which could interrupt or otherwise adversely affect our business, including:
 
 
increased transportation costs (the cost of fuel is a significant component of transportation costs, so increases in the price of petroleum products can adversely affect our profit margins);
 
 
delays and other logistical problems relating to the transportation of goods shipped by ocean freight;
 
 
work stoppages, strikes, lockouts or increased security concerns at seaports;
 
 
difficulties in staffing and managing our foreign operations;
 
 
tariffs, import and export controls and other barriers, such as quotas and local content rules;
 
 
restrictions on the transfer of funds;
 
 
changing economic conditions;
 
 
changes in governmental policies and regulations;
 
 
limitations on the level of intellectual property protections;
 
 
poor or unstable infrastructure of certain foreign countries;
 
 
trade sanctions, political unrest, terrorism, war, epidemics and pandemics;
 
 
expropriation and nationalization; and
 
 
difficulties in understanding and complying with local laws, regulations and customs in foreign jurisdictions.
 
These factors, and the failure to effectively respond to them, could result in, among other things, poor quality in our products, product shortages, delivery delays, decreased net sales and increased costs.
 
Fluctuations in foreign currency exchange rates could harm our results of operations.
 
We pay for our products, and our independent distributors pay us, in U.S. dollars. International sales accounted for approximately 62.8% and 71.6% of our consolidated net sales in 2011 and 2010, respectively. If the U.S. dollar strengthens compared to the currency in the foreign markets where our products are sold, our products will be more expensive in those markets, making them less attractive to consumers. If the U.S. dollar significantly weakens compared to the currency in the foreign markets where our products are produced, our manufacturers could increase the prices they charge us for our products, which could reduce our profitability. There can be no assurance that we can effectively mitigate our foreign exchange risk.
 
We are exposed to gains and losses resulting from the effect that fluctuations in foreign currency exchange rates have on the reported results in our consolidated financial statements due to the translation of the statement of operations and balance sheet of our Belgian subsidiary into U.S. dollars. For example, there is currently an intercompany loan due to our U.S. entity from our Belgian subsidiary which must be repaid in U.S. dollars. Because this intercompany loan is U.S. dollar denominated (and not Euro denominated, which is the functional currency of our Belgian subsidiary), our Belgian subsidiary recognizes a loss if the U.S. dollar strengthens compared to the Euro and recognizes a gain if the U.S. dollar weakens compared to the Euro. This impact is recorded in other income and expense.
 
In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011. We are exposed to similar gains and losses, as with our Belgian subsidiary, resulting from the effect of fluctuations in the foreign currency exchange rate between the U.S. dollar (our reporting currency) and the Japanese Yen (the functional currency of our Japanese subsidiary). Similar to our Belgian subsidiary, there is an intercompany loan due to our U.S. entity from our Japanese subsidiary. This intercompany loan is denominated in U.S. dollars as opposed to the Japanese Yen. If the U.S. dollar strengthens against the Yen, a loss would be recognized, but if the U.S. dollar weakens against the Yen, a gain would be recognized. This impact would be recorded in other income and expense.
 
 
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We translate the revenues and expenses of our foreign subsidiaries at the average rate of exchange during the applicable period. As a result, the reported revenues and expenses of our Belgian and Japanese subsidiaries would decrease if the U.S. dollar increased in value in relation to the Euro and Yen.
 
We have not used foreign currency exchange contracts to hedge the profit and loss effects of any foreign currency exchange translation effect.
 
We are dependent on our management and other personnel, and the failure to attract and retain such individuals could adversely affect our operations.
 
Our success depends on our ability to attract and retain qualified managerial and other personnel. Our management and other employees can terminate their employment with us at any time, and we do not maintain key person life insurance. Our inability to attract or retain qualified employees, or the loss of any key employee, could harm our business and results of operations.
 
Since early 2008, we have had significant turnover in our executive officers. In February 2008, Michael G. Staffaroni, our Chief Executive Officer since 2001, and Charles D. Beery, our Senior Vice  President—Global Sales since 2001, resigned. In April 2008, Patrick F. Hamner, our Senior Vice President, resigned and entered into a consulting agreement with us which terminated in June 2010. In May 2008, Michael W. Hessong, our Chief Financial Officer resigned and our Board of Directors elected Donald K. Carroll as our Chief Executive Officer. In February 2009, Mr. Carroll resigned as Chief Executive Officer and Mr. Hessong returned as our interim Chief Executive Officer. In July 2009, our Board of Directors elected Thomas C. Hansen to serve as our Chief Executive Officer. In June 2010, Lisa K. Peterson, our Chief Financial Officer resigned and our Board of Directors appointed Craig D. Storey as our Chief Financial Officer.
 
We rely on our independent sales representatives, and if our relationship with our representatives was terminated, it could result in reduced sales of our products.
 
Historically, we sold substantially all of our products domestically through a national sales force of independent sales representatives who were employed by independent sales agencies. Since 2011, our domestic retail accounts have been served by a national sales force of sales representatives employed by a single independent sales agency. In our German and French markets, as well was in Italy, Spain and Portugal, where we sell directly to retailers, we sell our products through independent sales representatives. In our Japanese market, where we began to sell directly to retailers effective March 1, 2011, we sell our products through employed sales staff. We rely on independent sales representatives to provide new customer prospects and market our products to our retail customers. Our independent sales representatives generally do not sell our products exclusively and may terminate their relationships with us at any time with limited notice. Our ability to maintain and increase our sales depends in large part on our success in maintaining relationships with our independent sales representatives on commercially reasonable terms. Any failure to maintain and develop new satisfactory relationships with independent sales representatives, or any failure of our independent sales representatives to effectively market our products, could adversely affect our sales.
  
Negative publicity relating to our products could cause our HEELYS brand to suffer and adversely affect our net sales and results of operations.
 
Various media outlets have reported on injuries suffered by users of our products and have quoted from or referred to medical studies and U.S. Consumer Product Safety Commission data relating to injury rates of users of wheeled footwear. This negative publicity, and any future negative publicity, relating to the safety of our products or products similar to ours could cause our HEELYS brand image to suffer and adversely affect our net sales and operating performance.
 
Additional bans on the use of our HEELYS-wheeled footwear due to public safety and liability concerns could adversely affect our net sales and results of operations.
 
Various places of business and other institutions, such as shopping malls and schools, have imposed bans on the use of our HEELYS-wheeled footwear due to public safety and liability concerns. If the number of businesses and other institutions imposing such bans increases in the future, consumers could find our HEELYS-wheeled footwear less appealing, which could adversely affect our net sales and results of operations.
 
 
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If our products fail to comply with U.S. consumer product laws, it could materially affect our gross margin and results of operations.
 
With the passage of the Consumer Product Safety Improvement Act of 2008, or "CPSIA," there are new requirements mandated for the textiles and apparel industries. These mandates relate to all products marketed to children 12 years of age and under. Among other requirements, the Consumer Product Safety Commission, or "CPSC," requires a certification and testing of lead paint levels as applied to certain products, along with testing the lead content of the product as a whole. We work with an accredited third party testing service to ensure compliance with all CPSIA requirements and to further product safety goals. We will continue to monitor the situation and intend to abide by all rules and changes made by the CPSC. This could have a negative impact on the cost of our goods and poses a potential risk if we do not adhere to these requirements.
 
 We are subject to product liability, warranty and recall claims and our insurance coverage may not cover such claims, which could cause us to incur substantial costs and adversely affect our business.
 
Due to the inherent risk of injury related to the use of our products, our business exposes us to claims for product liability and warranty claims if our products actually or allegedly fail to perform as expected, or the use of our products results or is alleged to result in personal injury, disability or death. There can be no assurance we will be able to successfully defend or settle the product liability claims and lawsuits to which we are, and in the future may be, subject.
 
We attach warning labels to our products and packaging relating to safe usage and the risk of injury. However, if a product liability claim is brought against us, the content of the warnings, the placement of them, or both, may be considered inadequate by courts, exposing us to liability. We cannot be certain that our safety warning labels are adequate. Product liability claims could result in us having to expend significant time and expense to defend these claims and to pay, if necessary, settlement amounts or damages, which could adversely affect our financial condition. In addition, claims that use of our products resulted in an injury, disability or death could cause our HEELYS brand image and operating performance to suffer by damaging our reputation and prospects and by diverting the time and attention of our management, even if we are not at fault.
 
There can be no assurance our product liability insurance coverage will be adequate, that our insurers will be financially viable when payment of a claim is required or that we will be able to obtain such insurance in the future on acceptable terms, if at all.
 
If any of our products are or are alleged to be defective, we may be required to recall that product. Any product recall could cause us to incur substantial cost, and irreparably harm our relationships with our customers and our brand image, which could adversely affect our business.
 
If our new products are not accepted by our customers or if we are unable to maintain our margins, it could materially affect our financial performance.
 
As is typical with new products, market acceptance of our new products is uncertain and achieving market acceptance may require substantial marketing efforts and expenditures. We also cannot assure that our new products will have the same or better margins than our current products. The failure of the new products to gain market acceptance, or our inability to maintain our current product margins with the new products, could adversely affect our business, financial performance and brand image.
 
We may not be able to compete effectively, which could have a negative impact on our sales and our business.
 
We compete with companies that sell to young consumers in several different product markets, including footwear, sporting goods and recreational products. These markets are intensely competitive and we expect competition to increase in the future. A number of our competitors have significantly greater financial, marketing, distribution and manufacturing resources than we do, as well as greater brand awareness in the markets in which they operate. We also compete with counterfeit, knockoff and infringing products, which are often sold at lower prices. If we fail to remain competitive with respect to the quality, design, price and timely delivery of products, our business, financial condition and results of operations could be materially adversely affected.
 
Third parties may claim that we are infringing their intellectual property rights, and such claims may be costly to defend, may require us to pay licensing fees, damages or other amounts and may prevent or limit the manufacture, marketing or sale of our products.
 
Third parties may successfully claim we are infringing their intellectual property rights. While we do not believe any of our products infringe the valid intellectual property rights of third parties, we may be unaware of the intellectual property rights of others that may cover some of our technology or products. For example, because many patent applications in the United States are not publicly disclosed immediately after they are filed, we could adopt technology without knowledge of a pending patent application, which technology would infringe a third-party patent once that patent is issued.
 
 
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Our competitors in both the United States and foreign countries may have applied for or obtained, or may in the future apply for or obtain, patents that will prevent, limit or otherwise interfere with our ability to make, market or sell our products. Although we may conduct our own independent review of patents issued to certain third parties, we cannot assure you we will be aware of all pre-existing technology that may subject us to patent litigation. Further, we may adopt a trademark or trade dress that a third party claims infringes their rights in such trademark or trade dress. If we are forced to defend against infringement claims, whether or not such claims are resolved in our favor, we could encounter expensive and time-consuming litigation which could divert the attention of our management and other key personnel from our business operations. Furthermore, if we are found to be infringing intellectual property rights of others, we could be required to pay licensing fees or damages. In addition, if we are not able to obtain license agreements on terms acceptable to us, or at all, we may be prevented from manufacturing, marketing or selling our products. As a result, our net sales could be significantly reduced and our cost of sales could be significantly increased, either of which could have an adverse effect on our business.
 
HEELYS-wheeled footwear could become subject to import duties in the United States and Japan, and if we cannot increase our prices to compensate for such duties, it could reduce our profitability.
 
HEELYS-wheeled footwear is currently classified by U.S. Customs and Border Protection and Japan Customs such that we do not pay import duties to the United States or Japan. These customs classifications can be changed at any time, and although we would vigorously oppose any proposed change, there can be no assurance that we would prevail. If the classification for HEELYS-wheeled footwear changed and HEELYS-wheeled footwear became subject to an import duty, it might be difficult to increase our prices to compensate for any such duty, which could reduce our profitability.
 
Expanding our distribution to mass merchants could have a material adverse effect on brand image and results of operations.
 
We primarily sell our products to sporting goods retailers, specialty apparel and footwear retailers, and family footwear stores in an effort to maintain a high-quality image for our HEELYS brand and targeted price points for our products. During the fourth quarter 2011 (Holiday season), the two-wheel version of our new brand, Sidewalk Sports™, was available exclusively in Kmart stores; and, if necessary we may sell certain styles of our product to discount retailers in order to sell excess inventory. Expanded sales of Sidewalk Sports™ or other related brands to mass merchants in the future could negatively affect our HEELYS brand image and our reputation with consumers, which could adversely affect our results of operations and financial condition.
 
Our operating results are subject to seasonal and quarterly variations in our net sales and net income, which could adversely affect the price of our common stock.
 
We have experienced, and expect to continue to experience, substantial seasonal and quarterly variations in our net sales and net income. Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including, among other things, the amount of inventory carried by our retailers, timing of holidays and advertising initiatives and changes in our product mix. In addition, variations in weather conditions may significantly affect our results of operations.
 
As a result of these seasonal and quarterly fluctuations, we believe comparisons of our operating results between different quarters within a single year are not necessarily meaningful and that these comparisons cannot be relied upon as indicators of our future performance. Any seasonal or quarterly fluctuations that we report in the future may differ from the expectations of market analysts and investors. This could cause the price of our common stock to fluctuate significantly.
 
Improvements to our information technology systems may be inadequate, which could adversely affect our ability to operate effectively.
 
As our business needs change, we could experience difficulties associated with our information technology systems. If we experience difficulties in our information technology systems or experience system failures, or if we are unable to successfully modify our information technology systems to respond to changes in our business or operating model, our ability to operate effectively and our internal controls could be adversely affected.
 
Disruptions to our information technology systems could adversely affect our ability to operate effectively.
 
During 2011, we migrated our information technology systems, located in our Texas headquarters, from Microsoft Solomon to Microsoft Navision. Our European operations are currently, and our operations in Japan will also be, operating on the Microsoft Navision platform. We are a highly automated business and disruption in, or failure of, our information technology systems could cause delays in completing sales. If we experience difficulties or disruptions in our information technology systems or experience system failures, for any reason, including acts of God, terrorism, or if we are unable to successfully modify or upgrade our information technology systems to respond to changes in our business, our ability to operate effectively and our internal controls could be adversely affected.
 
 
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We may have difficulty identifying and successfully integrating acquisitions into our business and any acquisitions we make could result in adverse consequences.
 
As part of our business strategy we may make acquisitions. The pursuit of acquisitions may divert the attention of management and cause us to incur significant expenses identifying, investigating and pursuing suitable acquisitions, whether or not they are consummated.
 
We have limited experience acquiring other businesses and may not be able to successfully integrate any acquired operations with our business or effectively manage the combined business following an acquisition. We also may not achieve the anticipated benefits of an acquisition due to any of the following factors:
 
 
unanticipated costs associated with making the acquisition and operating the acquired business;

 
harm to our business relationships with independent manufacturers, retail customers and independent distributors;

 
loss of key employees of the acquired business; or

 
difficulties associated with entering product categories or markets in which we have little or no prior experience.
 
If we experience any of the difficulties noted above, our business and financial condition could be adversely affected.
 
We have experienced volatility in our stock price and it may fluctuate in the future. Therefore, you may be unable to resell shares of our common stock at or above the price you paid for them.
 
The market price of our common stock has fluctuated significantly in the past and may fluctuate significantly in the future. Volatility in the trading price of our common stock may prevent you from being able to sell your shares of our common stock at prices equal to or greater than your purchase price. Such fluctuations may be influenced by many factors, many of which are outside of our control, including:
 
 
our operating and financial performance and prospects;
 
 
our quarterly or annual earnings or those of other companies in our industry;
 
 
the public's reaction to our press releases, other public announcements and filings with the SEC;
 
 
changes in earnings estimates or recommendations by research analysts who track our common stock or the stock of other companies in our industry;
 
 
strategic actions by us or our competitors;
 
 
new laws or regulations or new interpretations of existing laws or regulations applicable to our business;
 
 
changes in accounting standards, policies, guidance, interpretations or principles
 
 
changes in general economic conditions in the United States and global economies or financial markets, including such changes resulting from war or acts of terrorism; and
 
 
sales of our common stock.
 
In addition, in recent years the stock market has experienced significant price and volume fluctuations. This volatility has had a significant impact on the trading price of securities issued by many companies, including companies in our industry. The changes frequently occur irrespective of the operating performance of the affected companies. Hence, the trading price of our common stock could fluctuate based upon factors that have little or nothing to do with our business.
 
Existing stockholders significantly influence our corporate governance.
 
As of December 31, 2011, our executive officers, key employees, directors and their affiliates beneficially owned, in the aggregate, approximately 35% of our outstanding common stock. In addition, Capital Southwest Venture Corporation, or "CSVC," which owns approximately 33.8% of our common stock, has the contractual right to designate (i) two nominees for director to be included in management's slate of director nominees, so long as it owns at least 15% of the outstanding shares of our common stock, and (ii) one such nominee so long as it owns at least 10%, but less than 15%, of the outstanding shares of our common stock. CSVC's parent company is Capital Southwest Corporation ("CSC"). The Chairman of our Board of Directors is the President and CEO of CSC. In addition, one of our directors is a Vice President of CSC. As a result, through its designees, CSVC may significantly influence our corporate governance.
 
 
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Our Certificate of Incorporation, By-Laws and Delaware law contain provisions that could discourage a third party from acquiring us and consequently decrease the value of an investment in our common stock.
 
Our Certificate of Incorporation, By-Laws and Delaware corporate law contain provisions that could delay or prevent a change in control of our company or changes in our management. Among other things, these provisions:
 
 
authorize our board of directors, without prior stockholder approval, to issue preferred stock with rights, privileges and preferences, including voting rights, senior to those of our common stock;
 
 
prohibit stockholder action by written consent, thereby requiring all stockholder actions to be taken at a meeting of our stockholders;
 
 
establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting; and
 
 
impose restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock.

These provisions could discourage proxy contests, make it more difficult for our stockholders to elect directors and take other corporate actions and may discourage, delay or prevent a change in control or changes in our management that a stockholder might consider favorable. Any delay or prevention of a change in control or change in management that stockholders might otherwise consider to be favorable could deprive you of the opportunity to sell your common stock at a price in excess of the prevailing trading price and cause the trading price of our common stock to decline.
 
As a public company, we are required to meet periodic reporting requirements under SEC rules and regulations. Complying with federal securities laws as a public company is expensive. Any deficiencies in our financial reporting or internal controls could adversely affect our business and the trading price of our common stock.
 
SEC rules require, as a publicly traded company, that we file periodic reports containing our financial statements within a specified time following the completion of quarterly and annual periods. We may experience difficulty in meeting the SEC's reporting requirements. Any failure by us to file our periodic reports with the SEC in a timely manner could harm our reputation and reduce the trading price of our common stock and cause sanctions or other actions to be taken by the SEC. As a public company, we incur significant legal, accounting, insurance and other expenses.
 
We may identify deficiencies which would have to be remediated to satisfy the SEC rules for certification of our internal control over financial reporting. As a consequence, we may have to disclose in periodic reports we file with the SEC material weaknesses in our system of internal controls. The existence of a material weakness would preclude management from concluding that our internal control over financial reporting is effective. In addition, disclosures of this type in our SEC reports could cause investors to lose confidence in our financial reporting and may negatively affect the trading price of our common stock. Moreover, effective internal controls are necessary to produce reliable financial reports and to prevent fraud. If we have deficiencies in our disclosure controls and procedures or internal control over financial reporting it may negatively impact our business, results of operations and reputation.
 
None.
 
Item 2. 
 
We lease our corporate headquarters, an approximately 48,400 square-foot facility located in Carrollton, Texas, consisting of approximately 34,500 square feet of warehouse space and approximately 13,900 square feet of office space. Our lease expires in August 2015, but we have two five-year extension options.
 
 
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On May 1, 2008 our Belgian subsidiary entered into an operating lease for office space in Brussels, Belgium for nine years with the option to terminate the lease at the end of each three-year period. This lease was not terminated at the end of the first three year period. While we have begun taking steps in the first quarter of 2012 to close our Belgian office, and transition our business operations conducted through that office to our French and German offices, we have not terminated our operating lease for our Belgian office.
 
On April 1, 2008 our Belgian subsidiary entered into an operating lease for office space in Munich, Germany for three years with an automatic renewal at the end of the initial three year lease, unless six months notice is provided. This lease was renewed for a period of one year from April 1, 2011 through March 31, 2012 and has been renewed for a period of one year from April 1, 2012 through March 31, 2013.
 
On May 1, 2008 our Belgian subsidiary entered into an operating lease for office space in Annecy, France for nine years with the option to terminate the lease at the end of each three year period. This lease was not terminated at the end of the first three year period.
 
On March 1, 2011, our Japanese subsidiary entered into an operating lease for office space in Tokyo, Japan for two years with an automatic renewal at the end of the initial two year lease, unless six months notice is provided.
 
We believe our existing facilities are adequate to meet our current requirements.
 
Item 3. 
 
Due to the nature of the Company's products, from time to time the Company has to defend against personal injury and product liability claims arising out of personal injuries that allegedly are suffered using the Company's products. To date, none of these claims has had a material adverse effect on the Company. The Company is also engaged in various claims and legal proceedings relating to intellectual property matters, especially in connection with enforcing the Company's intellectual property rights against the various third parties importing and selling knockoff products domestically and internationally. Often, such legal proceedings result in counterclaims against the Company that the Company must defend. The Company believes none of the pending personal injury, product liability or intellectual property legal matters will have a material adverse effect on the Company's financial position, cash flows or results of operations.
 
 
Not applicable.

PART II
  
Market Information
 
Our common stock is listed on The Nasdaq Capital Market under the stock symbol "HLYS." As of March 13, 2012, there were approximately 126 holders of record of our common stock. The following table sets forth the range of high and low market prices for the common stock during the years ended December 31, 2011 and 2010.

2011
 
High
   
Low
 
First Quarter
  $ 3.39     $ 2.03  
Second Quarter
  $ 2.37     $ 1.90  
Third Quarter
  $ 2.43     $ 1.86  
Fourth Quarter
  $ 2.15     $ 1.75  
                 
2010
 
High
   
Low
 
First Quarter
  $ 2.55     $ 2.08  
Second Quarter
  $ 2.97     $ 2.31  
Third Quarter
  $ 3.75     $ 2.14  
Fourth Quarter
  $ 3.63     $ 2.37  
 
 
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Dividends
 
Other than a special cash dividend paid on December 22, 2008, we have not paid any dividends. Any future determination relating to dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including our outstanding indebtedness, earnings, capital requirements, financial condition and future prospects, applicable Delaware law, which provides that dividends are only payable out of surplus or net profit for the then current and immediately preceding fiscal years, and other factors that our board of directors may deem relevant. Future agreements governing our borrowings, and the terms of any preferred stock we may issue in the future, will also likely contain restrictive covenants prohibiting us from paying dividends.
 
Initial Public Offering of Our Common Stock and Use of Proceeds
 
On December 13, 2006, we completed the initial public offering of our common stock pursuant to a Registration Statement (File No. 333-137046) that was declared effective by the Securities and Exchange Commission on December 7, 2006. In that offering we sold a total of 3,125,000 shares of our common stock and selling stockholders sold 4,263,750 shares of our common stock, which included 963,750 shares resulting from the exercise of the underwriters' over-allotment option. All common stock registered under that registration statement were sold at a price to the public of $21.00 per share. We did not receive any proceeds from the selling stockholders' sale of their shares.
 
The net proceeds to us from the offering were approximately $58.8 million, after deducting underwriting discounts and commissions and other expenses incurred in connection with the offering. As of December 31, 2011, we had used $8.5 million of these proceeds to repay amounts outstanding under our revolving credit facility and $27.7 million for working capital purposes ($8.5 million in December 2006, $19.2 million in 2007), and $8.6 million in 2008 to expand our international operations.
 
No proceeds were used in 2011 or in 2010. We intend to use the remaining proceeds to fund potential acquisitions, market expansion, infrastructure improvements, working capital needs and other general corporate purposes.
 
Unregistered Sales of Equity Securities
 
During the period covered by this Annual Report on Form 10-K, we did not sell or issue any unregistered equity securities.
 
Repurchases
 
None.
 
Securities Authorized for Issuance under Equity Compensation Plans
 
The Company has reserved 2,972,725 shares of common stock subject to its 2006 Stock Incentive Plan, as amended and restated effective May 20, 2010, or the "2006 Plan," and had 358,546 shares remaining available at December 31, 2011 that may be granted to employees, consultants and nonemployee directors of the Company. The 2006 Plan is administered by the compensation committee of the Company's board of directors, which selects the persons to whom awards will be granted, determines the number of shares to be subject to each grant and prescribes the other terms and conditions of each grant and the vesting schedule. Unless specifically provided otherwise in an individual award agreement under the 2006 Plan, if a change in control of the Company, as defined by the 2006 Plan, occurs, (a) all of the options issued under the 2006 Plan will accelerate and become fully vested and exercisable and (b) the forfeiture restrictions under the restricted unit award agreement may lapse and the unvested restricted stock units may become vested and released from the forfeiture restrictions under such award only if the change in control constitutes a “change in control” within the meaning of Section 409A of the Internal Revenue Code of 1986, as amended.
 
Our board of directors and stockholders approved our 2006 Plan and we do not have any other equity based plans.
 
The following table provides information regarding the number of shares of our common stock that may be issued upon exercise of outstanding stock options or vesting of restricted stock units under the 2006 Plan as of December 31, 2011.
 
 
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Equity Compensation Plan Information

Plan Category
 
Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
   
Weighted-average
exercise price of
outstanding options,
 warrants and rights
   
Number of securities
remaining available
for future issuance
under equity
compensation plans
(excluding securities
reflected in column
(a))
 
   
(a)
   
(b)
   
(c)
 
Equity compensation plans approved by security holders
      2,072,002 (1)   $ 3.71 (2)       358,546  
Equity compensation plans not approved by security holders
          $          
Total
      2,072,002     $ 3.71         358,546  
 
(1)
Includes up to 63,559 shares issuable on vesting of outstanding restricted stock units at the end of the performance period May 1, 2010 to December 31, 2012, if the maximum performance goal for the performance year January 1, 2012 to December 31, 2012 is achieved. Includes up to 489,726 shares issuable on vesting of outstanding restricted stock units, at the end of the performance period January 1, 2011 to December 31, 2013, if the maximum performance goals for the performance years January 1, 2012 to December 31, 2012 and January 1, 2013 to December 31, 2013 are achieved.
 
(2)
Calculation of weighted-average exercise price does not include restricted stock units because they have no exercise price.
 
Exercise of Registration Rights

As previously disclosed in our Annual Reports on Form 10-K and our Registration Statement on Form S-1 filed with the SEC on September 1, 2006, the Company is party to a Registration Rights Agreement, dated May 26, 2000 (the “Registration Rights Agreement”), by and among the Company, Patricia and Samuel Ligon, and Capital Southwest Venture Corporation (“CSVC”).  The Registration Rights Agreement is attached as Exhibit 10.1 to our Registration Statement on Form S-1 filed on September 1, 2006.

Pursuant to its rights under Section 2(a) of the Registration Rights Agreement, CSVC has notified the Company of its election to exercise its registration rights with respect to all of the Company’s Registrable Securities (as defined in the Registration Rights Agreement) held by CSVC and CSVC has requested that the Company file a registration statement on Form S-3 (the “Registration Statement”) with respect to the Registrable Securities promptly after the Company files this Annual Report on Form 10-K with the SEC.  The Company intends to comply with its obligations under the Registration Rights Agreement and file the Registration Statement promptly after the Company files this Annual Report on Form 10-K with the SEC.

The Company will not receive any of the proceeds from any resale of the Company’s common stock by CVSC.

The foregoing disclosure shall not constitute an offer to sell or the solicitation of an offer to buy any securities, nor shall it constitute an offer, solicitation or sale in any jurisdiction in which such offer, solicitation or sale is unlawful.
 
 
We are a Smaller Reporting Company as defined in Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide information under this Item.
 
The following discussion should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements due to known and unknown risks, uncertainties and other factors, including those described in Part I, "Item 1A. Risk Factors" and elsewhere in this Annual Report on Form 10-K. Those risk factors expressly qualify all subsequent oral and written forward-looking statements attributable to us or persons acting on our behalf. We disclaim any intention or obligation to update or review any forward-looking statements or information, whether as a result of new information, future events or otherwise.
 
Throughout this report, references to the "Company," "we," and "our" refer to Heelys, Inc. and its consolidated subsidiaries, unless the context indicates otherwise.
  
Overview
 
We are a designer, marketer and distributor of innovative, action sports-inspired products primarily under the HEELYS brand targeted to the youth market. Our primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user to seamlessly transition from walking or running to rolling by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. In 2011, approximately 98% of our net sales was derived from the sale of our HEELYS-wheeled footwear. The remainder of our net sales was derived from the sale of our Nano™ inline footboard and branded accessories, such as replacement wheels, and from the distribution of third-party brands in Europe.

We introduced HEELYS-wheeled footwear in 2000, and for several years our domestic sales were concentrated with one large, national specialty retailer. Although we initially focused on driving our domestic sales growth, we also established relationships with independent distributors in Japan, South Korea and Southeast Asia. As a result, the sources of our net sales were largely concentrated and we were susceptible to customer-specific and region-specific factors. This concentration caused variability in our results of operations. Since that time, we have diversified our retail customer base in the United States by widening our distribution to include full-line sporting goods retailers, specialty apparel and footwear retailers, family footwear stores and select online retailers. We have also expanded our international distribution channels to mitigate this concentration. Historically, our products have been sold to independent distributors with exclusive rights to specified international markets. In 2008, we formed a Belgian subsidiary, with an office in Brussels and branch offices in Germany and France, and expanded our international opportunities by working more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers. Effective March 31, 2008 and April 30, 2008, respectively, we entered into agreements with our former distributor in Germany and Austria (German market) and our former distributor in France, Monaco and Andorra (French market) whereby we terminated their rights to distribute our products in their specified markets. Our Belgian subsidiary took over the distribution of our products in the German market effective April 1, 2008 and in the French market effective May 1, 2008. As part of an initiative to improve efficiency and reduce costs, we began taking steps in the first quarter of 2012 to close our office in Brussels and transition our business operations conducted through that office to our French and German offices. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011.
 
 
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 Continued growth of our net sales will depend on consumer demand for HEELYS-wheeled footwear and our ability to satisfy this demand. A number of factors may impact consumer demand for our products, including:
 
 
general economic conditions, particularly changes in consumer discretionary spending patterns;
 
 
the effectiveness of our marketing strategies;
 
 
our ability to effectively distribute our products;
 
 
our ability to design products that appeal to our target consumers;
 
 
our ability to protect our intellectual property rights; and
 
 
changes in the popularity of and participation in wheeled sports activities.
 
       We intend to continue to diversify our product offering with new HEELYS-wheeled footwear models in order to benefit from the recognition of our HEELYS brand. Designing, marketing and distributing new products will require us to devote additional resources to product development, marketing and operations. These additional resources may include hiring new employees to support expansion in these areas and increasing amounts allocated to product advertising and promotion. Each of these additional resource commitments will increase our selling, general and administrative expenses. Because the selling price and unit cost of new products may differ from those of our existing products, sales of these new products may also impact our gross margin. In addition, we may seek to selectively acquire new products and companies.
 
General
 
Net Sales
 
Net sales represent primarily sales of HEELYS-wheeled footwear, less an estimated reserve for sales returns, allowances (including certain allowances for marketing, promotion and advertising support) and discounts. Amounts billed to customers for shipping and handling are included in net sales.
 
We sell our products through distribution channels that generally merchandise our products in a manner that we believe enhances and protects our HEELYS brand image.
 
Domestically, our products can be found in full-line sporting goods retailers, specialty apparel and footwear retailers, family footwear stores and select online retailers. For 2011, 37.2% of our net sales were derived from domestic retail customers.
  
Internationally, our products historically have been sold primarily to independent distributors with exclusive rights to specified markets. During 2008, we formed a Belgian subsidiary, with an office in Brussels and branch offices in Germany and France, and expanded our international opportunities by working more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers. We took over the distribution of our products in Germany and Austria (German market), and in France, Monaco and Andorra (French market) during 2008. In 2011, our German and French markets accounted for 6.8% and 17.0% of our consolidated net sales, respectively. Through our Belgian subsidiary, we began to sell directly to retailers in Italy during the fourth quarter of 2009, and directly to retailers in Spain and Portugal in 2011. In 2011, our Italian market accounted for 19.6% of our consolidated net sales. Spain and Portugal accounted for less than 1% of our consolidated net sales. We began taking steps in the first quarter of 2012 to close our office in Brussels and transition our business operations conducted through that office to our French and German offices.

 
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In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011. Prior to then, our products were sold through an independent distributor in Japan. In 2011, our Japan market accounted for 5.9% of our total consolidated net sales.
 
In 2011, Oxylane Group accounted for 11.7% of our consolidated net sales. Oxylane Group is a French sporting goods retail chain operating under the name Decathlon. No other retail customer or independent distributor accounted for 10% or more of our consolidated net sales during 2011.
 
Sales to our customers in the German, French, Italian, Spain and Portugal markets are denominated in Euro. Sales to our independent distributors in the other Europe, Middle East and African (“EMEA”) countries are denominated in U.S. dollars. Sales to our independent distributors in non-EMEA markets continue to be processed at our office in Carrollton, Texas and are denominated in U.S. dollars. Sales to our customers in the Japanese market are denominated in Japanese Yen. Payments are required to be made in the same currency as invoiced.
 
During the second quarter of 2010, we began selling certain styles of our products through our website at www.heelys.com.

Cost of Sales and Gross Profit
 
Cost of sales consists primarily of the cost to purchase finished products from our independent manufacturers. Cost of sales also includes shipping and handling costs that are directly attributable to the procurement of inventory, including inbound freight, and inventory reserves for shrinkage and write-downs.
 
We source all of our products from manufacturers located in China. Our product costs are largely driven by the prices we negotiate with our independent manufacturers. Each season, we negotiate a unit price for each model of HEELYS-wheeled footwear. Factors that influence these prices include raw materials, labor costs and foreign exchange rates. We believe our sourcing model allows us to minimize our capital investment, retain production flexibility, cost-effectiveness and scalability inherent in the use of independent manufacturers and focus our resources on developing new products and enhancing our HEELYS brand image.
 
In May 2010, we entered into an agreement with TGB, LLC, a New Jersey limited liability company (“TGB”), under which TGB acted as the exclusive sourcer of our shoe products. In April 2011, we reached an agreement with TGB to terminate this sourcing agreement. From and after the termination of that sourcing agreement, we were not required to (and did not) purchase any other products from TGB and, instead, we began to purchase products directly from independent manufacturers.

We purchase all of our shoe products as finished goods directly from independent manufacturers. These purchases are coordinated through our employees in China.
 
When demand for our products slows, we may elect to discount our products to reduce our inventory, which causes our gross profit as a percentage of net sales, or gross margin, to decline. Our gross margin is affected by our sourcing costs, our product mix and our ability to avoid excess inventory by accurately forecasting demand for our products. The unit prices we charge our domestic and international retail customers are generally higher than we charge our independent distributors for similar products, because our independent distributors are responsible for distribution and marketing costs relating to our products.
 
Our inventories are stated at the lower of cost or market. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the forecast of future demand and market conditions. If we estimate the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we charge cost of sales for the difference between the cost of the inventory and the estimated net realizable value. If changes in market conditions result in reductions in the estimated net realizable value of our inventory below our previous estimate, we would write-down the inventory in the period in which we made such a determination and charge cost of sales.
 
Selling, General and Administrative Expenses
 
Selling, general and administrative expenses consist of wages and related payroll and employee benefit costs, sales and marketing expenses, advertising costs, travel and insurance expenses, shipping and handling costs that are not directly attributable to the procurement of inventory, product development costs, costs to enforce our intellectual property rights, depreciation, amortization, professional fees, facility expenses and costs associated with operating as a public company.
 
 
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Generally accepted accounting principles require the measurement of compensation expense of stock-based compensation awards based on the estimated fair value of that award on the date of grant. For stock options, we recognize this compensation expense using the straight-line method over the period during which the employee is required to provide service in exchange for the award. No compensation expense is recognized for stock option awards for which the employee does not render the required service. If the requisite service is not provided, previously recognized compensation expense is reversed. For all stock option awards granted to-date, the requisite service period is the same as the vesting period of the award. For restricted stock units (designated as performance awards), we recognize compensation expense using the straight-line method over the performance period. The amount of compensation expense recognized is based upon the estimated number of restricted stock units expected to be earned. The Company reassesses this estimate at each reporting period and adjusts the total amount of compensation expense to be recognized accordingly.
  
Our selling, general and administrative expenses may increase in future periods as we hire additional personnel, develop our infrastructure, increase our brand recognition through marketing, increase our product development efforts, secure and enforce our intellectual property rights and incur expenses associated with operating as a public company.
 
During the first quarter of 2011, we began to sell directly to retailers in Portugal and Spain through an independent agent who is paid commissions on those sales. For 2011, sales in these markets have been limited. As sales increase, our selling expenses will increase. Additionally, because sales to these retailers will generally be fulfilled out of our warehouse in Belgium, we would expect that our shipping and handling costs, which are included in general and administrative expense, will also increase. Because we generally are able to charge higher unit prices to international retail customers than we charge our independent distributors for similar products, we expect there to be a positive impact on our gross margin.
 
Income Taxes
 
We operate through Heeling Sports Limited, a Texas limited partnership, and as such we are subject to Texas franchise taxes on gross margin sourced to the State of Texas. In addition, the Company is subject to income taxes in certain other states as a result of business activities being performed in those states. In 2008, the Company formed a subsidiary in Belgium, with branch offices in Germany and France, to function as the headquarters for sales operations for Europe, the Middle East and Africa. As a result, we have been subject to income tax in Belgium, Germany and France since 2008 and will be subject to those taxes as long as we have operations in these jurisdictions. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011, and, as a result we are now subject to income tax in Japan. Increased activities in foreign jurisdictions or the formation of additional foreign subsidiaries could cause us to be liable for income taxes in additional jurisdictions.
 
Highlights of fiscal year ended December 31, 2011:
 
Consolidated net sales increased $1.6 million in 2011, or 5.2% from prior year. This increase was led by improved U.S. sales of $3.3 million, or 37.8% from prior year; offset by a $1.7 million, or 7.7%, decrease in international sales. The drop in international sales was primarily the result of a decline in sales in our Japanese market.

Gross margin percentage remained consistent at 41.6% year-on-year.

Selling and marketing expense increased $1.5 million in 2011. Domestic sales and marketing expense increased $0.2 million in 2011, the result of additional sales commissions related to the increase in domestic sales from prior year. International marketing expense increased $1.2 million, primarily due to increased commission expense related to the increase in sales in Italy from prior year and the sales and marketing expenses associated with the Japan office opened in the first quarter of 2011. This increase was offset by decreases in promotional marketing in Europe.

General and administrative costs increased $0.6 million in 2011. The increase was primarily the result of higher distribution costs associated with the increase in sales in the United States and Italy and the costs related to the opening of the Japan office during Q1 of 2011.

Net loss for the year was $5.6 million, $1.6 million greater than prior year. The increased loss was primarily the result of costs associated with the opening of the Japan office in 2011, and $1.2 million in inventory impairment charges and related reserve adjustments, including $812,000 attributable to the inventory purchased in the first quarter of 2011 from our previous Japanese distributor.

Cash and investments decreased $9.2 million in 2011. The change in cash and investments was the result of 2011 operating losses combined with an increase in receivables of $4.0 million relating to higher Q4 sales and an increase in inventories of $3.3 million to support sales in the first half of 2012, offset by a decrease in accounts payable and accrued liabilities of $1.3 million and $1.5 million, respectively.
 
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International Efficiency and Cost Reduction Initiative

As part of an initiative to improve efficiency and reduce costs, we began taking steps in the first quarter of 2012 to close our office in Brussels, Belgium and transition our business operations conducted through that office to our French and German offices. As part of this initiative, the Company expects to reduce its workforce in Belgium. These workforce reductions will primarily come from the elimination of certain finance, supply chain and customer service functions. The work performed by these persons mostly will be absorbed by our French, German and U.S. office employees, and we anticipate hiring limited personnel to assist with accounting and logistical support in those offices. Financial management and reporting for our Belgian subsidiary will be transitioned to our headquarters in the United States. The actions taken thus far to implement this initiative are expected to be substantially completed by June 30, 2012, with the total cumulative pre-tax costs estimated to be $0.9 million to $1.3 million. The Company currently anticipates that approximately 90% of these costs will relate to cash outlays, primarily related to employee separation expense and professional fees. The Company does not anticipate that the actions taken thus far with respect to the initiative will result in annual savings in 2012, but estimates annual savings of approximately $1.5 million in future years.

Comparison of the Years Ended December 31, 2011 and 2010
 
Net Sales

   
Year Ended December 31,
 
             
   
2011
   
2010
 
Net Sales (in thousands)
           
Domestic
  $ 11,903     $ 8,641  
International
    20,114       21,795  
Consolidated
  $ 32,017     $ 30,436  
                 
Net Sales (as % of Consolidated Net Sales)
               
Domestic
    37.2 %     28.4 %
International
    62.8 %     71.6 %
      100.0 %     100.0 %
 
   
Year Ended December 31,
 
             
   
2011
   
2010
 
Pairs Sold
           
Domestic
    472,000       367,000  
International
    532,000       669,000  
Consolidated
    1,004,000       1,036,000  
 
Domestically, our net sales increased $3.3 million, or 37.8%, from $8.6 million in 2010, to $11.9 million in 2011. This increase was primarily the result of increased unit sales of our HEELYS-wheeled footwear and an increase in the average sales price per pair sold. Unit sales of our HEELYS-wheeled footwear increased by 105,000 pairs, or 28.6%, from 367,000 pairs in 2010, to 472,000 pairs in 2011, primarily as a result of expanded placement, when compared to last year, in existing and new retail outlets, as well as the sale of our new brand, Sidewalk Sports™. We sold 43,000 pairs of our Sidewalk Sports™ wheeled footwear, which was sold exclusively through a discount retailer for the 2011 Holiday season. The increase in average sales price per pair is primarily attributable to reduced sales of aged inventory to a discount retailer. During 2010 we sold 63,000 pairs of certain older styles of our wheeled-footwear at a reduced price per pair to this retailer. We did not sell any product to this retailer during 2011. The increase in average sales price per pair, resulting from reduced sales of aged inventory, was offset by the impact of the sale of our Sidewalk Sports™ wheeled footwear which sells for less than our other wheeled products.

Internationally, our net sales decreased $1.7 million, or 7.7%, to $20.1 million in 2011, from $21.8 million in 2010. This decrease was primarily the result of lower unit sales of our HEELYS-wheeled footwear. Unit sales in our non-EMEA markets decreased 174,000 pairs to 88,000 pairs in 2011, from 262,000 pairs in 2010, which is primarily attributable to a decrease in pairs sold in our Japanese market which decreased 167,000 pairs to 48,000 pairs in 2011, from 215,000 pairs in 2010. We took over direct distribution in the Japanese market effective March 1, 2011. Prior to then, our products were sold through an independent distributor. We believe the decrease in sales in the Japanese market is due to the transition from distribution through an independent distributor to direct distribution and the impact of the earthquake and tsunami-related events in Japan, which resulted in business disruptions during the year. We believe the March 2011 earthquake in Japan, and related tsunami, nuclear and other disasters in the region impacted consumer buying behavior with reduced discretionary spending and purchases of non-essential items. We do not believe the earthquake and tsunami-related events in Japan will continue to have a significant impact on consumer buying behavior. Unit sales in our German and French markets decreased 85,000 pairs, or 34.3%, to 163,000 pairs in 2011, from 248,000 pairs in 2010. We believe the decrease in unit sales in both our German and French markets is primarily due to retailers being more cautious when placing orders to minimize their inventory levels and inventory related risks resulting from a decrease in consumer demand, which we believe is due to market competition from other wheeled products such as coaster boards. These decreases in unit sales were offset by increases in unit sales in our Italian market and to independent distributors in our EMEA markets. Unit sales in our Italian market increased 84,000 pairs, from 55,000 pairs in 2010, to 139,000 pairs in 2011. The increase in pairs sold in the Italian market is attributable to market expansion. Unit sales to independent distributors in our EMEA markets increased 36,000 pairs, from 104,000 pairs in 2010, to 140,000 pairs in 2011, which was primarily due to increased sales to our independent distributor in the United Kingdom (increase of 30,000 pairs sold) and sales to our new independent distributor in the United Arab Emirates (10,000 pairs sold).
 
 
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Gross Profit

   
Year Ended December 31,
 
             
   
2011
   
2010
 
Gross Profit (in thousands)
           
Domestic
  $ 4,704     $ 2,608  
International
    8,616       10,045  
Consolidated
  $ 13,320     $ 12,653  
                 
Gross Profit (%)
               
Domestic
    39.5 %     30.2 %
International
    42.8 %     46.1 %
Consolidated
    41.6 %     41.6 %
 
Domestically, gross profit margin increased from 30.2% for 2010, to 39.5% for 2011. The increase in gross profit margin is a result of a higher average price per pair sold as a result of a decrease in sales to a discount retailer. In 2010 we sold 63,000 pairs to a discount retailer. In connection with these sales we recorded inventory markdowns (in order to properly state our inventories at lower of cost or market) of $352,000 in 2010. We did not sell any product to this discount retailer during 2011. During 2011, we recognized inventory impairment charges and related inventory valuation reserve adjustments in the amount of $57,000.

Internationally, gross profit margin decreased to 42.8% for 2011, from 46.1% for 2010. Fluctuations in the exchange rate between the U.S. dollar (“USD”) and the Euro impacts our inventory cost. We pay for our inventory in USD and sell to customers in our German, French and Italian markets in Euro. During 2011, we sold inventory in these markets that we had purchased in 2010 when the exchange rate (USD to Euro) was higher, which resulted in a higher inventory value and lower margins on those sales. We sell to our independent distributors in USD. Historically, fulfillment of sales to independent distributors is direct from the manufacturer with the purchase of inventory and sale occurring virtually simultaneously and therefore the translated Euro value of the purchase of the inventory in USD and the Euro value of the sale in USD moves together and margins are maintained. However, during 2011, we fulfilled some distributor sales from our warehouse in Belgium with inventory we had purchased in 2010 when the exchange rate (USD to Euro) was higher, which resulted in higher inventory value than if that inventory had been purchased during the current year. So, while the USD value of these sales to distributors remained the same, the Euro value decreased, which resulted in lower margins on those sales. Additionally, we saw lower average sales prices in our Italian market resulting from changes in customer mix, with greater sales to larger customers who benefit from discount programs. Also, during 2011, we incurred approximately $348,000 to destroy damaged and older inventory items and sold certain of our slow moving and older inventory styles in our Japanese market at lower margins in order to reduce our excess inventories. Additionally, in late 2010 we began selling our two-wheeled footwear in the French market. This product has a higher manufacturing cost and sells at lower price points than our traditional one-wheeled footwear, resulting in lower gross profit margins on these sales. During 2011, we recognized $841,000 in inventory impairment and related inventory valuation reserve adjustments, which was primarily attributable to inventory we purchased during the first quarter from our former independent distributor in Japan.
 
 
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Sales and Marketing Expense

   
Year Ended December 31,
 
             
   
2011
   
2010
 
Selling & Marketing (in thousands)
           
Domestic
  $ 3,817     $ 3,576  
International
    4,934       3,715  
Consolidated
  $ 8,751     $ 7,291  
 
Domestically, selling and marketing expense, excluding commissions and payroll and payroll related expenses, remained consistent at $2.4 million for the years ended December 31, 2011 and 2010. During 2011, we decreased advertising and marketing spend for our HX2™ two wheeled-footwear and Nano™ inline footboard, which received additional advertising and marketing support in 2010 during their new product launches, but increased advertising and marketing of our core HEELYS wheeled-footwear.  

Internationally, selling and marketing expense, excluding commissions and payroll and payroll related expenses, increased $201,000 from $1.9 million in 2010, to $2.1 million in 2011. We recognized $536,000 in selling and marketing expenses, excluding commissions and payroll and payroll related expenses, directly attributable to our office in Japan which we opened during the first quarter of 2011. Of this amount approximately $469,000 was for consumer advertising and related costs (including event marketing) including approximately $55,000 for a marketing event for one of our Japanese customers during the third quarter and approximately $68,000 resulting from our participation in a Dance Nation event held on December 24, 2011. Selling and marketing expenses, excluding commissions and payroll and payroll related expenses, directly attributable to our Belgian subsidiary decreased $329,000 to $1.6 million in 2011, from $1.9 million in 2010. This decrease was primarily due to management’s decision to reduce consumer advertising during the fourth quarter in our German and French markets as a result of decreased consumer demand.
 
Commissions on domestic sales increased $161,000, or 43.8%, from $368,000 in 2010, to $529,000 in 2011. The increase in commissions is primarily due to the increase in domestic sales on which commissions are paid.
 
Internationally, commissions increased $624,000 from $845,000 in 2010, to $1.5 million in 2011, primarily due to increased sales in the Italian market where we sell directly to retailers through an independent agent who is paid commissions on those sales. Commission expense is impacted by increases and decreases in sales as well as changes in product and customer mix due to differing commission rates paid on those sales.
 
Payroll and payroll related expenses attributable to our domestic operations increased $33,000 from $848,000 in 2010, to $881,000 in 2011. Payroll and payroll related costs attributable to our international operations increased $394,000 from $955,000 in 2010, to $1.3 million in 2011, primarily as a result of the opening of our office in Japan.
 
General and Administrative Expense

   
Year Ended December 31,
 
             
   
2011
   
2010
 
General & Administrative (in thousands)
           
Domestic
  $ 4,577     $ 5,070  
International
    5,172       4,153  
Unallocated
    986       883  
Consolidated
  $ 10,735     $ 10,106  

Consolidated general and administrative expenses, excluding unallocated costs, increased $526,000 from $9.2 million in 2010, to $9.8 million in 2011.
 
Consolidated shipping and handling costs increased $589,000 from $2.0 million in 2010, to $2.5 million in 2011. Shipping and handling costs attributable to our EMEA operations accounted for $270,000 of the increase, primarily as a result of an increase in shipments out of our warehouse in Belgium to fulfill sales to retailers in our Italian market. Inventory handling related costs directly attributable to the opening of our Japan operations, including order fulfillment, accounted for $272,000 of the increase.
 
 
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 Legal and other fees related to our intellectual property and associated enforcement efforts decreased $706,000 to $472,000 in 2011, from $1.2 million in 2010. These decreases are a combination of differing enforcement actions during the periods and an overall cost containment effort by management.
 
Payroll and payroll related costs attributed to our domestic employees decreased $193,000 to $2.1 million in 2011, from $2.3 million in 2010. Payroll and payroll related costs attributed to our Belgian subsidiary (including branch offices in Germany and France) increased $52,000 from $946,000 in 2010, to $1.0 million in 2011. Payroll and payroll related costs attributed to our Japan operations were $210,000 in 2011.

Unallocated costs are those costs that are directly attributable to operating as a public company, as well as professional fees incurred at the consolidated level, including fees for tax, accounting and other consulting and professional services.
 
 Other Expense (Income)

   
Year Ended December 31,
 
             
   
2011
   
2010
 
Other (Income) Expense (in thousands)
           
Interest (income) expense, net
  $ (274 )   $ (355 )
Other (income) expense, net
    (525 )     (818 )
Exchange (gain) loss, net
    (6 )     153  
Consolidated
  $ (805 )   $ (1,020 )
 
The decrease in interest income (expense), net is primarily the result of a $87,000 decrease in interest income to $307,000 in 2011, from $394,000 in 2010.
 
Other income is the result of settlements of patent and trademark litigation. Litigation settlement payments related to intellectual property legal matters (whether received by the Company or paid by the Company) are reported as other income (expense). Legal fees related to intellectual property matters and associated enforcement are included in general and administrative expenses. We recognized $575,000 and $822,000 in other income resulting from litigation settlement payments in the Company’s favor in 2011 and 2010, respectively, which included a settlement of a potential patent and trademark lawsuit in the amount of $375,000 during the third quarter of 2011 and $750,000 during the second quarter of 2010 for the settlement of another potential patent and trademark lawsuit.

Gains (losses) resulting from foreign currency transactions are mainly attributable to intercompany loans due to our U.S. entity from our Belgian and Japanese subsidiaries, which must be repaid in U.S. dollars.
 
Income Taxes

We recognized income tax expense of $239,000, effective tax rate of (4.5%), in 2011; compared to an income tax expense of $267,000, effective tax rate of (7.2%), in 2010. Our effective rate differs from the statutory federal rate of 35% primarily due to domestic and international operating losses for which no tax benefits have been recognized and foreign taxes at rates other than 35%, as well as for certain other items such as state and local taxes and non-deductible expenses. While we did not record the benefit of losses in the United States and Japan for the current year, profits in our French and Belgian operations, offset by losses in our German operations, resulted in net income tax expense of $239,000 for the fiscal year ended December 31, 2011. We operate in multiple jurisdictions and have seasonality in our business which causes variability in our consolidated effective tax rate during the year. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011, and, as a result, we are now subject to income tax in Japan. Increased activities in foreign jurisdictions or the formation of additional foreign subsidiaries could cause us to be liable for income taxes in additional jurisdictions.
  
Liquidity and Capital Resources
 
Our primary cash need is for working capital, which we generally fund with cash flow from operating activities, and may be impacted by fluctuations in demand for our products, investments in our infrastructure and expenditures on marketing and advertising. At December 31, 2011, we had a total of $17.9 million in cash and cash equivalents and $40.5 million in current investments. Our current investments will mature during the next 12 months and include investments in debt securities ($40.0 million) and a certificate of deposit ($500,000).
 
The Company has established an investment policy, the purpose of which is to establish sound investment guidelines for the ongoing management of the Company’s excess cash and investments. The policy provides guidelines on, among other things, investment term limitations, permitted investments, credit quality, single issuer concentration and corporate debt sector concentrations. In all categories of investments, emphasis is placed on securities of high quality subject to the following quality limitations at the time of investment:
 
 
30

 
 
·
U.S. Treasury and other U.S. Federal Agencies, debentures or mortgages;
 
·
$1 net asset value money market mutual funds governed by SEC Rule 2a-7;
 
·
Commercial Paper (minimum A-1/P-1/F-10); Corporate Notes (minimum A or better): and
 
·
Municipal Debt (short-term: minimum A-1/P-1 or equivalent; long term: A or better).
 
Cash used in operating activities for the year ended December 31, 2011 was $8.3 million compared to cash provided of $2.7 million for the year ended December 31, 2010. Cash flows from operating activities are comprised of net loss adjusted for non-cash items and changes in operating assets and liabilities. The 2011 loss included $1.2 million in inventory impairment charges and related inventory valuation reserve adjustments, including $812,000 attributable to the inventory we purchased during the first quarter of 2011 from our former distributor in Japan.

The increase in accounts receivables is due to increased sales as well as timing. The increase in inventory is primarily to support sales in the first half of 2012. The increase in accounts payable and accrued liabilities is primarily due to inventory purchases. During the third quarter of 2011, we settled a potential patent and trademark lawsuit, in the Company’s favor, in the amount of $375,000. The full amount of the settlement was received during the third quarter of 2011.

Net cash provided by changes in operating assets and liabilities for the year ended December 31, 2010 was primarily due to the collection of a $2.9 million federal income tax refund for the carryback of 2008 net operating losses to 2006 offset by $1.2 million settlement of outstanding state tax liabilities. The reduction in net accounts receivable was due to timing as well as reduced sales. The increase in inventory during 2010 was primarily due to an increase in inventory levels in our Belgian warehouse due to lower than expected sales during December 2010 as well as the need to maintain higher inventory levels to meet the demand of our international retailers. Additionally, we had approximately $841,000 of inventory being held in China which we agreed to purchase as a result of an order cancellation by our former independent distributor in Japan. During the fourth quarter of 2010, we received a federal income tax refund of $3.1 million for the carryback of 2009 net operating losses to 2007.
 
As of December 31, 2011, we had open purchase commitments of $3.8 million for the purchase of inventory, the majority of which are expected to be settled during the first quarter of 2012.

Cash flows provided by and used in operating activities is subject to seasonality.
 
Net cash used in investing activities of $9.0 million for the year ended December 31, 2011, and $6.1 million for the year ended December 31, 2010, is primarily the result of purchases of investments, offset by proceeds from investments that matured during the respective periods.

Cash used in financing activities for the years ended December 31, 2011 and 2010, was for payments of our previously acquired goodwill and intangibles associated with the termination of agreements with our former independent distributors in the German and French markets in 2008. As of December 31, 2011, we have outstanding liabilities of $214,000 due to our former independent distributor in the German market, $93,000 of which are recorded as a current liabilities and are expected to be settled during the next 12 months. All liabilities due to our former independent distributor in the French market have been settled.
 
We believe our cash flows from operating activities, together with the cash on hand (including cash equivalents) and investments, will be sufficient to meet our liquidity needs and capital expenditure requirements for at least the next 12 months.
 
Operating Leases and Related Obligations
 
Leases
 
We lease our corporate headquarters, an approximately 48,400 square-foot facility located in Carrollton, Texas, consisting of approximately 34,500 square feet of warehouse space and approximately 13,900 square feet of office space. Our lease expires in August 2015, but we have two five-year extension options. The lease for our corporate headquarters provides that if we are in default of the lease, we must pay certain damages to the landlord, and the landlord may elect to require us to continue to pay rent through the end of the lease term or to pay the present value of the excess, if any, of the aggregate rent otherwise payable through the end of the lease over the aggregate fair market value of the premises for the lease period.
 
Effective May 1, 2008, our Belgian subsidiary entered into an operating lease for office space in Brussels, Belgium for nine years with the option to terminate the lease at the end of each three year period. This lease was not terminated at the end of the first three year period.  Payments under this lease agreement are made in Euro. While we have begun taking steps in the first quarter of 2012 to close our Belgian office, and transition our business operations conducted through that office to our French and German offices, we have not terminated our operating lease for our Belgian office.
 
 
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Effective April 1, 2008, our Belgian subsidiary entered into an operating lease for office space in Munich, Germany for three years with an automatic renewal at the end of the initial three year lease unless six months notice is provided. This lease was renewed for a one year period from April 1, 2011 through March 31, 2012 and has been renewed for another period of one year from April 1, 2012 through March 31, 2013. Payments under this lease agreement are made in Euro.
 
Effective May 1, 2008, our Belgian subsidiary entered into an operating lease for office space in Annecy, France for nine years with the option to terminate the lease at the end of each three year period. This lease was not terminated at the end of the original three year period. Payments under this lease agreement are made in Euro.
 
On March 1, 2011, our Japanese subsidiary entered into an operating lease for office space in Tokyo, Japan for two years with an automatic renewal at the end of the initial two year lease, unless six months notice is provided. Payments under this lease agreement are made in Japanese Yen.
 
Third-Party Distribution Arrangements
 
We use a third-party distribution facility in Belgium and pay this third-party distributor fees and charges for services including storage, handling, processing and packing materials. These fees and charges are activity based and therefore fluctuate and as a result related future obligations cannot be quantified. This agreement is for one year with automatic one year renewal terms. We expensed $1.6 million and $1.3 million related to this third-party distribution facility in 2011 and in 2010, respectively.

We use a third-party distribution facility in Japan and pay this third-party distributor a monthly management fee as well as fees and charges for services, including storage, handling, processing and packing materials. Other than the monthly management fee, these fees and charges are activity-based and fluctuate; as a result the related future obligations for these fees and charges cannot be quantified. Our agreement with this distributor is for one year with automatic one year renewal terms. We expensed $191,000 related to this third-party distribution facility in 2011.

 Purchase Commitments
 
At December 31, 2011, we had open purchase commitments of $3.8 million for inventory purchases.
  
Termination of Distributorship Agreements
 
Effective March 31, 2008, we entered into agreements to terminate our arrangement regarding the distribution of Heelys-branded footwear and products in Germany and Austria, allowing us to market, through our Belgian subsidiary, our products directly in such countries. This included a Termination Agreement (the "Termination Agreement") with The Territory Distribution GmbH (the "Distributor"), and Achim Lippoth, the sole owner of the Distributor ("Lippoth"), pursuant to which, among other things, a prior Distributor Agreement between the Company and the Distributor was terminated, we  agreed to purchase from the Distributor all of the Distributor's inventory of unsold Heelys products and other specified assets for the Distributor's cost, and all of the unshipped orders for Heelys products on the Distributor's order book as of March 31, 2008 for a price equal to the Distributor's net wholesale margin on such unshipped orders, and the Distributor and Lippoth agreed, until March 31, 2010, not to compete with us relating to the Company's products anywhere in the world. In connection with the Termination Agreement we entered into two consulting agreements, one with The Sansean Group Limited ("Sansean"), and one with Lippoth, pursuant to which, among other things, Sansean and Lippoth agreed to perform certain consulting services and we agreed to pay Sansean and Lippoth consulting fees as set forth in their respective consulting agreements. Payments under these agreements are to be made in Euro.
 
Effective April 30, 2008, we entered into agreements to terminate our current arrangement regarding the distribution of Heelys-branded footwear and products in France, Monaco and Andorra, allowing our company, through our Belgian subsidiary, to market products directly in such countries. This included a Termination Agreement (the "Termination Agreement") with Trotwood Import/Export (the "Distributor"), Trotwood Investments Ltd., the sole owner of the Distributor ("TIL"), and David Stanley ("D. Stanley") and Margarete Stanley ("M. Stanley"), pursuant to which, among other things, a prior International Distributor Agreement between our company and the Distributor was terminated, we agreed to purchase from the Distributor all of the Distributor's inventory of unsold Heelys products for the Distributor's cost of such products, the Distributor's order books relating to Heelys products at the value on Distributor's books and certain other incidental assets of the Distributor related to its distribution operations as described in the Termination Agreement (we agreed to pay Distributor for such items on or before May 16, 2008), we agreed to purchase from the Distributor all of the unshipped orders for Heelys products on the Distributor's order book as of April 30, 2008 that are not novated to our company or one of its affiliates for a price equal to the Distributor's net wholesale margin on such unshipped orders (which is to be paid on or before the end of the month following our receipt of payment for the Heelys products shipped in response to such unshipped orders). In addition, the Distributor, Shareholder, D. Stanley and M. Stanley agreed, until April 30, 2012, not to compete with us relating to our products anywhere in the world and we agreed to pay Distributor an additional amount set forth in the Termination Agreement for each pair of Heelys branded footwear sold by our company or its affiliates in France, Monaco and Andorra. In connection with the Termination Agreement, we entered into a Consulting Agreement with TIL pursuant to which, among other things, TIL agreed to perform certain consulting services and we agreed to pay TIL consulting fees as set forth in such consulting agreement. Payments under these agreements are to be made in Euro. 
 
 
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The primary assets acquired as a result of these agreements were the customer lists and goodwill. In addition, both of these former distributors agreed to not compete with the Company for a limited period of time. The fair value of the acquired assets was based upon the amount at which the assets could be bought or sold in a current transaction between willing parties. As a result, the Company recorded goodwill and intangibles (including acquired customer relationships and non-compete agreements) in the amount of $3.7 million (2.4 million Euro). As of December 31, 2011, the Company paid $3.2 million (2.2 million Euro) for these acquired assets with the balance of $214,000 (166,000 Euro) to be paid out over time in accordance with the terms of the respective agreements; $121,000 is recorded as other long term liability and $93,000 is recorded as a current liability. As of December 31, 2011, all liabilities due to our former distributor in the French market have been settled.
 
On November 25, 2010, we notified Privee AG Corporation (“Privee AG”), our independent distributor in Japan, that we would not be renewing our distributor agreement with Privee AG (the “Notice”), under which Privee AG acted as our exclusive distributor in Japan (the “Agreement”). Pursuant to the Notice, the Agreement terminated on February 28, 2011, which was the expiration date of the then current term of the Agreement.

Termination of Sourcing Agreement

From May 2010 to April 2011, TGB, LLC, a New Jersey limited liability company (“TGB”), acted as the exclusive sourcer of our shoe products. From and after the termination of that sourcing agreement in April 2011, we were not required to (and did not) purchase any other products from TGB and, instead, we purchased products directly from independent manufacturers.
 
Seasonality
 
Similar to other vendors of footwear products, sales of our products are subject to seasonality. There are three major buying seasons in footwear: spring/summer, back-to-school and holiday. We offer two primary lines: spring/summer and a combined back-to-school/holiday line. A few new styles will typically be added for holiday. Shipments for spring/summer take place during the first quarter and early weeks of the second quarter, shipments for back-to-school generally begin in May and finish in late August and shipments for the holiday season begin in October and finish in early December. Historically, we have experienced greater revenues in the second half of the year than those in the first half due to a concentration of shopping around the back-to-school and holiday seasons.
 
Backlog
 
Historically, we received most of our orders three to four months prior to the date the products were shipped to customers. At December 31, 2011, our backlog was approximately $5.4 million, compared to approximately $4.9 million at December 31, 2010. Although generally these orders are not subject to cancellation prior to the date of shipment, cancellations have and may continue to occur. In the current economic environment, our retail customers are being cautious when placing orders and have shifted towards shorter lead times and at-once inventory purchases. For a variety of reasons, including the timing of release dates for our product offerings, shipments, order deadlines and receipt of orders, backlog may not be a reliable measure of future sales and may not be comparable from one period to another.
 
Vulnerability Due to Customer Concentration
 
Oxylane Group, a French sporting goods retail chain operating under the name Decathlon, accounted for 11.7% and 11.9% of our consolidated net sales for the 2011 and 2010, respectively. In 2010, Privee AG Corporation (“Privee AG”) accounted for 17.7% of our consolidated net sales. Privee AG was the Company's independent distributor in Japan and we did not renew our distributor agreement with them, so that distributor agreement terminated on February 28, 2011. In February 2011, we formed Heeling Sports Japan, K.K., a Japanese corporation and indirect wholly-owned subsidiary, to manage our operations in Japan and to take over the distribution of our products in that country effective March 1, 2011. No other retail customer or independent distributor accounted for 10% or more of our net sales in either of these periods.
 
 
33


We took over the distribution of our products in Germany and Austria (German market) effective April 1, 2008 and in France, Monaco and Andorra (French market) effective May 1, 2008. In 2011, our German and French markets accounted for 6.8% and 17.0% of our consolidated net sales, respectively. In 2010, our German and French markets accounted for 12.4% and 21.4% of our consolidated net sales, respectively.
 
During the fourth quarter of 2009, we began to sell directly to retailers in Italy through our Belgian subsidiary. Our Italian market accounted for 19.6% and 8.4% of our consolidated net sales in 2011 and 2010, respectively. No other country, other than the United States, accounted for 10% or more of our consolidated net sales in either of these periods.

We anticipate that our net sales may remain concentrated for the foreseeable future. If any of our significant retail customers or independent distributors decreases its purchases of our products or stops purchasing our products our net sales and results of operations could be adversely affected.
 
Off-Balance Sheet Arrangements
 
We do not have any off-balance sheet arrangements.
 
Critical Accounting Policies
 
Our management's discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosures at the date of our financial statements. We continually evaluate our estimates and judgments, including those related to net sales, collectability of accounts receivable, inventory reserve allowances, long-lived assets, income taxes and stock-based compensation. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis of our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results or changes in the estimates or other judgments of matters inherently uncertain that are included within these accounting policies could result in a significant change to the information presented in the accompanying consolidated financial statements. We believe the following discussion addresses the critical accounting policies that are necessary to understand and evaluate our reported consolidated financial results.
 
Revenue Recognition.     Revenues are recognized when merchandise is shipped and the customer takes title and assumes risk of loss, collection of related receivables is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Title passes upon shipment or upon receipt by the customer depending on the agreement with the customer. Revenues are stated net of discounts, marketing discretionary funds, estimated returns and other allowances, including permitted returns of damaged or defective merchandise. We base our estimates and judgments on historical experience and various other factors, including customer communications and analysis of relevant market information.
 
Accounts Receivable.     We continually make estimates relating to the collectability of our accounts receivable, as well as estimates for customer returns, defective merchandise and allowances for co-op advertising and marketing discretionary funds. In determining these allowances, we consider our historical experience, level of credit losses and make judgments about the creditworthiness of significant customers. Because we cannot predict future changes in the financial stability of our customers, actual future losses from uncollectible accounts may differ from our estimates. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, a larger reserve might be required. If we determine that smaller or larger allowances are appropriate, these changes in estimates are recorded in the period in which such determination is made.
 
Inventories.     Our inventories are stated at the lower of cost or market. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the forecast of future demand and market conditions. If we estimate the net realizable value of our inventory is less than the cost of the inventory, we record a write-down equal to the difference between the cost of the inventory and the estimated net realizable value. This write-down is recorded as cost of sales. If changes in market conditions result in reductions in the estimated net realizable value of our inventory below our previous estimate, we would increase our write-down in the period in which we made such a determination.
 
Goodwill.     Goodwill is not amortized but is instead measured for impairment at least annually, or when events indicate that an impairment might exist. We compare the estimated fair value of goodwill to its carrying value. Our estimates of fair value utilized in impairment testing are based upon a number of factors, including assumptions about the expected future operating performance of our reporting units. Estimates may change in future periods due to, among other things, the expected future operating performance of our reporting units, technological changes, economic conditions, changes to our business operations or inability to meet business plans. Such changes may result in impairment charges recorded in future periods. Any resulting impairment charge would be classified as a separate line item on the consolidated statement of operations for amounts necessary to reduce the carrying value of the asset to fair value. The Company performs its annual impairment test during the fourth quarter.
 
 
34

 
Stock-Based Compensation.     We account for stock-based awards in accordance Financial Accounting Standards Board Accounting Standards Codification 718, "Compensation-Stock Compensation," ("ASC 718"). Under ASC 718 stock-based compensation expense is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the requisite service period. We estimate the fair value of stock option awards using a Black-Scholes option pricing model that includes the following variables: 1) exercise price of the instrument, 2) fair market value of the underlying stock on date of grant, 3) expected life, 4) estimated volatility and 5) the risk-free interest rate. We recognize compensation expense attributable to stock option awards using the straight-line method over the period during which the employee is required to provide service in exchange for the award. No compensation expense is recognized for stock option awards for which the employee does not render the required service. If the requisite service is not provided, previously recognized compensation expense is reversed. In 2010 and 2011, we granted restricted stock units which are designated as performance awards. We determine the fair value of restricted stock unit awards based on the closing trade price of the Company’s common stock on the date of grant. We recognize compensation expense attributable to restricted stock unit awards using the straight-line method over the performance period. The amount of compensation expense recognized is based upon the estimated number of restricted stock units expected to be earned. We reassess this estimate at each reporting period and adjust the total amount of compensation expense to be recognized accordingly.
  
Income Taxes.     Tax laws require items to be included in our tax returns at different times than when these items are reflected in the consolidated financial statements. Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These timing differences create deferred tax assets and liabilities. We assess the realizability of our deferred tax assets to determine whether a valuation allowance is required. Based on all available evidence, both positive and negative, and the weight of that evidence to the extent such evidence can be objectively verified, if we determine it is more likely than not the deferred tax asset will not be realized, a valuation allowance is established. We follow guidance provided by Financial Accounting Standards Board Accounting Standards Codification 740, "Income Taxes," ("ASC 740"). ASC 740 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the Company has taken or expects to take on a tax return. The impact of an uncertain tax position that is more likely than not of being sustained upon examination by the relevant taxing authority is recognized at the largest amount that is more likely than not to be sustained. An uncertain tax position is not recognized if the position has less than a 50% likelihood of being sustained. Also, under ASC 740, interest expense is recognized on the full amount of deferred benefits for uncertain tax positions. We adjust our reserves for uncertain tax positions in light of changing facts and circumstances; however, due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the tax liabilities. If our estimate of tax liabilities proves to be less than the ultimate assessment, an additional charge would result. If payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. We recognize interest accrued related to recognized uncertain tax positions in interest expense and related penalties in general and administrative expense. Accrued interest and penalties are included within the related tax liability line in the consolidated balance sheet.
 
Recent Accounting Pronouncements
 
See Note 3 in the Notes to Consolidated Financial Statements for information regarding recently issued accounting pronouncements.
   
We are a Smaller Reporting Company as defined in Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide information under this Item.
 
 
Information with respect to this Item is set forth beginning on page F-1.
 
   
None.
 
 
35

 
 
Evaluation of Disclosure Controls and Procedures
 
The term "disclosure controls and procedures" refers to the controls and other procedures of a company that are designed to provide reasonable assurance that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within required time periods. We have established disclosure controls and procedures to ensure that material information relating to Heelys, Inc. and its consolidated subsidiaries is made known to the officers who certify our financial reports, as well as other members of our senior management and Board of Directors, to allow timely decisions regarding required disclosures. As of the end of the period covered by this Annual Report on Form 10-K, we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within required time periods, and that it is made known to our officers who certify our financial reports, as well as other members of our senior management and Board of Directors, to allow timely decisions regarding required disclosures.
  
Inherent Limitations on Effectiveness of Controls
 
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors or fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
 
Changes in Internal Control over Financial Reporting
 
There were no changes to our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting during the fourth quarter of 2011. We have completed our efforts regarding compliance with Section 404 of the Sarbanes-Oxley Act of 2002 for the year ended December 31, 2011. The results of our evaluation are discussed below in Management's Report on Internal Control Over Financial Reporting.
 
Management's Report on Internal Control over Financial Reporting
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Exchange Act. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.
 
We conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Framework”). Based on our evaluation under the COSO Framework, our management has concluded that as of December 31, 2011, our internal control over financial reporting is effective.
 
This Annual Report on Form 10-K does not include an attestation report of the Company's independent registered public accounting firm regarding internal control over financial reporting. The preceding management's report was not subject to attestation by our independent registered public accounting firm in accordance with recent amendments to Section 404 of the Sarbanes-Oxley Act of 2002 pursuant to Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act that permit us to provide only our management’s report in this Annual Report.
 
Item 9B.
  
None.
 
 
36

 
PART III
   
Incorporated by reference from the information in our proxy statement for the 2012 Annual Meeting of Stockholders, which we will file with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K relates.
 
Code of Business Conduct and Ethics
 
We have adopted a code of business conduct and ethics that applies to all of our officers, directors and employees. Our code of business conduct and ethics is posted on our website at www.heelys.com and we will send a paper copy to any stockholder who submits a request in writing to our Secretary. If we make any substantive amendments to this code of conduct or if we grant any waivers from a provision of such code of conduct to any director or executive officer, we will promptly disclose the nature of the amendment or waiver on our website at the address provided above.
 
Incorporated by reference from the information in our proxy statement for the 2012 Annual Meeting of Stockholders, which we will file with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K relates.
  
Incorporated by reference from the information in our proxy statement for the 2012 Annual Meeting of Stockholders, which we will file with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K relates.
    
Incorporated by reference from the information in our proxy statement for the 2012 Annual Meeting of Stockholders, which we will file with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K relates.
 
Incorporated by reference from the information in our proxy statement for the 2012 Annual Meeting of Stockholders, which we will file with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K relates.
 
PART IV
 
(a)(1) 
Financial Statements
 
The following documents are filed as a part of this report:
 
Report of Independent Registered Public Accounting Firm
 
Consolidated Balance Sheets as of December 31, 2011 and December 31, 2010
 
Consolidated Statements of Operations for the Years ended December 31, 2011 and 2010
 
Consolidated Statements of Stockholders' Equity and Comprehensive Loss for the Years ended December 31, 2010 and 2011
 
Consolidated Statements of Cash Flows for the Years ended December 31, 2011 and 2010
 
Notes to Consolidated Financial Statements
 
(2)
Financial Statement Schedules
 
Financial statement schedules have been omitted because they either are not applicable or the required information is included in the consolidated financial statements or notes thereto.

(3)
Exhibits
 
(a) The following exhibits are incorporated by reference or filed herewith. References to the Form S-1 are to the Registrant's Registration Statement on Form S-1 (File No. 333-137046), filed with the Securities and Exchange Commission (SEC) on September 1, 2006. References to Amendment No. 1 to Form S-1 are to Amendment No. 1 to the Form S-1 filed with the SEC on October 4, 2006. References to Amendment No. 2 to Form S-1 are to Amendment No. 2 to the Form S-1 filed with the SEC on October 27, 2006. References to Amendment No. 3 to Form S-1 are to Amendment No. 3 to the Form S-1 filed with the SEC on November 24, 2006.

 
37


Exhibit No.
 
Description
3.1
 
Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Form S-1).
     
3.2
 
Amended and Restated By-Laws of the Registrant (incorporated by reference to Exhibit 3.1 of Registrant's Current Report on Form 8-K filed November 13, 2009).
     
4.1
 
Form of Registrant's Common Stock certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to the Form S-1).
     
10.1
 
Registration Rights Agreement, dated May 26, 2000, among the Registrant, Samuel B. Ligon and Patricia P. Ligon and Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.1 to the Form S-1).
     
10.2
 
Lease Agreement, dated November 4, 2004, between CP Commercial Properties—XIX, Inc. and Heeling Sports, Limited, as amended by the First Amendment to Lease Agreement, dated February 27, 2006, for 3200 Belmeade, Suite 100, Carrollton, Texas (incorporated by reference to Exhibit 10.5 to the Form S-1).
     
10.3
 
Letter Agreement, dated June 28, 2006, by and between Richard E. Middlekauff and Roger R. Adams, and approved by the Registrant (incorporated by reference to Exhibit 10.9 to the Form S-1).
     
10.4
 
Waiver and Agreement, dated as of September 14, 2006, among the Registrant, Roger R. Adams, Richard E. Middlekauff, Robert J. Ward, CYPO, Inc., Heeling Holding Corporation, Heeling Management Corporation, Samuel B. Ligon and Patricia P. Ligon and Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.15 to Amendment No. 3 to the Form S-1).
     
10.5
 
2006 Stock Incentive Plan, as amended by Amendment to Heeling, Inc. 2006 Stock Incentive Plan and form of Stock Option Agreement thereunder (incorporated by reference to Exhibit 10.16 to the Form S-1).*
     
10.6
 
Form of Indemnification Agreement entered into by the Registrant with each of its directors and executive officers (incorporated by reference to Exhibit 10.18 to the Form S-1).*
     
10.7
 
Investor Rights Agreement, dated as of May 24, 2000, among the Registrant, Roger R. Adams, Richard E. Middlekauff, Robert J. Ward, Cypo, Inc., Heeling Holding Corporation, Heeling Management Corp., Samuel P. Ligon and Patricia P. Ligon and Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.20 to Amendment No. 2 to the Form S-1).
     
10.8
 
Severance and General Release Agreement dated as of February 1, 2008, between Michael G. Staffaroni and Heeling Sports Limited (incorporated by reference to Exhibit 10.4 to Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2010 filed on August 13, 2010).*
     
10.9
 
Settlement Agreement and Technology License Agreement dated as of March 11, 2008, between Heeling Sports Limited and Elan-Polo, Inc. (incorporated by reference to Exhibit 10.2 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)
 
 
38

 
10.10
 
Termination Agreement dated as of March 13, 2008, between Heeling Sports Limited and The Territory Distribution GmbH (the "Distributor") and Achim Lippoth, a German individual and the sole owner of the Distributor. (incorporated by reference to Exhibit 10.3 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)
     
10.11
 
Consulting Agreement dated as of March 31, 2008, between Heeling Sports EMEA and The Sansean Group Limited. (incorporated by reference to Exhibit 10.4 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)
     
10.12
 
Consulting Agreement dated as of March 31, 2008, between Heeling Sports EMEA and Achim Lippoth, a German individual. (incorporated by reference to Exhibit 10.5 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)
     
10.13
 
Termination Agreement dated as of April 30, 2008, between Heeling Sports Limited and Trotwood Import/Export (the "Distributor"), Trotwood Investments Ltd., the sole owner of the Distributor (the "Shareholder") and David Stanley and Margarete Stanley, the sole owners of the Shareholder. (incorporated by reference to Exhibit 10.6 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)
     
10.14
 
Consulting Agreement dated as of April 30, 2008, between Heeling Sports EMEA and Trotwood Investments Ltd. represented by Margarete Stanley. (incorporated by reference to Exhibit 10.7 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)
     
10.15
 
Consulting Agreement dated as of April 30, 2008, between Heelys, Inc. and Patrick F. Hamner (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on May 2, 2008).*
     
10.16
 
Employment Agreement dated as of July 17, 2008, between Heelys, Inc. and Donald K. Carroll (incorporated by reference to Exhibit 10.5 to Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2010 filed on August 13, 2010).*
     
10.17
 
Executive Employment Agreement, dated as of August 29, 2008, between Heeling Sports Limited and Lisa K. Peterson (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K/A filed on September 4, 2008).*
     
10.18
 
Executive Employment Agreement, dated as of August 29, 2008, between Heeling Sports Limited and John Benton Price (incorporated by reference to Exhibit 10.2 of Registrant's Current Report on Form 8-K/A filed on September 4, 2008).*
     
10.19
 
Executive Employment Agreement, dated as of October 28, 2008, between Heeling Sports Limited and William D. Albers (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on October 31, 2008).*
     
10.20
 
Executive Employment Agreement, dated as of October 28, 2008, between Heeling Sports Limited and John W. O'Neil (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on October 31, 2008).*
 
 
39

 
10.21
 
Severance and General Release Agreement dated as of February 10, 2009, between Donald K. Carroll and Heeling Sports Limited (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on February 10, 2009).*
     
10.22
 
Letter of Agreement dated as of February 9, 2009, between Michael W. Hessong and Heelys, Inc. (incorporated by reference to Exhibit 10.2 of Registrant's Current Report on Form 8-K filed on February 10, 2009).*
     
10.23
 
Executive Employment Agreement, dated as of July 17, 2009, by and between Heeling Sports Limited and Thomas C. Hansen (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on July 20, 2009).*
     
10.24
 
Compromise and Settlement Agreement, effective as of August 21, 2009 (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on September 1, 2009).
     
10.25
 
First Amendment to Executive Employment Agreement dated February 18, 2010 (to be effective as of March 1, 2010) by and between John W. O’Neil and Heeling Sports Limited (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on February 18, 2010).*
     
10.26
 
Heelys, Inc. 2006 Stock Incentive Plan, as amended and restated effective as of May 20, 2010 (incorporated by reference to Appendix A of the Company’s Definitive Schedule 14A, as filed with the Commission on April 23, 2010).*
     
10.27
 
Sourcing Agreement dated April 21, 2010, to be effective May 1, 2010, between Heeling Sports Limited and TGB, LLC (incorporated by reference to Exhibit 10.1 of Registrant’s Current Report on Form 8-K filed on April 26, 2010).
     
10.28
 
Letter from Heelys, Inc. to Craig D. Storey regarding employment terms (incorporated by reference to Exhibit 10.3 to Registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2010 filed on August 13, 2010).*
     
10.29
 
Form of Stock Option Agreement to be entered into by the Company with stock option grantees under the Heelys, Inc. 2006 Stock Incentive Plan (incorporated by reference to Exhibit 10.2 of Registrant's Current Report on Form 8-K filed on August 27, 2010).*
     
10.30
 
Form of Restricted Stock Unit Award Agreement under the Heelys, Inc. 2006 Stock Incentive Plan (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on November 12, 2010).*
     
10.31
 
Summary of terms of 2010 Management Incentive Plan (which plan is not set forth is any formal plan document) (incorporated by reference to Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2010 filed on November 12, 2010).*
     
10.32
 
Termination Agreement, dated as of February 22, 2011, and effective as of February 28, 2011, by and between Heeling Sports Limited and Privee AG Corporation (incorporated by reference to Exhibit 99.1 to Registrants Current Report on Form 8-K filed on February 24, 2011).
     
10.33
 
Summary of terms of Heelys, Inc. 2011 Management Incentive Plan (which plan is not set forth is any formal plan document; incorporated by reference to Exhibit 10.33 to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 filed on March 10, 2011 ).*
     
10.34
 
Heelys, Inc. 2012 Management Incentive Plan (incorporated by reference to Exhibit 10.1 to Registrant's Current Report on Form 8-K filed on March 20, 2012).*
 
 
40

 
10.35
 
Form of Award Agreement under Heelys, Inc. 2012 Management Incentive Plan (incorporated by reference to Exhibit 10.2 to Registrant's Current Report on Form 8-K filed on March 20, 2012).*
     
10.36
 
Heelys, Inc. 2012 Long-Term Management Incentive Plan (incorporated by reference to Exhibit 10.3 to Registrant's Current Report on Form 8-K filed on March 20, 2012).*
     
10.37
 
Form of Award Agreement under Heelys, Inc. 2012 Long-Term Management Incentive Plan (incorporated by reference to Exhibit 10.4 to Registrant's Current Report on Form 8-K filed on March 20, 2012).*
     
10.38
 
Executive Restrictive Covenant and Retention Agreement dated March 16, 2012 by and between Craig D. Story and Heeling Sports Limited (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on March 20, 2012).*
     
 
List of subsidiaries of the Registrant.†
     
 
Consent of Grant Thornton LLP, independent registered public accounting firm.†
     
 
Certification pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 by Thomas C. Hansen, Chief Executive Officer.†
     
 
Certification pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 by Craig D. Storey, Chief Financial Officer.†
     
 
Certification by Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.†
     
101.INS
  Instance Document
     
101.SCH
  XBRL Taxonomy Extension Schema Document
     
101.CAL
  XBRL Taxonomy Extension Calculation Linkbase Document
     
101.DEF
  XBRL Taxonomy Extension Definition Linkbase Document
     
101.LAB
  XBRL Taxonomy Extension Label Linkbase Document
     
101.PRE
  XBRL Taxonomy Extension Presentation Linkbase Document
     
*
 
Management contract or a compensatory plan or arrangement required to be filed as an Exhibit pursuant to Item 15(b) of Form 10-K.
     
 
Filed herewith.
 
 
41

 
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
HEELYS, INC.
   
 
By:
/s/ THOMAS C. HANSEN
     
   
Thomas C. Hansen
Chief Executive Officer
     
Date: March 21, 2012
   
 
 
42

 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Signature
 
Title
 
Date
         
/s/ THOMAS C. HANSEN
 
Chief Executive Officer and Director
 
March 21, 2012
Thomas C. Hansen
 
(Principal Executive Officer)
   
         
/s/ CRAIG D. STOREY
 
Chief Financial Officer
 
March 21, 2012
Craig D. Storey
 
(Principal Financial Officer and Principal Accounting Officer)
   
         
/s/ GARY L. MARTIN
 
Chairman of the Board
 
March 21, 2012
Gary L. Martin
       
         
/s/ JERRY R. EDWARDS
 
Director
 
March 21, 2012
Jerry R. Edwards
       
         
/s/ PATRICK F. HAMNER
 
Director
 
March 21, 2012
Patrick F. Hamner
       
         
/s/ N. RODERICK MCGEACHY, III
 
Director
 
March 21, 2012
N. Roderick McGeachy, III
       
         
/s/ GLENN M. NEBLETT
 
Director
 
March 21, 2012
Glenn M. Neblett
       
         
/s/ RALPH T. PARKS 
 
Director
 
March 21, 2012
Ralph T. Parks
       
         
/s/ RICHARD F. STRUP
 
Director
 
March 21, 2012
Richard F. Strup
       
 
 
43

 
HEELYS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

   
Page
Report of Independent Registered Public Accounting Firm
 
F-2
     
Consolidated Balance Sheets as of December 31, 2011 and 2010
 
F-3
     
Consolidated Statements of Operations for the Years Ended December 31, 2011 and 2010
 
F-4
     
Consolidated Statements of Stockholders' Equity and Comprehensive Loss for the Years Ended December 31, 2010 and 2011
 
F-5
     
Consolidated Statements of Cash Flows for the Years Ended December 31, 2011 and 2010
 
F-6
     
Notes to Consolidated Financial Statements
 
F-7 - F-24
 
 
F-1

 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
Board of Directors and Shareholders
Heelys, Inc.
 
We have audited the accompanying consolidated balance sheets of Heelys, Inc. and subsidiaries (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders' equity and comprehensive loss and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heelys, Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
 
/s/ Grant Thornton LLP
 
Dallas, Texas
March 21, 2012
 
 
F-2

 
HEELYS, INC.
 CONSOLIDATED BALANCE SHEETS
(in thousands, except share and par value data)
 
   
December 31,
   
December 31,
 
   
2011
   
2010
 
ASSETS
           
CURRENT ASSETS:
           
Cash and cash equivalents
  $ 17,925     $ 35,320  
Investments
    40,469       32,299  
Accounts receivable, net of allowances of $391 and $237, respectively
    7,077       3,135  
Inventories
    8,836       6,810  
Prepaid expenses and other current assets
    1,193       689  
Income taxes receivable
    133       -  
Deferred income taxes
    14       8  
                 
Total current assets
    75,647       78,261  
                 
PROPERTY AND EQUIPMENT, net of accumulated depreciation of $1,933 and  $1,906, respectively
    570       798  
PATENTS AND TRADEMARKS, net of accumulated amortization of $1,456 and $1,355, respectively
    320       372  
INTANGIBLE ASSETS, net of accumulated amortization of $1,091 and $891, respectively
    380       689  
GOODWILL
    1,532       1,568  
DEFERRED INCOME TAXES
    364       126  
                 
TOTAL ASSETS
  $ 78,813     $ 81,814  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
CURRENT LIABILITIES:
               
Accounts payable
  $ 2,277     $ 1,089  
Accrued liabilities
    2,974       1,661  
Income taxes payable
    -       506  
Deferred income taxes
    104       18  
                 
Total current liabilities
    5,355       3,274  
                 
LONG TERM LIABILITIES:
               
Income taxes payable
    660       547  
Deferred income taxes
    40       2  
Other long term liabilities
    247       219  
                 
TOTAL LIABILITIES
    6,302       4,042  
                 
COMMITMENTS AND CONTINGENCIES (Note 11)
               
                 
STOCKHOLDERS' EQUITY:
               
Common stock, $0.001 par value, 75,000,000 shares authorized; 27,571,052 shares issued and outstanding as of December 31, 2011 and 2010
    28       28  
Additional paid-in capital
    66,126       65,691  
Retained earnings
    6,941       12,541  
Accumulated other comprehensive loss
    (584 )     (488 )
                 
Total stockholders' equity
    72,511       77,772  
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 78,813     $ 81,814  
 
See notes to consolidated financial statements.
 
 
F-3

 
HEELYS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

   
Year Ended December 31,
 
             
   
2011
   
2010
 
             
NET SALES
  $ 32,017     $ 30,436  
COST OF SALES
    18,697       17,783  
                 
GROSS PROFIT
    13,320       12,653  
                 
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
               
Selling and marketing
    8,751       7,291  
General and administrative
    10,735       10,106  
                 
Total selling, general and administrative expenses
    19,486       17,397  
                 
LOSS FROM OPERATIONS
    (6,166 )     (4,744 )
                 
OTHER (INCOME) EXPENSE
               
Interest (income) expense, net
    (274 )     (355 )
Other (income) expense, net
    (525 )     (818 )
Exchange (gain) loss, net
    (6 )     153  
                 
Total other (income) expense, net
    (805 )     (1,020 )
                 
LOSS BEFORE INCOME TAXES
    (5,361 )     (3,724 )
INCOME TAX EXPENSE
    239       267  
                 
NET LOSS
  $ (5,600 )   $ (3,991 )
                 
LOSS PER SHARE:
               
Basic and diluted
  $ (0.20 )   $ (0.14 )
WEIGHTED AVERAGE SHARES OUTSTANDING:
               
Basic and diluted
    27,571       27,571  
 
See notes to consolidated financial statements.
 
 
F-4

 
HEELYS, INC.
 CONSOLIDATED STATEMENTS OF
STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS
FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2011
(in thousands)

   
Common Stock
   
Additional
Paid-In
    Retained    
Accumulated
Other
Comprehensive
   
Total
Stockholders'
 
   
Shares
   
Amount
   
Capital
   
 Earnings
   
 Loss
   
 Equity
 
                                     
BALANCE—January 1, 2010
    27,571     $ 28     $ 65,305     $ 16,532     $ (125 )   $ 81,740  
Comprehensive loss:
                                               
Net loss
                            (3,991 )             (3,991 )
Foreign currency translation adjustment
                                    (363 )     (363 )
Total comprehensive loss
                                            (4,354 )
Stock-based compensation expense
                    386                       386  
BALANCE—December 31, 2010
    27,571       28       65,691       12,541       (488 )     77,772  
                                                 
Comprehensive loss:
                                               
Net loss
                            (5,600 )             (5,600 )
Foreign currency translation adjustment
                                    (96 )     (96 )
Total comprehensive loss
                                            (5,696 )
Stock-based compensation expense
                    435                       435  
BALANCE—December 31, 2011
    27,571     $ 28     $ 66,126     $ 6,941     $ (584 )   $ 72,511  
 
See notes to consolidated financial statements.
 
 
F-5

 
HEELYS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

   
Year Ended December 31,
 
   
2011
   
2010
 
OPERATING ACTIVITIES:
           
Net Loss
  $ (5,600 )   $ (3,991 )
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
               
Depreciation and amortization
    759       770  
Accretion (amortization) of premium (discount) on investments, net
    650       485  
Accrued interest income
    (207 )     (167 )
Deferred income taxes
    (130 )     2,992  
Stock-based compensation
    435       386  
Unrealized exchange (gain) loss, net
    (12 )     48  
Loss on disposal of property and equipment
    27       29  
Inventory impairment charges and reserves
    1,246       352  
Changes in operating assets and liabilities:
               
Accounts receivable
    (4,040 )     2,344  
Inventories
    (3,337 )     (1,298 )
Prepaid expenses and other current assets
    (279 )     210  
Accounts payable
    1,275       (452 )
Accrued liabilities
    1,514       (641 )
Income taxes payable/receivable
    (552 )     1,644  
Net cash (used in) provided by operating activities
    (8,251 )     2,711  
                 
INVESTING ACTIVITIES:
               
Purchases of investments
    (57,691 )     (44,362 )
Proceeds from maturities of investments
    48,872       38,700  
Purchases of equipment
    (125 )     (306 )
Increase in patents and trademarks
    (89 )     (162 )
Net cash used in investing activities
    (9,033 )     (6,130 )
                 
FINANCING ACTIVITIES:
               
Payment for previously acquired goodwill and intangible assets
    (143 )     (575 )
Net cash used in financing activities
    (143 )     (575 )
                 
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
    32       (56 )
NET DECREASE IN CASH AND CASH EQUIVALENTS
    (17,395 )     (4,050 )
CASH AND CASH EQUIVALENTS, beginning of year
    35,320       39,370  
CASH AND CASH EQUIVALENTS, end of year
  $ 17,925     $ 35,320  
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
               
Cash paid during the period for:
               
Income taxes
  $ 957     $ 1,269  
Interest
  $ -     $ 242  
 
See notes to consolidated financial statements.
 
 
F-6

 
HEELYS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. BUSINESS DESCRIPTION AND BASIS OF PRESENTATION
 
Business Description —Heelys, Inc. and subsidiaries (the "Company" or "Heelys") designs, markets and distributes innovative, action sports-inspired products primarily under the HEELYS brand targeted to the youth market. The primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS are distributed directly to retail stores in the United States and certain international countries, and through international wholesale distributors.
 
The Company initially incorporated as Heeling, Inc. in Nevada in 2000. The Company was reincorporated in Delaware in August 2006 and changed its name to Heelys, Inc. Through its general and limited partner interests, Heelys, Inc. owns 100% of Heeling Sports Limited, a Texas limited partnership, which was formed in May 2000.
 
In February 2008, the Company formed Heeling Sports EMEA SPRL, a Belgium corporation and indirect wholly-owned subsidiary of the Company, with offices in Brussels, and branch offices in Germany and France, primarily to manage the Company's European operations. As part of an initiative to improve efficiency and reduce costs, the Company began taking steps in the first quarter of 2012 to close its office in Brussels and transition the business operations conducted through that office to its French and German offices.

In February 2011, the Company formed Heeling Sports Japan K.K., a Japanese corporation and indirect wholly-owned subsidiary of the Company with offices in Tokyo, to manage its operations in Japan and to take over distribution in that country effective March 1, 2011.

Consolidated Financial Statements —The consolidated financial statements include the accounts of Heelys, Inc. and its subsidiaries. All intercompany balances and transactions are eliminated in consolidation.
 
Use of Estimates —The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses for the period. Management's significant estimates are as follows: allowances for estimated customer returns, marketing discretionary funds and doubtful accounts; assessment of lower of cost or market on inventory; income taxes including deferred taxes and uncertain tax positions; and legal reserves for current pending claims (if any) and estimated incurred-but-not-reported claims. Actual results could differ from these estimates and the differences could be material. Differences are reported in the period in which they become known.

Foreign Currency Translation —The U.S. dollar is the Company's reporting currency. Assets and liabilities of foreign operations which are denominated in a functional currency other than the U.S. dollar are translated at the rate of exchange at the balance sheet date. Revenues and expenses are translated at the average rate of exchange during the applicable period. Adjustments resulting from translating foreign functional currency financial statements into U.S. dollars are included in the foreign currency translation adjustment, a component of accumulated other comprehensive loss in stockholders' equity.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Fair Value Measurements —The Company uses a hierarchy that prioritizes fair value measurements based on the types of inputs used for the various valuation techniques (market approach, income approach, and cost approach).
 
The levels of hierarchy are described below:
 
 
Level 1: Observable inputs such as quoted prices in active markets for identical assets or liabilities.
 
 
Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly; these include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.
 
 
Level 3: Unobservable inputs in which there is little or no market data available, which require the reporting entity to develop its own assumptions.
 
 
F-7

 
The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability. Financial assets and liabilities are classified in their entirety based on the most stringent level of input that is significant to the fair value measurement.
  
Refer to Note 6 for discussion regarding fair value of investments. All other financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value due to their liquid and short-term nature.
 
Accounts Receivable —Accounts receivable are stated net of estimated allowances for uncollectible accounts, customer returns, defective merchandise, co-op advertising and marketing discretionary funds. Accounts are not collateralized and do not bear interest. In determining the amount of the allowances for accounts receivable, the Company considers, among other things, historical experience. If the Company determines a smaller or larger allowance was appropriate, these changes in estimates are recorded in the period in which such determination is made. After all collection efforts are exhausted and an account is deemed uncollectible, it is written off against the allowance for doubtful accounts.
 
Inventories —Inventories are purchased as finished goods from independent manufacturers and are stated at the lower of cost or market. Inventories are valued on a first-in first-out ("FIFO") basis. Inventory costs include inbound freight. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the forecast of future demand and market conditions. Ongoing estimates are made relating to the net realizable value of inventories. If the estimated net realizable value of inventory is less than the cost, a write-down equal to the difference between the cost of the inventory and the estimated net realizable value is recorded. If changes in market conditions result in reductions in the estimated net realizable value of inventory below previous estimates, an increase in the write-down is recorded in the period in which such a determination was made. During 2011 and 2010, the Company charged cost of sales $1.2 million and $352,000, respectively, in order to properly state inventories at lower of cost or market. Inventories at December 31, 2011 and 2010 include $579,000 and $398,000, respectively, of packaging and other raw materials directly attributable to the Company’s Nano™ inline footboard. 

Goodwill and Intangible Assets —Goodwill is not amortized but is instead measured for impairment at least annually, or when events indicate that impairment might exist. The Company compares the estimated fair value of the reporting unit to the carrying value. The Company's estimate of fair value utilized in goodwill tests is based upon a number of factors, including assumptions about the expected future operating performance of the Company’s reporting units. Estimates may change in future periods due to, among other things, the expected future operating performance of the Company's reporting units, technological changes, economic conditions, changes to the Company's business operations or inability to meet business plans. Such changes may result in impairment charges recorded in future periods. Any impairment charge related to goodwill would be classified as a separate line item on the consolidated statement of operations for amounts necessary to reduce the carrying value of the asset to fair value. The Company performs its annual impairment test during the fourth quarter.  Intangible assets that are determined to have definite lives are amortized over their useful lives and are measured for impairment only when events or circumstances indicate the carrying value may be impaired. In these cases, the Company estimates the future undiscounted cash flows to be derived from the asset to determine whether or not a potential impairment exists. If the carrying value exceeds the Company's estimate of future undiscounted cash flows, the Company then calculates the impairment as the excess of the carrying value of the asset over the estimate of its fair value. There were no impairments identified in either of the periods presented.
 
Long-Lived Assets —The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets held and used is generally measured by a comparison of the carrying amount of an asset to undiscounted pretax future net cash flows expected to be generated by that asset. An impairment loss is recognized if the estimated undiscounted future cash flows are less than the carrying value of the related assets. There were no impairments identified in either of the periods presented.
  
Income Taxes —The Company accounts for income taxes using the asset and liability method. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of other assets and liabilities. The Company evaluates its ability to realize the tax benefits associated with deferred tax assets and a valuation allowance is established unless management determines that it is more likely than not that the Company will ultimately realize the tax benefit associated with a deferred tax asset. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by a taxing authority, based on the technical merits of the position. The amount recognized in the financial statements from an uncertain tax position is measured based on the largest amount of benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. These liabilities (for uncertain tax positions) are included in income taxes payable in the consolidated balance sheet. Related accrued interest is included in interest expense and related penalties are included in general and administrative expense. Accrued interest and penalties are included within the related income tax liability line in the consolidated balance sheet.
 
 
F-8

 
Revenue Recognition —Revenues are recognized when merchandise is shipped, title passes to the customer, the customer assumes risk of loss, the collection of relevant receivables is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Title passes upon shipment or upon receipt by the customer depending on the agreement with the customer. The Company records reductions to revenue for customer discounts, marketing discretionary funds, estimated returns and other allowances, including permitted returns of damaged or defective merchandise. The Company recorded total reductions to revenue for these allowances of $105,000 and $585,000 during 2011 and 2010, respectively.
 
Shipping and Handling Costs —Shipping and handling costs that are not directly attributable to the procurement of inventory are expensed as incurred and are included in general and administrative expense. These costs include costs that the Company incurs to ship product to its customers, storage charges and rent expense for warehouse facilities, warehouse labor, warehouse and packing materials and deprecation of warehouse equipment. Shipping and handling costs included in general and administrative expense were $2.5 million and $2.0 million during 2011 and 2010, respectively. Shipping and handling costs billed to customers are included in net sales, and were $92,000 and $79,000 during 2011 and 2010, respectively. Shipping and handling costs that are directly attributable to the procurement of inventory are recognized in cost of sales when such inventory is sold.

 Advertising Costs —Advertising production costs are expensed the first time the advertisement is run. Media (TV, radio and print) placement costs are expensed in the month the advertising appears or is aired. Through cooperative advertising programs, the Company reimburses its retail customers for certain of their costs of advertising the Company's products. The Company records these costs in selling and marketing expense at the point in time when it is obligated to its customers for the costs, which is when the related revenues are recognized. This obligation may arise prior to the related advertisement being run. Total advertising and promotion expenses were $4.2 million and $4.0 million during 2011 and 2010, respectively. Prepaid advertising and promotion expenses recorded in prepaid expense totaled $30,000 and $107,000 at December 31, 2011 and 2010, respectively.
 
Stock-Based Compensation —Stock-based compensation expense is measured at the grant date based on the estimated fair value of the award, and is recognized as expense over the requisite service period. Fair value of stock option awards is estimated using a Black-Scholes option pricing model. Fair value of restricted stock unit awards is based on the closing trade price of the Company’s common stock on the date of grant. Stock-based compensation is recognized using the straight-line method over the period during which the employee is required to provide service in exchange for the award. No compensation expense is recognized for awards for which the employee does not render the required service. If the requisite service is not provided, previously recognized compensation expense is reversed. The total amount of compensation expense attributable to restricted stock unit awards (designated as performance awards) is based upon the estimated number of restricted stock units expected to be earned. This estimate is reassessed at each reporting period and the total amount of compensation expense to be recognized is adjusted accordingly.
 
Insurance —The Company's insurance retention for general liability claims is $50,000 per claim. An estimated liability is provided for current pending claims (if any) and estimated incurred-but-not-reported claims due to this retention risk. A liability is accrued by a charge to income if it is probable that a liability has been incurred at the date of the financial statements, and the amount of loss can be reasonably estimated. A liability for estimated claims in the amount of $150,000 and $160,000 as of December 31, 2011 and 2010, respectively, is reflected in the balance sheet as an accrued liability. Effective January 1, 2012, the Company’s insurance retention for general liability claims will be $25,000 per occurrence with a maximum out-of-pocket of $500,000 per year.
 
Foreign Currency Transactions —Gains and losses generated by transactions denominated in a currency different from the functional currency of the applicable entity are recorded in other income and expense in the period in which they occur. The Company recognized a $6,000 net gain on foreign currency transactions in 2011, compared to a net loss of $153,000 in 2010.

3. RECENT ACCOUNTING PRONOUNCEMENTS

In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, to make the presentation of items within other comprehensive income (“OCI”) more prominent. The new standard will require companies to present items of net income, items of OCI and total comprehensive income in one continuous statement or two separate consecutive statements, and companies will no longer be allowed to present items of OCI in the statement of stockholders’ equity. This new standard is effective for the Company beginning January 1, 2012, with early adoption permitted. The adoption of this new standard may change the order in which certain financial statements are presented and provide additional detail in those financial statements when applicable, but will not have any other impact on the Company’s financial statements.
 
In September 2011, FASB issued ASU 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment, which amends current guidance to simplify how entities test goodwill for impairment. The amendments permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350. Under this amendment, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. This pronouncement is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The Company does not expect the adoption of this new pronouncement to have a material effect on its consolidated financial statements.
 
 
F-9

 
4. LOSS PER SHARE

Basic loss per common share is calculated by dividing net loss available to common stockholders for the period by the weighted-average number of common shares outstanding during the period. Diluted loss per share reflects the effects of potentially dilutive securities that could share in the loss of the Company. A reconciliation of the numerator and denominator used in the calculation of basic and diluted loss per share is as follows (in thousands):
  
   
Year Ended December 31,
 
   
2011
   
2010
 
Numerator— net loss available to common stockholders
  $ (5,600 )   $ (3,991 )
Denominator:
               
Weighted average common stock outstanding for basic loss per share
    27,571       27,571  
Effect of dilutive securities:
               
Stock options
           
Restricted stock units
           
                 
Adjusted weighted average common stock and assumed conversions for diluted loss per share
    27,571       27,571  
 
Stock options to purchase approximately 1.5 million shares of common stock and restricted stock units convertible into approximately 779,000 shares of common stock were not included in the computation of diluted loss per share for the year ended December 31, 2011, because the effect of their inclusion would be anti-dilutive. Stock options to purchase approximately 1.6 million shares of common stock and restricted stock units convertible into approximately 190,000 shares of common stock were not included in the computation of diluted loss per share for the year ended December 31, 2010, because the effect of their inclusion would be anti-dilutive.

5. CASH EQUIVALENTS

Cash equivalents consist of highly liquid investments with original maturity dates of three months or less when purchased. Cash equivalents at December 31, 2011 and 2010 include investments in the Fidelity Money Market Fund in the amount of $4.9 million and $18.9 million, respectively. Investments in the Fidelity Money Market Fund are valued using observable inputs (Level 1 fair value hierarchy).
 
 
F-10


 6. INVESTMENTS
 
Investments consist of the following:

   
As of December 31, 2011
   
   
Amortized
Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses(1a)
   
Aggregate
Fair Value(2)
 
Maturities
   
(In thousands, except table notes)
   
Current held-to-maturity securities
                         
Certificate of deposit(3)
  $ 500     $ -     $ -     $ 500  
Feb-2012
Commercial paper
    11,472       -       (8 )     11,464  
 Jan-2012 thru Oct-2012
Corporate bonds
    9,436       -       (30 )     9,406  
Jun-2012 thru Sep-2012
Municipal bonds
    19,061       -