UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

or

¨ 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: 001-35240

SKULLCANDY, INC.

(Exact name of registrant as specified in its charter)

Delaware	56-2362196
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)
1441 West Ute Boulevard, Suite 250 Park City, Utah	84098
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (435) 940-1545

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  ¨

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  ¨

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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	x  (Do not check if a smaller reporting company)	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 5, 2012, 27,540,720 shares of registrant’s common stock were outstanding.

SKULLCANDY, INC.

INDEX TO FORM 10-Q

	Page
PART I. FINANCIAL INFORMATION
Item 1.    Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets (unaudited) as of September 30, 2012, September  30, 2011 and December 31, 2011		2
Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2012 and 2011		3
Condensed Consolidated Statements of Comprehensive Income (unaudited) for the three and nine months ended September 30, 2012 and 2011		4
Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended September  30, 2012 and 2011		5
Notes to Condensed Consolidated Financial Statements (unaudited)		6
Item 2.    Management’s  Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3.    Quantitative and Qualitative Disclosures about Market Risk		27
Item 4.    Controls and Procedures		28
PART II. OTHER INFORMATION
Item 1.    Legal Proceedings		29
Item 1A. Risk Factors		30
Item 6.    Exhibits		31
Signatures		32

i

PART I

Item 1. Condensed Consolidated Financial Statements

SKULLCANDY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands of dollars)

(unaudited)

	As of September 30, 2012			As of September 30, 2011			As of December 31, 2011
Assets
Current assets:
Cash and cash equivalents	$	1,898		$	14,922		$	23,302
Accounts receivable, net		60,022			34,616			50,616
Inventories		55,387			51,223			43,975
Prepaid expenses and other current assets		6,126			5,684			8,499
Deferred taxes		3,164			2,716			3,978
Total current assets		126,597			109,161			130,370
Property and equipment, net		14,637			6,885			10,294
Intangibles		12,854			13,940			13,678
Goodwill		13,867			13,492			13,867
Deferred financing fees		221			462			402
Total assets	$	168,176		$	143,940		$	168,611
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	14,211		$	23,849		$	23,206
Accrued liabilities		18,774			11,713			25,100
Bank line of credit		5,176			14,174			9,884
Total current liabilities		38,161			49,736			58,190
Deferred taxes		1,128			2,107			3,609
Stockholders’ equity:
Common stock		3			3			3
Treasury stock		(43,294	)		(43,294	)		(43,294	)
Additional paid-in capital		126,454			117,392			119,042
Accumulated other comprehensive income		398			(15	)		118
Retained earnings		44,755			18,018			30,339
Total Skullcandy stockholders’ equity		128,316			92,104			106,208
Noncontrolling interests		571			(7	)		604
Total stockholders’ equity		128,887			92,097			106,812
Total liabilities and stockholders’ equity	$	168,176		$	143,940		$	168,611

See Accompanying Notes to Condensed Consolidated Financial Statements

2

SKULLCANDY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands of dollars, except share and per share information)

(unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Net sales	$	71,000	$	60,641	$	196,716	$	149,056
Cost of goods sold		36,886		31,843		100,951		75,144
Gross profit		34,114		28,798		95,765		73,912
Selling, general and administrative expenses		23,494		20,571		71,944		52,195
Income from operations		10,620		8,227		23,821		21,717
Other expense		219		1,734		592		1,716
Interest expense		184		334		455		1,005
Interest expense—related party		—		2,767		—		6,384
Income before income taxes and noncontrolling interests		10,217		3,392		22,774		12,612
Income taxes		3,782		2,440		8,391		6,323
Net income		6,435		952		14,383		6,289
Net loss attributable to noncontrolling interests		57		7		33		7
Preferred dividends		—		—		—		(17	)
Net income attributable to Skullcandy, Inc.	$	6,492	$	959	$	14,416	$	6,279
Net income per common share attributable to Skullcandy, Inc.
Basic	$	0.24	$	0.04	$	0.53	$	0.36
Diluted		0.23		0.04		0.51		0.28
Weighted average common shares outstanding
Basic		27,461,021		24,427,591		27,361,173		17,664,628
Diluted		28,130,470		26,262,943		28,031,085		22,043,053

See Accompanying Notes to Condensed Consolidated Financial Statements

3

SKULLCANDY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands of dollars)

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012		2011
Net income	$	6,435		$	952		$	14,383	$	6,289
Unrealized gain (loss) on foreign currency cash flow hedges, net of tax of $72 and $36 for the three and nine months ended September 30, 2012, respectively		(173	)		—			147		—
Foreign currency translation adjustment		70			(15	)		133		(15	)
Comprehensive income		6,332			937		$	14,663	$	6,274
Comprehensive income attributable to noncontrolling interests		57			7			33		7
Comprehensive income attributable to Skullcandy, Inc.	$	6,389		$	944		$	14,696	$	6,281

See Accompanying Notes to Condensed Consolidated Financial Statements

4

SKULLCANDY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands of dollars)

(unaudited)

	Nine Months Ended September 30,
	2012			2011
Operating activities
Net income	$	14,383		$	6,289
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		4,287			1,102
Loss on disposal of fixed assets		—			124
Provision for doubtful accounts		1,546			783
Deferred income taxes		(1,666	)		565
Noncash interest expense		180			6,583
Stock-based compensation expense		5,101			3,491
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable		(10,914	)		11,346
Inventories		(11,378	)		(21,205	)
Prepaid expenses and other current assets		2,542			(1,996	)
Accounts payable		(9,039	)		8,244
Income taxes payable		(1,225	)		2,244
Accrued liabilities		(5,095	)		(4,805	)
Net cash provided by (used in) operating activities		(11,278	)		12,765
Investing activities
Purchase of property and equipment		(7,796	)		(3,516	)
Business acquisitions		—			(29,462	)
Net cash used in investing activities		(7,796	)		(32,978	)
Financing activities
Net borrowings (repayments) on bank line of credit		(4,708	)		3,371
Repayment of long-term debt		—			(46,780	)
Proceeds from exercise of stock options		1,758			1,076
Income tax benefit from stock option exercises		546			902
Proceeds from issuance of common stock, net of issuance costs		—			70,104
Net cash provided by (used in) financing activities		(2,404	)		28,673
Effect of exchange rate changes on cash and cash equivalents		74			—
Net increase in cash and cash equivalents		(21,404	)		8,460
Cash and cash equivalents, beginning of period		23,302			6,462
Cash and cash equivalents, end of period	$	1,898		$	14,922
Supplemental cash flow information:
Cash paid for interest		113			6,488
Cash paid for income tax		10,718			2,601

See Accompanying Notes to Condensed Consolidated Financial Statements

5

SKULLCANDY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(1) Description of Business

Skullcandy, Inc., a Delaware corporation (the “Company”), is a global designer, marketer and distributor of performance audio and gaming headphones and other accessory related products under the Skullcandy, Astro Gaming and 2XL by Skullcandy brands.

(2) Basis of Presentation

The accompanying condensed consolidated balance sheets as of September 30, 2012 and 2011 and December 31, 2011 and the condensed consolidated statements of operations for the three and nine months ended September 30, 2012 and 2011 and the condensed consolidated statements of comprehensive income for the three and nine months ended September 30, 2012 and 2011 and cash flows for the nine months ended September 30, 2012 and 2011 are unaudited. The September 30, 2011 balance sheet is presented for comparability purposes to understand the impact of seasonal fluctuations on financial condition. These unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) on the same basis as the audited consolidated financial statements and, in the opinion of management, reflect all adjustments (all of which are considered of normal recurring nature) considered necessary to present fairly the Company’s financial position, results of operations for the three and nine months ended September 30, 2012 and cash flows for the nine months ended September 30, 2012 and 2011. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. Historically, the Company has experienced greater net sales in the second half of the year than those in the first half due to a concentration of shopping during the fall and holiday seasons. The Company anticipates that this seasonal impact on net sales is likely to continue. Accordingly, the Company’s results of operations for any particular quarter are not indicative of the results the Company expects for the full year.

These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 23, 2012. The December 31, 2011 condensed consolidated balance sheet included herein was derived from the audited financial statements as of that date, but does not include all disclosures including notes required by GAAP for complete financial statements.

The Company entered into a joint venture in Mexico on September 19, 2011. The Company has the majority ownership and voting rights and controls the day-to-day operations of the entity. Accordingly, it has consolidated the results of the joint venture operations in its condensed consolidated financial statements. The noncontrolling interests, which reflect the portion of the earnings of operations which are applicable to the other noncontrolling partner, have been classified as noncontrolling interests in the accompanying financial statements.

Initial Public Offering

On July 19, 2011, the Company completed its initial public offering (“IPO”) of common stock in which the Company sold and issued 4,166,667 shares of common stock at a price of $20 per share. As a result of the IPO, the Company raised a total of $83,333,000 in gross proceeds, or approximately $77,500,000 in net proceeds after deducting underwriting discounts and commissions and before deducting offering expenses. Upon the closing of the IPO, all shares of the Company’s preferred stock outstanding automatically converted into 4,507,720 shares of common stock. In addition, the Company’s convertible note converted into 3,862,124 shares of common stock.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries as well as the results of the Mexico joint venture, as noted above. All significant intercompany balances and transactions have been eliminated in the condensed consolidated financial statements.

Recent Accounting Pronouncements

In July 2012, the FASB issued a new accounting standard that simplifies the impairment test for indefinite-lived intangible assets other than goodwill. The new guidance gives the option to first assess qualitative factors to determine if it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount as a basis for determining whether it is necessary to perform a quantitative valuation test. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning on or after September 15, 2012. The Company will adopt this accounting standard in the fourth quarter of 2012. The Company does not anticipate that this adoption will have a significant impact on our financial position, results of operations or cash flows.

6

(3) Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash and accounts receivable. Credit is extended to customers based on an evaluation of the customer’s financial condition and collateral is not required. The most significant customers that accounted for a significant portion of net sales are as follows:

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012			2011
Net Sales Customer A		*			*		*			10.7	%
Net Sales Customer B		11.8	%		*		11.8	%		12.4	%

* Indicates less than 10% of net sales for the period

No single customer accounted for greater than 10% of the Company’s accounts receivable as of September 30, 2012 and 2011. Customer B accounted for 16.4% of the Company’s accounts receivable as of December 31, 2011. The Company maintains its cash balances at various financial institutions. At times such balances may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash.

(4) Allowance for Doubtful Accounts and Sales Returns

Following is a rollforward of the allowance for doubtful accounts and for sales returns and allowances, which are classified as a reduction of accounts receivable and in accrued liabilities, respectively:

	Doubtful Accounts			Sales Returns & Allowances
	(in thousands)
Balance, December 31, 2011	$	599		$	3,824
Provision		1,546			12,929
Deductions		(391	)		(13,052	)
Balance, September 30, 2012	$	1,754		$	3,701

(5) Property and Equipment, Net

Property and equipment, net, consisted of the following:

	Sept. 30, 2012			Sept. 30, 2011			December 31, 2011
	(in thousands)
Cost:
Leasehold improvements	$	2,488		$	1,691		$	1,706
Furniture and fixtures		6,790			2,689			3,355
Other equipment		6,939			2,825			4,973
Computer equipment and software		3,808			1,611			2,809
Vehicles		146			137			151
		20,171			8,953			12,994
Less accumulated depreciation		(5,534	)		(2,068	)		(2,700	)
Property and equipment, net	$	14,637		$	6,885		$	10,294

7

(6) Acquisitions

On August 26, 2011, the Company completed its purchase of all outstanding stock of Kungsbacka 57 AB, a subsidiary of 57 North AB, for $18,625,000. The purchase was made by Skullcandy International GmbH (formerly Skullcandy International AG), a wholly owned subsidiary of the Company. Kungsbacka 57 AB previously held an exclusive distribution agreement for Skullcandy products in Europe through November of 2013. The Company paid the purchase price using proceeds from the IPO. No cash was acquired in the acquisition. The following table summarizes the identifiable net tangible and intangible assets acquired from Kungsbacka 57 AB:

	(in thousands)
Inventories	$	2,900
Prepaid expenses and other current assets		725
Total tangible assets		3,625
Accrued liabilities		(375	)
Total current liabilities		(375	)
Net tangible assets acquired		3,250
Goodwill		7,062
Non-compete agreements		430
Customer relationships		10,850
Deferred tax liability		(2,967	)
Total fair value of purchase price	$	18,625

The non-compete agreements are being amortized over a period of three years and the customer relationships are being amortized over a period of eight years. Goodwill is not amortizable for tax purposes. There were no operations in Skullcandy GmbH prior to the acquisition of Kungsbacka 57 AB. Goodwill from this acquisition relates to expected synergies from combining operations.

(7) Net Income per Share

Basic net income per common share is computed by dividing the net income attributable to Skullcandy, Inc. for the reporting period by the weighted average number of shares of common stock outstanding during the same period. Diluted net income per common share reflects the effects of potentially dilutive securities, which consist of preferred stock, convertible note, unvested restricted stock and stock options.

A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per common share is as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	(in thousands)
Numerator
Net income attributable to Skullcandy, Inc.	$	6,492	$	959	$	14,416	$	6,279
Denominator
Weighted average common stock outstanding for basic net income per common share		27,461		24,428		27,361		17,665
Effect of dilutive securities—preferred stock		—		930		—		3,302
Effect of dilutive securities—unvested restricted stock and stock options		669		904		670		1,076
Weighted average common shares and dilutive securities outstanding		28,130		26,262		28,031		22,043

For the three and nine months ended September 30, 2012, 2,663,161 shares and 2,692,889 shares, respectively, subject to stock options were excluded from the diluted calculation as their inclusion would have been anti-dilutive. For the three and nine months ended September 30, 2011, 1,462,790 shares subject to stock options, preferred stock and the convertible note

8

were excluded from the diluted calculation as their inclusion would have been anti-dilutive. Contingently issuable shares (“PSUs”) that have not met the necessary conditions as of the end of a reporting period are not included in the calculation of diluted net income per common share for that period. The Company had contingently issuable awards outstanding that did not meet the performance conditions as of September 30, 2012 and, therefore, were excluded from the calculation of diluted net income per common share. The maximum number of potentially dilutive shares that could be issued upon vesting for such awards was 278,586 as of September 30, 2012. These amounts were also excluded from the computation of anti-dilutive securities. There were no PSUs outstanding as of September 30, 2011.

(8) Debt

Revolving Credit Facility

On August 31, 2010, the Company entered into a revolving credit and security agreement, or the credit facility, with PNC Bank and UPS Capital Corporation, as lenders. Simultaneously with entering into the credit facility, the Company borrowed amounts under the credit facility to pay off the outstanding balance of the previous credit facility. The credit facility is secured with a first-priority lien against substantially all the assets of the Company. The Company’s credit facility contains certain financial covenants and other restrictions that limit the Company’s ability, among other things, to: undergo a merger or consolidation, sell certain assets, create liens, guarantee certain obligations of third parties, make certain investments or capital expenditures, materially change the Company’s line of business, and declare dividends or make distributions. The credit facility provides for revolving loans and letters of credit of up to $28,750,000 (which may be increased to up to $50,000,000 upon the Company’s request subject to certain conditions) and expires on August 31, 2013. The total amount of available borrowings is subject to limitations based on specified percentages of the value of eligible receivables and inventory. At September 30, 2012, September 30, 2011 and December 31, 2011 total borrowings were $5,176,000, $14,174,000 and $9,884,000, respectively. At September 30, 2012, the Company had $22,920,000 of additional availability under the credit facility. The Company may request up to two increases in the total maximum available amount of the credit facility from the existing lenders, each in an amount not to exceed $10,625,000, such that the aggregate amount of the facility does not exceed $50,000,000. As of September 30, 2012, the credit facility carried an interest rate of 4.25%. At September 30, 2012, the Company was in compliance with all financial covenants.

In October 2011, the Company entered into a first amendment and waiver to revolving credit and security agreement, or the amendment. The amendment increased the amount of allowable capital expenditures to $6,000,000 annually and waived any past non-compliance with the capital expenditure covenant. Under the amendment, the Company may select from two interest rate options for borrowings under the credit facility: (i) Alternate Base Rate (as defined in the credit facility) plus 1.00% or (ii) Eurodollar Rate (as defined in the credit facility) plus 1.5%. The amendment also allows the Company to enter into foreign currency contracts with the lenders to hedge its foreign currency risk.

On March 6, 2012, the Company entered into a second amendment to the revolving credit and security agreement. The amendment provides for an increase in the permitted aggregate annual capital expenditures of the Company to $12,000,000.

9

(9) Segments

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company operates exclusively in the consumer products category in which the Company develops and distributes headphones and other audio accessories. Prior to the Company’s acquisition of Kungsbacka 57 AB in August of 2011, the Company operated in one business segment. Based on the nature of the financial information that is reviewed by the chief operating decision maker, following the acquisition of Kungsbacka 57 AB, the Company operates in two operating and reportable segments, North America and International. The North America segment primarily consists of Skullcandy and Astro Gaming product sales generated in the United States and Mexico (through the Company’s joint venture). The International segment primarily includes Skullcandy product sales generated in Europe and Asia that are served by the Company’s European and Asian operations. Included in the North America segment for the three months ended September 30, 2012 and 2011 and nine months ended September 30, 2012 and 2011 are international net sales of $6,015,000 and $10,713,000 and $17,226,000 and $28,604,000, respectively, that represent products that were sold from North America to retailers and distributors in other countries. All intercompany revenues, expenses, payables and receivables are eliminated in consolidation and are not reviewed when evaluating segment performance. Each segment’s performance is evaluated based on net sales, gross profit and operating income. Information related to the Company’s operating segments is as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	(in thousands)
Net sales
North America	$	57,412	$	56,239	$	167,613	$	144,654
International		13,588		4,402		29,103		4,402
Consolidated		71,000		60,641		196,716		149,056
Gross profit
North America		27,182		27,236		80,842		72,350
International		6,932		1,562		14,923		1,562
Consolidated		34,114		28,798		95,765		73,912
Income from operations
North America		7,426		7,234		17,698		20,724
International		3,194		993		6,123		993
Consolidated	$	10,620	$	8,227	$	23,821	$	21,717

	As of September 30,		As of December 31,
	2012		2011
	(in thousands)
Identifiable assets
North America	$	116,026	$	126,465
International		52,150		42,146
Consolidated		168,176		168,611
Long-lived assets
North America		16,116		13,086
International		11,375		10,886
Consolidated	$	27,491	$	23,972

10

(10) Stock-Based Compensation

The Company has an incentive award plan that provides for the grant of incentive and nonqualified options to purchase the Company’s common stock and PSUs and restricted stock units (“RSUs”) to selected officers, other key employees and directors. Options are granted at a price not less than the fair market value on the date of grant and generally become exercisable between one and four years after the date of grant in accordance with an applicable vesting schedule, and generally expire ten years from the date of grant. The PSUs entitle each participant to earn a number of shares of the Company’s common stock ranging from 0%-150% of the target number of PSUs granted based on the attainment of certain pre-determined financial and stock price performance goals during the performance period running from January 1, 2012 to December 31, 2014 (the “Performance Period”). Each PSU will vest and be earned as of January 1, 2015 as follows: (i) 0-105% of the Target PSUs (as defined in the grant) will fully vest and be earned based on attainment of certain levels of year to year growth in the Company’s annual earnings per share during the Performance Period, and (ii) 0-45% of the Target PSUs will fully vest and be earned based on attainment of certain levels of year to year growth in the Company’s annual revenue during the Performance Period. In no event will more than 100% of the Target PSUs fully vest and be earned unless the Company’s stock price reaches a certain minimum level during the performance period. RSU’s have been granted to all members of the Board of Directors (with the exception of the Company’s CEO) and vest upon the earlier of (1) June 15, 2013 or (2) the next annual meeting at which one or more members of the Board of Directors are standing for re-election, subject in either case to the continued service on the Board through such date.

Stock Options

The following table summarizes stock option activity under the Company’s incentive award plan for the nine months ended September 30, 2012:

	Options Outstanding			Price Range	Weighted- Average Price		Weighted- Average Contractual Term (in years)		Aggregate Intrinsic Value (1)
Balance at December 31, 2011		4,423,407		$0.37 – 20.00	$	13.07
Granted		620,678		12.42 – 16.06		12.98
Exercised		(275,206	)	0.37 – 11.99		6.39
Forfeited		(436,747	)	5.26 – 20.00		14.08
Balance at September 30, 2012		4,332,132		0.37 – 20.00		13.38		7.55		10,691,872
Vested and Exercisable		2,309,438		0.37 – 20.00		11.35		6.44		8,784,296
Unvested		2,022,694		7.42 – 20.00		15.69		8.82		1,907,576

Performance-Based Restricted Stock Units

The following table summarizes PSU activity under the Company’s incentive award plan for the nine months ended September 30, 2012:

	PSUs Outstanding			Weighted- Average Grant Date Fair Value
Balance at December 31, 2011		—			—
Granted		293,883			12.25
Vested		—			—
Forfeited		(15,297	)		12.42
Balance at September 30, 2012		278,586			12.24

11

Restricted Stock Units

The following table summarizes RSU activity under the Company’s incentive award plan for the nine months ended September 30, 2012:

	RSUs Outstanding		Weighted- Average Grant Date Fair Value
Balance at December 31, 2011		—		—
Granted		31,600		14.45
Vested		—		—
Forfeited		—		—
Balance at September 30, 2012		31,600		14.45

Summary of Stock-Based Compensation

The Company recorded stock-based compensation expense related to stock options and RSUs of $1,665,000 and $1,835,000 for the three months ended September 30, 2012 and 2011, respectively. The Company recorded $5,101,000 and $3,491,000 in stock-based compensation expense related to stock options and RSUs for the nine months ended September 30, 2012 and 2011, respectively. Stock-based compensation is recorded in selling, general and administrative expenses in the accompanying condensed consolidated statements of operations. The unrecognized compensation cost of stock options, PSUs and RSUs as of September 30, 2012 and December 31, 2011 was $13,585,000 and $17,306,000, respectively, which is expected to be recognized over the weighted average remaining vesting period of 2.6 years and 3.01 years, respectively.

(11) Financial Derivatives and Hedging Activities

As part of the Company’s overall risk management practices, the Company enters into financial derivatives primarily designed to either hedge foreign currency risks associated with forecasted international sales transactions – “cash flow hedges”; or to mitigate the impact that changes in currency exchange rates have on the amounts due from foreign currency denominated receivables – “foreign currency hedges.”

The Company records all derivatives on the condensed consolidated balance sheets at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting, and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting.

The effective portion of the gain or loss on derivative instruments designated and qualifying as a hedge of the exposure to variability in expected future cash flows related to forecasted transactions is deferred and reported as a component of accumulated other comprehensive income (“OCI”). Deferred gains or losses are reclassified to the Company’s condensed consolidated statements of operations at the time the hedged forecasted transaction is recorded in the condensed consolidated statements of operations. The effectiveness of cash flow hedges is assessed at inception and quarterly thereafter. If the instrument becomes ineffective or it becomes probable that the originally-forecasted transaction will not occur, the related change in fair value of the derivative instrument is also reclassified from accumulated other comprehensive income and recognized in earnings. The Company does not offset fair value amounts recognized for derivative instruments.

Credit risk related to derivative activity arises in the event a counterparty fails to meet its obligations to the Company. This exposure is generally limited to the amounts, if any, by which the counterparty’s obligations exceed the Company’s obligation to them. The Company’s policy is to enter into contracts only with financial institutions which meet certain minimum credit ratings.

Derivatives Designated as Hedging Instruments – Cash Flow Hedges

In October 2011, the Company began to use currency forward contracts as cash flow hedges to manage its exposure to fluctuations in the Euro (EUR) to U.S. Dollar (USD) and Great British Pound (GBP) to U.S. Dollar exchange rates on a portion of forecasted international sales. Currency forward contracts involve fixing the exchange rate for delivery of a specified amount of foreign currency on a specified date. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges of foreign exchange risk is deferred as a component of accumulated other comprehensive income in the accompanying condensed consolidated balance sheets and is subsequently reclassified into earnings in the period that the hedged forecasted sales transactions effect earnings. The ineffective portion of the changes in fair value of derivatives designated as cash flow hedges are recognized directly to earnings and reflected in the accompanying condensed consolidated statements of operations.

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As of September 30, 2012, the Company had the following outstanding derivatives that were used to hedge foreign exchange risks associated with forecasted transactions and designated as hedging instruments (in thousands, except for the number of instruments):

	Number of Instruments		Sell Notional		Buy Notional
Sell EUR/Buy USD Forward Contract		9	€	12,895	$	17,015
Sell GBP/Buy USD Forward Contract		9	£	5,166		8,286
		18			$	25,301

These contracts have maturities of nine months or less. The following tables summarize the amount of income recognized from derivative instruments for the periods indicated and the line items in the accompanying statements of operations where the results are recorded for cash flow hedges (in thousands):

	Amount of Gain (Loss) Recognized in OCI on Derivative (Effective Portion) Three months ended					Location of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)		Amount of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) Three months ended					Location of Gain Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing)		Amount of Gain  Recognized in Income on Derivative (Ineffective Portion and Amount Excluded  from Effectiveness Testing) Three months ended
	Sept. 30, 2012			Sept. 30, 2011				Sept. 30, 2012			Sept. 30, 2011				Sept. 30, 2012		Sept. 30, 2011
Sell EUR/Buy USD Forward Contract	$	139		$	—		Net sales	$	273		$	—		Net sales	$	—	$	—
Sell GBP/Buy USD Forward Contract		(113	)		—		Net sales		(2	)		—		Net sales		1		—
	$	26		$	—			$	271		$	—			$	1	$	—

	Amount of Gain (Loss) Recognized in OCI on Derivative (Effective Portion) Nine months ended					Location of  Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)		Amount of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) Nine months ended					Location of Gain Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing)		Amount of Gain Recognized in Income on Derivative (Ineffective Portion and Amount Excluded  from Effectiveness Testing) Nine months ended
	Sept. 30, 2012			Sept. 30, 2011				Sept. 30, 2012			Sept. 30, 2011				Sept. 30, 2012		Sept. 30, 2011
Sell EUR/Buy USD Forward Contract	$	641		$	—		Net sales	$	400		$	—		Net sales	$	—	$	—
Sell GBP/Buy USD Forward Contract		(135	)		—		Net sales		(55	)		—		Net sales		1		—
	$	506		$	—			$	345		$	—			$	1	$	—

The Company expects all of the amounts recorded as a component of accumulated other comprehensive income (deferred gains of $363,000) will be realized in the consolidated statements of operations within the next nine months and the amount will vary depending on market rates.

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Derivatives Not Designated as Hedging Instruments—Foreign Currency Derivatives

The Company also enters into forward foreign exchange contracts to mitigate the impact changes in currency exchange rates have on balance sheet monetary assets and liabilities. None of these contracts are designated as hedges for accounting purposes and, accordingly, changes in value of the foreign exchange forward contracts and in the offsetting underlying on-balance-sheet transactions are reflected in the accompanying consolidated statements of operations under the caption “Other expense.” As of September 30, 2012, the Company had the following outstanding derivatives that were not designated as hedging instruments (in thousands, except for the number of instruments):

	Number of Instruments		Sell Notional		Buy Notional
Sell EUR/Buy USD Forward Contract		2	€	2,212	$	2,803
Sell GBP/Buy USD Forward Contract		2	£	636		1,014
		4			$	3,817

These contracts generally have maturities of approximately one month from the trade date. The following tables summarize the amount of income from derivative instruments recognized for the periods indicated and the accounts in the accompanying consolidated statements of operations where the results are recorded for economic foreign currency derivatives (in thousands):

	Location of Loss Recognized in Income on Derivative	Amount of Loss Recognized in Income on Derivatives
		Three Months Ended September 30,
		2012			2011
Forecasted sales derivatives
Sell EUR/Buy USD Forward Contract	Net sales	$	(30	)	$	—
Sell GBP/Buy USD Forward Contract	Net sales		(28	)		—
		$	(58	)	$	—
Accounts receivable derivatives
Sell EUR/Buy USD Forward Contract	Other income (expense)	$	(19	)	$	—
Sell GBP/Buy USD Forward Contract	Other income (expense)		(24	)		—
		$	(43	)	$	—

	Location of Gain (Loss) Recognized in Income on Derivative	Amount of Gain (Loss) Recognized in Income on Derivatives
		Nine Months Ended September 30,
		2012			2011
Forecasted sales derivatives
Sell EUR/Buy USD Forward Contract	Net sales	$	(14	)	$	—
Sell GBP/Buy USD Forward Contract	Net sales		(44	)		—
		$	(58	)	$	—
Accounts receivable derivatives
Sell EUR/Buy USD Forward Contract	Other income (expense)	$	2		$	—
Sell GBP/Buy USD Forward Contract	Other income (expense)		(42	)		—
		$	(40	)	$	—

The impact of derivatives not designated as hedging instruments was substantially all offset by the remeasurement of the underlying on-balance sheet item.

Fair Value Measurements

The following table summarizes the fair values of derivative instruments as of the periods indicated and the line items in the accompanying consolidated balance sheets where the instruments are recorded (in thousands):

	Derivative Assets				Derivative Liabilities
	September 30, 2012		December 31, 2011		September 30, 2012			December 31, 2011
Derivatives designated as cash flow hedges
Balance Sheet Location		Prepaid expenses and other current assets		Prepaid expenses and other current assets		Accrued liabilities			Accrued liabilities
Sell EUR/Buy USD Forward Contract	$	416	$	175	$	—		$	—
Sell GBP/Buy USD Forward Contract		18		27		(71	)		—
	$	434	$	202	$	(71	)	$	—

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	Derivative Assets				Derivative Liabilities
	September 30, 2012		December 31, 2011		September 30, 2012			December 31, 2011
Derivatives not designated as hedging instruments
Balance Sheet Location		Prepaid expenses and other current assets		Prepaid expenses and other current assets		Accrued liabilities			Accrued liabilities
Sell EUR/Buy USD Forward Contract	$	—	$	31	$	(41	)	$	—
Sell GBP/Buy USD Forward Contract		1		1		(14	)		(5	)
	$	1	$	32	$	(55	)	$	(5	)

The amounts set forth in the table above represent the net asset or liability giving effect to rights of offset with each counterparty.

The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:

Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3—Inputs that are both significant to the fair value measurement and unobservable.

The following table shows the derivatives by level within the fair value hierarchy (in thousands):

	Quoted Prices in Active Markets for Identical Assets and Liabilities (Level 1)				Significant Other Observable Inputs (Level 2)						Significant Unobservable Inputs (Level 3)				Total Fair Value As  of
	September 30, 2012		December 31, 2011		September 30, 2012			December 31, 2011			September 30, 2012		December 31, 2011		September 30, 2012			December 31, 2011
Assets
Derivative Financial Instruments	$	—	$	—	$	435		$	234		$	—	$	—	$	435		$	234
Liabilities
Derivative Financial Instruments	$	—	$	—	$	(126	)	$	(5	)	$	—	$	—	$	(126	)	$	(5	)

The fair values of the foreign exchange forward contracts are considered to be Level 2. Foreign currency forward contracts are valued using readily available foreign currency forward and interest rate curves. The fair value of each contract is determined by comparing the contract rate to the forward rate and discounting to present value. Contracts in a gain position are recorded in the consolidated balance sheet under the caption “Prepaid expenses and other current assets” and the value of contracts in a loss position is recorded under the caption “Accrued liabilities.”

(12) Income Taxes

In order to determine the quarterly provision for income taxes, the Company uses an estimated annual effective tax rate, which is based on expected annual income and statutory tax rates in the various jurisdictions in which the Company operates. To the extent that application of the estimated annual effective tax rate is not representative of the quarterly portion of actual tax expense expected to be recorded for the year, the Company determines the quarterly provision for income taxes based on actual year-to-date income. Certain significant or unusual items are separately recognized in the quarter during which they occur and can be a source of variability in the effective tax rates from quarter to quarter.

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Income tax expense for the three months ended September 30, 2012 and 2011 was $3,782,000 and $2,440,000, respectively, or approximately 36.8% and 71.8% of pre-tax income. Income tax expense for the nine months ended September 30, 2012 and 2011 was $8,391,000 and $6,323,000, respectively, or approximately 36.8% and 50.1% of pre-tax income. The decrease in the effective income tax rate for both periods is primarily due to the difference between the book and tax treatment of incentive stock options and the expenses related to the second and third contingent payments pursuant to the securities purchase and redemption agreement which were not deductible for tax purposes. The effective tax for the three and nine months ended September 30, 2012 differs from the U.S. federal statutory rate of 35% primarily due to state income taxes and incentive stock options. The Company’s effective tax rate may fluctuate significantly on a quarterly basis dependent upon the proportionate levels of income in countries with lower statutory rates versus countries with higher statutory rates.

The Company is subject to income taxes in the United States and various foreign jurisdictions and to continual examination by tax authorities. Significant judgment is required in evaluating the Company’s uncertain tax positions and determining its provision for income taxes. As of September 30, 2012, September 30, 2011 and December 31, 2011, the Company had $281,000, $134,000 and $192,000, respectively of liabilities for uncertain tax positions. The Company recognizes interest and penalties related to uncertain tax positions as a component of income tax expense. The Company did not incur any material interest or penalties related to income taxes in any of the periods presented. The Company does not anticipate any significant events or circumstances that would cause a material change to these uncertainties during the ensuing year.

The Company files U.S., state, and foreign income tax returns in jurisdictions with various statutes of limitations. The Company’s consolidated federal and state tax returns and any significant foreign tax returns are not currently under examination.

(13) Product Warranty Obligations

The Company provides for product warranties in accordance with the contract terms given to various customers and end users by accruing estimated warranty costs at the time of revenue recognition. Warranties are generally fulfilled by replacing defective products with new products.

Activity in the warranty accrual balance, which is included in accrued liabilities on the condensed consolidated balance sheets, was as follows:

	Warranty Accrual
	(in thousands)
Balance at December 31, 2011	$	1,559
Warranty Claims		(873	)
Warranty Costs Accrued		807
Balance at September 30, 2012	$	1,493

(14) Commitments and Contingencies

In October 2010, Rapha Products Group LLC, or Rapha, filed a claim in the Northern District of Georgia, alleging that the Company’s Pipe and Super Pipe speaker docks infringed U.S. design patent No. D555,636. The Company filed a motion for summary judgment of non-infringement in March 2011, which the court declined to grant in August 2012, citing issues of fact that needed to be decided. In October 2012, the parties agreed to mediate the case and the court granted the Company’s request to stay discovery pending the mediation.

In August 2012, Hitachi Metals, Ltd. and Hitachi Metals North Carolina, Ltd., together referred to as Hitachi, filed a complaint in the International Trade Commission, the ITC, entitled “Certain Sintered Rare Earth Magnets, Methods of Making Same and Products Containing the Same.” The complaint named Skullcandy and 28 other companies, including many of the Company’s competitors such as Bose, Beats Electronics, and Monster Cable, and alleges that the magnets contained in the speakers of certain of the Company’s products infringe U.S. Patent Nos. 6,461,565; 6,491,765; 6,527,874; and 6,537,385. While the ITC cannot award monetary damages, an adverse ruling can prohibit the Company from importing any of its products that contain these magnets and may require the Company to change the suppliers of its magnets to those that have a license from Hitachi. If the Company is required to change its magnet suppliers, the Company cannot assure you that it will be able to source the magnets from a licensed supplier in a timely manner, if at all. Additionally, sourcing magnets from licensed suppliers may increase the cost of production. The Company is vigorously defending against this action.

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In addition, the Company is subject to various claims, complaints and legal actions in the normal course of business from time to time. The Company does not believe it has any currently pending litigation of which the outcome will have a material adverse effect on its operations or financial position.

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

The following discussion and analysis of the financial condition and results of our operations should be read together with our condensed consolidated financial statements and the related notes included in Part I of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and the related notes included in our 2011 10-K filed with the Securities and Exchange Commission on March 23, 2012.

Cautionary Statement Regarding Forward-Looking Statements

This quarterly report contains forward-looking statements. The words “may,” “will,” “plan,” “believe,” “expect,” “anticipate,” “intend,” “estimate” and other expressions that are predictions of or indicate future events and trends and that do not relate to historical matters identify forward-looking statements. Although forward-looking statements reflect our current views, reliance should not be placed on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, which may cause the actual results, performance or achievements to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements speak only as of the date the statements are made. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changed circumstances or otherwise. These forward-looking statements are subject to numerous risks and uncertainties, including the risks and uncertainties described under “Risk Factors” in Part II of this quarterly report and in our 2011 10-K filed with the Securities and Exchange Commission on March 23, 2012, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this quarterly report. Moreover, we operate in an evolving environment. New risk factors and uncertainties emerge from time to time and it is not possible for our management to predict all risk factors and uncertainties, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors may cause actual results to differ materially from those contained in any forward-looking statement. We qualify all of our forward-looking statements by these cautionary statements.

Overview

Skullcandy is a global designer, marketer and distributor of performance audio and gaming headphones and other accessory related products under the Skullcandy, Astro Gaming and 2XL by Skullcandy brands. Skullcandy became one of the world’s most distinct audio brands by bringing color, character and performance to an otherwise monochromatic space and helped revolutionize the audio arena by introducing headphones, earbuds and other audio and wireless lifestyle products that possess unmistakable style and exceptional performance. From the award-winning, optic-inspired Roc Nation Aviator headphones to the evolutionary fitting FIX earbuds and a roster of some of the world’s finest athletes, musicians and artists, Skullcandy continues to redefine world-class audio performance and style. The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position, robust net sales growth and strong profitability.

Our net sales are derived primarily from the sale of headphones and audio accessories. We pioneered the distribution of headphones in specialty retailers focused on action sports and the youth lifestyle, such as Zumiez, Tilly’s and hundreds of independent snow, skate and surf retailers. Through this channel we reach consumer influencers, individuals who help establish and maintain the credibility and authenticity of our brand. Building on this foundation, we have successfully expanded our distribution to select consumer electronics, mass, sporting goods and mobile phone retailers such as Best Buy, Target, Dick’s Sporting Goods and AT&T Wireless. Skullcandy products are sold in the United States and in approximately 80 other countries around the world. We also offer products through our websites, with online sales representing approximately 8.4% and 9.1% of our net sales for the nine months ended September 30, 2012 and 2011, respectively.

A number of industry trends have facilitated our growth to date, and we expect these trends to continue. The increasing use of portable media devices, such as Apple’s iPod, and smartphones with integrated music and video capabilities, such as Apple’s iPhone and third-party Android-based phones, has driven growth in the headphones and audio accessories markets. Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our consumer influencers are teens and young adults that associate themselves with skateboarding, snowboarding, surfing and other action sports. These consumers influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the youth action sports lifestyle, and headphones have become an accessory worn to express individuality. We believe these trends provide us with an expanding consumer base for our products. Furthermore, we believe that these trends in preferences and lifestyles are not unique to the United States and are prevalent in a number of markets around the world.

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We face potential challenges that could limit our ability to take advantage of these opportunities, including, among others, the risk that we may not be able to effectively extend the recognition and reputation of our brand or continue to develop innovative and popular products. We also face the risk that we may not be able to sustain our past growth or manage our anticipated future growth. In addition, we rely on Target and Best Buy for a significant portion of our net sales. During 2011 and the nine months ended September 30, 2012 , Best Buy accounted for more than 10% of our net sales. Moreover, we expect to experience growth internationally, which will require significant additional operating expenditures and increase our exposure to the risks inherent in international operations. Furthermore, our industry is very competitive and we cannot assure you that we will be able to compete effectively. See “Risk Factors” in Part II of this quarterly report and in our 2011 10-K filed with the Securities and Exchange Commission on March 23, 2012 for a more complete discussion of the risks facing our business. Historically, we have experienced greater net sales in the second half of the year than those in the first half due to a concentration of shopping during the fall and holiday seasons. We anticipate that this seasonal impact on our net sales is likely to continue. Accordingly, our results of operations for any particular quarter are not indicative of the results we expect for the full year.

Segment Information

We operate exclusively in the consumer products category in which we develop and distribute headphones and other audio accessories. Prior to our acquisition of Kungsbacka 57 AB on August 26, 2011, we operated in one business segment. Following that acquisition we began to operate in two segments –North America and International. The North America segment primarily consists of Skullcandy and Astro Gaming product sales generated in the United States and Mexico (through our joint venture). The International segment primarily includes Skullcandy product sales generated in Europe and Asia that are served by our European and Asian operations.

Basis of Presentation

Our net sales are derived primarily from the sale of headphones and audio accessories under the Skullcandy, Astro Gaming and 2XL by Skullcandy brands. Amounts billed to retailers for shipping and handling are included in net sales. Sales are reported net of estimated product returns and pricing adjustments.

Gross profit is influenced by cost of goods sold, which consists primarily of product costs, packaging, freight, duties and warehousing. We are experiencing higher product costs due to increasing labor and other costs in China. If we are unable to pass along these costs to our retailers and distributors or shift our sales mix to higher margin products, our gross profit as a percentage of net sales, or gross margin, may decrease.

Our selling, general and administrative expenses consist primarily of wages and related payroll and employee benefit expenses, including stock-based compensation, marketing and advertising expense, commissions to outside sales representatives, legal and professional fees, travel expenses, utilities, other facility related costs, such as rent and depreciation and amortization, and consulting expenses. The primary components of our marketing and advertising expenses include in-store advertising, brand building fixtures, sponsorship of trade shows and events, promotional products and sponsorships for athletes, DJs, musicians and artists. We expect our selling, general and administrative expenses to increase in absolute dollars as we hire additional personnel and incur increased costs related to the growth of our business and our operation as a public company.

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Results of Operations

The following tables sets forth selected items in our statements of operations in dollars (in thousands) and as a percentage of net sales and net sales and gross profit by segment for the periods presented:

	Three Months Ended September 30,								Nine Months Ended September 30,
	2012				2011				2012				2011
Net sales	$	71,000	100.0	%	$	60,641	100.0	%	$	196,716	100.0	%	$	149,056		100.0	%
Cost of goods sold		36,886	52.0			31,843	52.5			100,951	51.3			75,144		50.4
Gross profit		34,114	48.0			28,798	47.5			95,765	48.7			73,912		49.6
Selling, general and administrative expenses		23,494	33.1			20,571	33.9			71,944	36.6			52,195		35.0
Income from operations		10,620	15.0			8,227	13.6			23,821	12.1			21,717		14.6
Other expense		219	0.3			1,734	2.9			592	0.3			1,716		1.2
Interest expense		184	0.3			3,101	5.1			455	0.2			7,389		5.0
Income before income taxes and noncontrolling interests		10,217	14.4			3,392	5.6			22,774	11.6			12,612		8.5
Income taxes		3,782	5.3			2,440	4.0			8,391	4.3			6,323		4.2
Net income	$	6,435	9.1		$	952	1.6		$	14,383	7.3		$	6,289		4.2
Noncontrolling interests		57	0.1			7	0.0			33	0.0			7		0.0
Preferred dividends		—	—			—	—			—	—			(17	)	0.0
Net income attributable to Skullcandy, Inc.	$	6,492	9.1	%	$	959	1.6	%	$	14,416	7.3	%	$	6,279		4.2	%

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Net sales
North America	$	57,412	$	56,239	$	167,613	$	144,654
International		13,588		4,402		29,103		4,402
Consolidated		71,000		60,641		196,716		149,056
Gross profit
North America		27,182		27,236		80,842		72,350
International		6,932		1,562		14,923		1,562
Consolidated		34,114		28,798		95,765		73,912

Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011

Net Sales

Net sales increased $10.4 million, or 17.1%, to $71.0 million for the three months ended September 30, 2012 from $60.6 million for the three months ended September 30, 2011.

North America net sales increased $1.2 million, or 2.1% to $57.4 million from $56.2 million. The increase was primarily driven by increased Astro Gaming sales of $4.7 million. International net sales increased $9.2 million, or 208.7%, to $13.6 million from $4.4 million. On August 26, 2011, we completed the purchase of all outstanding stock of Kungsbacka 57 AB, a subsidiary of 57 North, for $18.6 million. Kungsbacka 57 AB previously held an exclusive distribution agreement for Skullcandy products in Europe through November of 2013. The acquisition has enabled us to take direct control of our European business, which we believe is allowing us to capture revenue that would otherwise have been earned by 57 North and accelerate our growth in this region. Prior to our acquisition of Kungsbacka 57 AB, we operated in one business segment. As a result, the three months ended September 30, 2012 are not comparable to the three months ended September 30, 2011 as the prior year does not include a full quarter of activity for our direct European Business. Included in the North America segment for the three

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months ended September 30, 2012 and 2011 are net sales of $6.0 million and $10.7 million, respectively, which represent products that were sold from North America to retailers and distributors in other countries. Adjusting for these sales from North America to retailers and distributors in other countries, North America net sales increased 12.9% to $51.4 million from $45.5 million and International net sales increased 29.7% to $19.6 million from $15.1 million. We are in the process of transitioning these international relationships from Skullcandy, Inc. to Skullcandy GmbH, our European subsidiary, as Skullcandy GmbH’s warehouses have better geographic locations to serve most of our international customers.

Online net sales, substantially all of which are included in North America net sales, decreased $0.2 million, or 3.8%, to $6.0 million for the three months ended September 30, 2012 from $6.2 million for the three months ended September 30, 2011. An increase in Astro Gaming online net sales was offset by declines in our direct audio consumer business.

Gross Profit

Gross profit increased $5.3 million, or 18.5%, to $34.1 million for the three months ended September 30, 2012 from $28.8 million for the three months ended September 30, 2011. Gross profit as a percentage of net sales, or gross margin, was 48.0% for the three months ended September 30, 2012 compared to 47.5% for the three months ended September 30, 2011. North America gross margin decreased to 47.3% for the three months ended September 30, 2012 from 48.4% for the three months ended September 30, 2011 as a result of a shift in sales mix to higher price point products with lower gross margin structures. The North America gross margin in the third quarter of 2011 was negatively impacted by sales of Astro Gaming inventory that had been recorded at fair value under the acquisition method of accounting. International gross margin increased to 51.0% for the three months ended September 30, 2012 from 35.5% for the three months ended September 30, 2011. We experienced lower gross margins on our direct business in Europe from the date of our Kungsback 57AB acquisition through September 30, 2011 as a result of inventory that was recorded at fair value under the acquisition method of accounting.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $2.9 million, or 14.2 %, to $23.5 million for the three months ended September 30, 2012 from $20.6 million for the three months ended September 30, 2011. Depreciation and amortization expense increased $1.2 million as a result of increased investments for international operational growth, product design, fixtures and the acquisition of certain intangible assets related to our acquisition of the distribution rights in Europe in August 2011. As a percentage of net sales, selling, general and administrative expenses decreased to 33.1% for the three months ended September 30, 2012 from 33.9% for the three months ended September 30, 2011. We expect to continue to make critical investments in the business to support long-term growth, including additional personnel in key areas, product development, point of sale merchandising, international expansion and development of our gaming platform.

Income from Operations

As a result of the factors above, income from operations increased $2.4 million, or 29.1%, to $10.6 million for the three months ended September 30, 2012 from $8.2 million for the three months ended September 30, 2011. Income from operations as a percentage of net sales increased 1.4 percentage points to 15.0% for the three months ended September 30, 2012 from 13.6% for the three months ended September 30, 2011.

Other Expense

Other expense for the three months ended September 30, 2012 consisted of foreign currency remeasurement losses. For the three months ended September 30, 2011, other expense consisted primarily of a $1.4 million expense related to a derivative liability associated with the third contingent payment paid pursuant to the securities purchase and redemption agreement. The derivative liability was recorded as a derivative due to the variability in the potential amount payable. The estimated fair value of this derivative was approximately $2.4 million as of December 31, 2010 and June 30, 2011. The amount became fixed at $3.8 million upon the consummation of our IPO and the additional $1.4 million was included in other expense. The derivative liability was paid on July 29, 2011.

Interest Expense

Interest expense decreased $2.9 million to $0.2 million for the three months ended September 30, 2012 from $3.1 million for the three months ended September 30, 2011. Included in interest expense for the three months ended September 30, 2011 was an expense of $2.2 million related to the second contingent payment paid pursuant to the securities purchase and redemption agreement that was incurred upon the consummation of our IPO. All long-term debt was repaid with the proceeds of our IPO in July 2011, or was converted to common stock. In addition, as of September 30, 2012, there were $5.2 million in borrowings outstanding on the revolving credit facility compared to $14.2 million outstanding as of September 30, 2011.

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Income Taxes

Income taxes were $3.8 million for the three months ended September 30, 2012 compared to $2.4 million for the three months ended September 30, 2011. Our effective tax rate for the three months ended September 30, 2012 and 2011 was 36.8% and 71.8%, respectively. The decrease in the effective income tax rate is primarily due to the difference between the book and tax treatment of incentive stock options and the expenses related to the second and third contingent payments pursuant to the securities purchase and redemption agreement which were not deductible for tax purposes in 2011. We expect our effective tax rate will continue to fluctuate significantly on a quarterly basis depending upon the proportionate levels of income in countries with lower statutory rates versus countries with higher statutory rates.

Net Income

As a result of the factors above, net income increased $5.5 million to $6.4 million for the three months ended September 30, 2012 from $1.0 million for the three months ended September 30, 2011.

Noncontrolling Interest

We entered into a joint venture in Mexico in September 2011 to facilitate distribution of our products in Mexico. We own a majority of the joint venture and the voting rights and control the day-to-day operations. Noncontrolling interests consists of losses from our Mexico joint venture that are attributable to the other partner in the joint venture.

Net Income Attributable to Skullcandy, Inc.

As a result of the factors above, net income attributable to Skullcandy, Inc. was $6.5 million for the three months ended September 30, 2012 compared to $1.0 million for the three months ended September 30, 2011.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Net Sales

Net sales increased $47.7 million, or 32.0%, to $196.7 million for the nine months ended September 30, 2012 from $149.1 million for the nine months ended September 30, 2011.

North America net sales increased $23.0 million, or 13.7% to $167.6 million from $144.7 million. International net sales increased $24.7 million, or 84.9%, to $29.1 million from $4.4 million. On August 26, 2011, we completed the purchase of all outstanding stock of Kungsbacka 57 AB, a subsidiary of 57 North, for $18.6 million. Kungsbacka 57 AB previously held an exclusive distribution agreement for Skullcandy products in Europe through November of 2013. The acquisition has enabled us to take direct control of our European business, which we believe is allowing us to capture revenue that would otherwise have been earned by 57 North and accelerate our growth in this region. Prior to our acquisition of Kungsbacka 57 AB on August 26, 2011, we operated in one business segment. As a result, the nine months ended September 30, 2012 are not comparable to the nine months ended September 30, 2011 as the prior year does not include a full year of activity for our direct European business. Included in the North America segment for the nine months ended September 30, 2012 and 2011 are net sales of $17.2 and $28.6 million, respectively, which represent products that were sold from North America to retailers and distributors in other countries. Adjusting for these sales from North America to retailers and distributors in other countries, North America net sales increased 29.6% to $150.4 million from $116.1 million and International net sales increased 40.4% to $46.3 million from $33.0 million.

Online net sales, substantially all of which are included in North America net sales, increased $2.9 million, or 21.1%, to $16.5 million for the nine months ended September 30, 2012 from $13.6 million for the three months ended September 30, 2011. The increase in online net sales is primarily due to the acquisition of Astro Gaming, Inc. on April 21, 2011.

Gross Profit

Gross profit increased $21.9 million, or 29.6%, to $95.8 million for the nine months ended September 30, 2012 from $73.9 million for the nine months ended September 30, 2011. Gross margin was 48.7% for the nine months ended September 30, 2012 compared to 49.6% for the nine months ended September 30, 2011. The decrease in North America gross margin to 48.2% for the nine months ended September 30, 2012 from 50.0% for the nine months ended September 30, 2011 is mostly due to a shift in sales mix to higher price point products with lower gross margin structures and lower margin sales to the closeout channel. North America gross margin for the nine months ended September 30, 2011 was negatively impacted by Astro Gaming inventory that had been recorded at fair value under the acquisition method of accounting. The International gross margin increased to 51.3% for the nine months ended September 30, 2012 from 35.5% for the nine months ended September 30, 2011. We experienced lower gross margins on our direct business in Europe from the date of our Kungsback 57AB acquisition through September 30, 2011 as a result of inventory that was recorded at fair value under the acquisition method of accounting.

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Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $19.7 million, or 37.8%, to $71.9 million for the nine months ended September 30, 2012 from $52.2 million for the nine months ended September 30, 2011. Payroll and benefits expenses increased 40.7%, or $7.9 million, due to an increased employee headcount to support planned growth. Depreciation and amortization expense increased $3.2 million as a result of increased investments for international operational growth, product design, fixtures and the acquisition of certain intangible assets related to our acquisition of the distribution rights in Europe in August 2011. Employee travel related expenses increased $1.2 million due to international expansion and increased employee headcount. As a percentage of net sales, selling, general and administrative expenses increased to 36.6% for the nine months ended September 30, 2012 from 35.0% for the nine months ended September 30, 2011.

Income from Operations

As a result of the factors above, income from operations increased $2.1 million, or 9.7%, to $23.8 million for the nine months ended September 30, 2012 from $21.7 million for the nine months ended September 30, 2011. Income from operations as a percentage of net sales decreased 2.5 percentage points to 12.1% for the nine months ended September 30, 2012 from 14.6% for the nine months ended September 30, 2011.

Other Expense

Other expense for the nine months ended September 30, 2012 primarily consisted of foreign currency remeasurement losses. For the nine months ended September 30, 2011, other expense consisted primarily of a $1.4 million expense related to a derivative liability associated with the third contingent payment paid pursuant to the securities purchase and redemption agreement. The derivative liability was recorded as a derivative due to the variability in the potential amount payable. The estimated fair value of this derivative was approximately $2.4 million as of December 31, 2010 and June 30, 2011. The amount became fixed at $3.8 million upon the consummation of our IPO and the additional $1.4 million was included in other expense. The derivative liability was paid on July 29, 2011.

Interest Expense

Interest expense decreased $6.9 million to $0.5 million for the nine months ended September 30, 2012 from $7.4 million for the nine months ended September 30, 2011. Included in interest expense for the nine months ended September 30, 2011 was an expense of $2.2 million related to the second contingent payment paid pursuant to the securities purchase and redemption agreement that was incurred upon the consummation of our IPO. All long-term debt was repaid with the proceeds of our IPO in July 2011 or was converted to common stock. In addition, as of September 30, 2012 there were $5.2 million in borrowings outstanding on the revolving credit facility compared to $14.2 million outstanding as of September 30, 2011.

Income Taxes

Income taxes were $8.4 million for the nine months ended September 30, 2012 compared to $6.3 million for the nine months ended September 30, 2011. Our effective tax rate for the nine months ended September 30, 2012 and September 30, 2011 was 36.8% and 50.1%, respectively. The decrease in the effective income tax rate is primarily due to the difference between the book and tax treatment of incentive stock options and the expenses related to the second and third contingent payments pursuant to the securities purchase and redemption agreement which were not deductible for tax purposes in 2011. We expect our effective tax rate will continue to fluctuate significantly on a quarterly basis depending upon the proportionate levels of income in countries with lower statutory rates versus countries with higher statutory rates.

Net Income

As a result of the factors above, net income increased $8.1 million to $14.4 million for the nine months ended September 30, 2012 from $6.3 million for the nine months ended September 30, 2011.

Noncontrolling Interest

We entered into a joint venture in Mexico in September 2011 to facilitate distribution of our products in Mexico. We own a majority of the joint venture and the voting rights and control the day-to-day operations. Noncontrolling interests consists of losses from our Mexico joint venture that are attributable to the other partner in the joint venture.

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Preferred Dividends

Preferred dividends were immaterial for the nine months ended September 30, 2011. Subsequent to July 2011, there have been no preferred dividends. All shares of our preferred stock that were previously outstanding automatically converted into 4,507,720 shares of common stock upon the closing of our IPO.

Net Income Attributable to Skullcandy, Inc.

As a result of the factors above, net income attributable to Skullcandy, Inc. was $14.4 million for the nine months ended September 30, 2012 compared to $6.3 million for the nine months ended September 30, 2011.

Liquidity and Capital Resources

Our primary cash needs are working capital and capital expenditures. Historically, we have financed these needs with operating cash flows, sales of equity securities and borrowings under our credit facility. These sources of liquidity may be impacted by fluctuations in demand for our products, ongoing investments in our infrastructure and expenditures on marketing and advertising.

The following table sets forth, for the periods indicated, our beginning balance of cash, net cash flows provided by and used in operating, investing and financing activities and our ending balance of cash:

	Nine Months Ended September 30,
	2012			2011
	(in thousands)
Cash and cash equivalents at beginning of period	$	23,302		$	6,462
Net cash provided by (used in) operating activities		(11,278	)		12,765
Net cash used in investing activities		(7,796	)		(32,978	)
Net cash provided by (used in) financing activities		(2,404	)		28,673
Effect of exchange rate changes on cash and cash equivalents		74			—
Cash and cash equivalents at end of period	$	1,898		$	14,922

Net Cash Provided by (Used in) Operating Activities. Cash from operating activities consists primarily of net income adjusted for certain non-cash items including depreciation and amortization expense, provision for doubtful accounts, deferred income taxes, non-cash interest expense, stock-based compensation expense and the effect of changes in working capital and other activities. For the nine months ended September 30, 2012, net cash used in operating activities was $11.3 million and consisted of net income of $14.4 million plus $9.4 million for non-cash items, less $35.1 million for working capital and other activities. Working capital and other activities consisted primarily of a decrease in prepaid expenses and other current assets of $2.5 million, offset by increases in accounts receivable of $10.9 million, inventory of $11.4 million and decreases in accounts payable of $9.0 million, income taxes payable of $1.2 million and accrued liabilities of $5.1 million.

For the nine months ended September 30, 2011, net cash provided by operating activities was $12.8 million and consisted of net income of $6.3 million plus $12.7 million for non-cash items, less $6.2 million for working capital and other activities, net of the effects of business acquisitions. Working capital and other activities consisted primarily of a decrease in accounts receivable of $11.3 million, an increases in accounts payable of $8.2 million and taxes payable of $2.2 million, offset by increases in inventory of $21.2 million and prepaid expenses and other of $2.0 million and decreases in accrued liabilities and other current liabilities of $4.8 million.

Net Cash Provided Used in Investing Activities. For the nine months ended September 30, 2012, net cash used in investing activities of $7.8 million relates to capital expenditures.

For the nine months ended September 30, 2011, net cash used in investing activities consisted mostly of $10.8 million for the acquisition of Astro Gaming, Inc. and $18.6 million for the acquisition of Kungsbacka 57 AB and $3.5 million of capital expenditures.

Net Cash Provided by (Used in) Financing Activities. For the nine months ended September 30, 2012, net cash used in financing activities was $2.4 million, which consisted of net repayments on the bank line of credit of $4.7 million offset by $1.8 million in proceeds from the exercise of stock options and a tax benefit of $0.5 million.

For the nine months ended September 30, 2011, net cash provided by financing activities was $28.7 million and consisted of proceeds from issuance of common stock, net of issuance costs, of $70.1 million, repayments of long term debt

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of $46.8 million, net borrowings on our bank line of credit of $3.4 million, proceeds from exercise of stock options of $1.1 million and the related income tax benefit of $0.9 million. We believe that our cash, cash flow from operating activities, available borrowings under our credit facility will be sufficient to meet our capital requirements for at least the next twelve months.

Indebtedness

On August 31, 2010, we entered into a revolving credit and security agreement, or the credit facility, with PNC Bank and UPS Capital Corporation, as lenders. The credit facility provides for revolving loans and letters of credit of up to $28.8 million (which may be increased to up to $50.0 million upon our request subject to certain conditions) and expires on August 31, 2013. The credit facility is secured by substantially all of our assets. The total amount of available borrowings is subject to limitations based on specified percentages of the value of eligible receivables and inventory. At September 30, 2012, there were $5.2 million in outstanding borrowings and we had $22.9 million of additional availability under the credit facility. We may request up to two increases in the total maximum available amount of the credit facility from the existing lenders, each in an amount not to exceed $10.6 million, such that the aggregate amount of the facility does not exceed $50.0 million. We are required to pay a commitment fee on any unused credit facility commitments at a per annum rate of 0.50%. The credit facility includes restrictions on, among other things, our ability to incur additional indebtedness, pay dividends or make other distributions, make investments, make loans and make capital expenditures, and requires that we maintain a Fixed Charge Coverage Ratio (as defined in the credit facility) of not less than 1.15 to 1.0, measured on a trailing 12-month basis. At September 30, 2012, we were in compliance with all financial covenants.

In October 2011, we entered into a first amendment and waiver to revolving credit and security agreement. The amendment increased the amount of allowable capital expenditures to $6.0 million annually and waived any past non-compliance with the capital expenditure covenant. Under the amendment, we may select from two interest rate options for borrowings under the credit facility: (i) Alternate Base Rate (as defined in the credit facility) plus 1.0% or (ii) Eurodollar Rate (as defined in the credit facility) plus 1.5%. The amendment also allows us to enter into foreign currency contracts with the lenders to hedge our foreign currency risk.

On March 6, 2012, we entered into a second amendment to our revolving credit and security agreement. This amendment provides for an increase in the permitted aggregate annual capital expenditures to $12.0 million.

Contractual Obligations

In the three months and nine months ended September 30, 2012, there were no material changes to our contractual obligations as discussed in our annual report on Form 10-K for the year ended December 31, 2011.

Off-Balance Sheet Arrangements

We currently do not have any off-balance sheet arrangements or financing activities with special-purpose entities.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. To prepare these financial statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities. These estimates also affect our reported net sales and expenses. Judgments must also be made about the disclosure of contingent liabilities. Actual results could be significantly different from these estimates. We believe that the following discussion addresses the accounting policies that are necessary to understand and evaluate our reported financial results.

Revenue Recognition and Sales Returns and Allowances

Net sales are recognized when title and risk of loss pass to the retailer or distributor and when collectability is reasonably assured. Generally, we extend credit to our retailers and distributors and do not require collateral. Our payment terms are typically between net-30 and net-120. The net-120 terms are for certain international customers. We recognize revenue net of estimated product returns and pricing adjustments. Further, we provide for product warranties in accordance with the contract terms given to various retailers and end users by accruing estimated warranty costs at the time of revenue recognition. We have entered into contracts with various retailers granting a conditional right of return allowance with respect to defective products. The contracts with each retailer specify the defective allowance percentage of gross sales. We have executed an open return program with a major retailer allowing for an unlimited amount of returns. Estimates for these items are based on actual experience and are recorded as a reduction of revenue at the time of recognition or when circumstances change resulting in a change in estimated returns.

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Accounts Receivable

Throughout the year, we perform credit evaluations of our retailers and distributors, and we adjust credit limits based on payment history and the retailer’s or distributor’s current creditworthiness. We continuously monitor our collections and maintain an allowance for doubtful accounts based on our historical experience and any specific customer collection issues that have been identified. Bad debt expense is reported as a component of selling, general and administrative expenses. Historically, our losses associated with uncollectible accounts have been consistent with our estimates, but there can be no assurance that we will continue to experience the same credit loss rates that we have experienced in the past. Unforeseen, material financial difficulties of our retailers or distributors could have an adverse impact on our profits.

Inventories

We value inventories at the lower of the cost or the current estimated market value of the inventory. Substantially all of our inventory is comprised of finished goods. We regularly review our inventory quantities on hand and adjust inventory values for excess and obsolete inventory based primarily on estimated forecasts of product demand and market value. Demand for our products could fluctuate significantly. The demand for our products could be negatively affected by many factors, including the following:

• unanticipated changes in consumer preferences;

• weakening economic conditions;

• terrorist acts or threats;

• reduced consumer confidence in the retail market; and

• unseasonable weather.

Some of these factors could also interrupt the production and importation of our products or otherwise increase the cost of our products. As a result, our operations and financial performance could be negatively affected. Additionally, our estimates of product demand and market value could be inaccurate, which could result in excess and obsolete inventory.

Long-Lived Assets Including Goodwill and Intangible Assets

We review property, plant and equipment and certain identifiable intangibles, excluding goodwill, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If property and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair market value. We did not record any impairments during the three and nine months ended September 30, 2012 and 2011.

Prior to the acquisitions of Astro Gaming, Inc. in April 2011, and Kungsbacka 57 AB in August 2011, we did not have goodwill. We do not amortize goodwill and intangible assets with indefinite useful lives, rather such assets are required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. We perform our goodwill and intangible asset impairment tests in the fourth quarter of each fiscal year. We did not record any impairments during the three and nine months ended September 30, 2012 and 2011.

We amortize our intangible assets with definite lives over their estimated useful lives and review these assets for impairment. We are currently amortizing our acquired intangible assets with definite lives over periods ranging between three to eight years.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred income tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities at tax rates expected to be in effect when such assets or liabilities are realized or settled. Deferred income tax assets are reduced by valuation allowances when necessary.

Assessing whether deferred tax assets are realizable requires significant judgment. We consider all available positive and negative evidence, including historical operating performance and expectations of future operating performance. The ultimate realization of deferred tax assets is often dependent upon future taxable income and therefore can be uncertain. To the extent we believe it is more likely than not that all or some portion of the asset will not be realized, valuation allowances are established against our deferred tax assets, which increase income tax expense in the period when such a determination is made.

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Income taxes include the largest amount of tax benefit for an uncertain tax position that is more likely than not to be sustained upon audit based on the technical merits of the tax position. Settlements with tax authorities, the expiration of statutes of limitations for particular tax positions, or obtaining new information on particular tax positions may cause a change to the effective tax rate. We recognize accrued interest and penalties related to unrecognized tax benefits in the provision for income taxes on the consolidated statements of operations.

Stock-Based Compensation

We have stock-based compensation plans which allow for the issuance of stock-based awards, including stock options, performance-based restricted stock units and restricted stock units to employees, officers, directors and consultants. The fair value of PSUs and RSUs is based on the closing price of our common stock on the date of grant. The fair value of each stock option award is calculated on the date of grant using the Black-Scholes option-pricing model. We recognize the fair value of each award as an expense over the requisite service period.

For purposes of calculating stock-based compensation on stock options, we estimate the fair value of stock options using a Black-Scholes-Merton valuation model, which requires the use of certain subjective assumptions including expected term, volatility, expected dividend, risk-free interest rate, forfeiture rate and the fair value of our common stock. These assumptions generally require significant judgment.

We estimate the expected term of employee options using the average of the time-to-vesting and the contractual term. We derive our expected volatility from the historical volatilities of several unrelated public companies within our industry because we have little information on the volatility of the price of our common stock since we have no trading history prior to our IPO on July 19, 2011. When making the selections of our industry peer companies to be used in the volatility calculation, we also considered the stage of development, size and financial leverage of potential comparable companies. These historical volatilities are weighted based on certain qualitative factors and combined to produce a single volatility factor. Our expected dividend rate is zero, as we have never paid any dividends on our common stock and do not anticipate any dividends in the foreseeable future. We base the risk-free interest rate on the U.S. Treasury yield in effect at the time of grant for zero coupon U.S. Treasury notes with maturities approximately equal to each grant’s expected life.

We estimate our forfeiture rate based on an analysis of our actual forfeitures and will continue to evaluate the appropriateness of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover behavior and other factors. Quarterly changes in the estimated forfeiture rate can have a significant effect on reported stock-based compensation expense, as the cumulative effect of adjusting the rate for all expense amortization is recognized in the period the forfeiture estimate is changed. If a revised forfeiture rate is higher than the previously estimated forfeiture rate, an adjustment is made that will result in a decrease to the stock-based compensation expense recognized in the consolidated financial statements. If a revised forfeiture rate is lower than the previously estimated forfeiture rate, an adjustment is made that will result in an increase to the stock-based compensation expense recognized in the consolidated financial statements.

If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there is a difference between the assumptions used in determining stock-based compensation expense and the actual factors which become known over time, we may change the input factors used in determining stock-based compensation costs for future grants. These changes, if any, may materially impact our results of operations in the period such changes are made. We expect to continue to grant stock options in the future, and to the extent that we do, our actual stock-based compensation expense recognized in future periods will likely increase.

PSUs vest subject to the achievement of certain predetermined performance goals and employment over the requisite service period. If a performance goal is not met or is not expected to be met, we do not recognize expense on the number of the PSUs that are not expected to vest, and we reverse any previously recognized compensation expense on those PSUs in the period that expectations change.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

We maintain a credit facility that provides for revolving loans and letters of credit of up to $28.8 million (which may be increased to up to $50.0 million upon our request subject to certain conditions). At September 30, 2012, there were $5.2 million in borrowings outstanding and we had $22.9 million of additional availability under the credit facility. We currently do not engage in any interest rate hedging activity. Based on the average interest rate on the credit facility during the three months ended September 30, 2012, and to the extent that borrowings were outstanding, we do not believe that a 10% change in the interest rate would have a material effect on our results of operations or financial condition.

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Foreign Currency Risk

In the normal course of business, we are exposed to foreign currency exchange rate risks that could impact our results of operations. We are exposed to gains and losses resulting from fluctuations in foreign currency exchange rates relating to certain sales and expenses of our international subsidiaries that are denominated in currencies other than their functional currencies. 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 operating results and financial position of our international subsidiaries. Changes in foreign currency rates affect our consolidated statement of operations and distort comparisons between periods. For example, when the U.S. dollar strengthens compared to the Euro, there is a negative effect on our reported results from our European operation because it takes more profits in Euro to generate the same amount of profits in stronger U.S. dollars. We do not enter into foreign currency exchange contracts to hedge the translation of operating results and financial position of our international subsidiaries.

We use various foreign currency exchange contracts as part of our overall strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates. On the date we enter into a derivative contract, we designate the derivative as a hedge of the identified exposure. We formally document all relationships between hedging instruments and hedged items, as well as the risk-management objective and strategy for entering into various hedge transactions. We identify in this documentation the asset, liability, firm commitment, or forecasted transaction that has been designated as a hedged item and indicate how the hedging instrument is expected to hedge the risks related to the hedged item. We formally measure effectiveness of our hedging relationships both at the hedge inception and on a quarterly basis in accordance with our risk management policy. Derivatives that do not qualify or are no longer deemed effective to qualify for hedge accounting but are used by management to mitigate exposure to currency risks are marked to fair value with corresponding gains or losses recorded in earnings. We enter into forward exchange and other derivative contracts with major banks and are exposed to foreign currency losses in the event of nonperformance by these banks. We anticipate, however, that these banks will be able to fully satisfy their obligations under the contracts. Accordingly, we do not obtain collateral or other security to support the contracts.

The net fair value of foreign currency forward contracts (including adjustments for credit risk) as of September 30, 2012 was an asset of $0.3 million compared to an asset of $0.2 million as of December 31, 2011. The potential decrease in fair value of foreign currency forward contracts (excluding adjustments for credit risk), assuming a 10% adverse change in the underlying foreign currency exchange rates versus the U.S. Dollar, would be approximately $2.6 million as of September 30, 2012 compared with a decrease of approximately $1.4 million as of December 31, 2011. If adjustments for credit risk were to be included, the decrease would be smaller.

Inflation

Inflationary factors, such as increases in the cost of our product and overhead costs, may adversely affect our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of net sales if the selling prices of our products do not increase with these increased costs.

Outstanding Orders

We typically receive the bulk of our orders from retailers approximately three weeks prior to the date the products are to be shipped and from distributors approximately six weeks prior to the date the products are to be shipped. Generally, these orders are not subject to cancellation prior to the date of shipment. Retailers regularly request reduced order lead-time, which puts pressure on our supply chain. Our open order book varies by season, with the highest level occurring during the fourth quarter.

Item 4. Controls and Procedures.

On October 1, 2012, Kyle B. Wescoat started as our Senior Vice President and Chief Financial Officer. In connection with his role as our Chief Financial Officer, Kyle has also transitioned to be our Principal Accounting Officer, replacing Ron Ross, our Vice President, Finance.

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports we file pursuant to the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and

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communicated to our management, including our Principal Executive Officer and our Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Quarterly Report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that as of the end of the period covered by this Quarterly Report our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and include controls and procedures designed to ensure that the information required to be disclosed by us in such reports is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures will prevent or detect all error and all fraud. While our disclosure controls and procedures are designed to provide reasonable assurance of their effectiveness, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Skullcandy, Inc. have been detected.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

Item 1. Legal Proceedings.

In October 2010, Rapha Products Group LLC, or Rapha, filed a claim in the Northern District of Georgia, alleging that our Pipe and Super Pipe speaker docks infringed U.S. design patent No. D555,636. We filed a motion for summary judgment of non-infringement in March 2011, which the court declined to grant in August 2012, citing issues of fact that needed to be decided. In October 2012 the parties agreed to mediate the case and the court granted our request to stay discovery pending the mediation.

In August 2012, Hitachi Metals, Ltd. and Hitachi Metals North Carolina, Ltd., together referred to as Hitachi, filed a complaint in the International Trade Commission, the ITC, entitled “Certain Sintered Rare Earth Magnets, Methods of Making Same and Products Containing the Same.” The complaint named Skullcandy and 28 other companies, including many of our competitors such as Bose, Beats Electronics, and Monster Cable, and alleges that the magnets contained in the speakers of certain of our products infringe U.S. Patent Nos. 6,461,565; 6,491,765; 6,527,874; and 6,537,385. While the ITC cannot award monetary damages, an adverse ruling can prohibit us from importing any of our products that contain these magnets and may require us to change the suppliers of our magnets to those that have a license from Hitachi. If we are required to change our magnet suppliers, we cannot assure you that we will be able to source the magnets from a licensed supplier in a timely manner, if at all. Additionally, sourcing magnets from licensed suppliers may increase the cost of production. We are vigorously defending against this action.

In addition, we are subject to various claims, complaints and legal actions in the normal course of business from time to time. We do not believe we have any currently pending litigation of which the outcome will have a material adverse effect on our operations or financial position.

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Item 1A. Risk Factors.

We operate in a rapidly changing environment that involves a number of risks that could materially and adversely affect our business, financial condition, prospects, operating results or cash flows. For a detailed discussion of the risks that affect our business, please refer to the section entitled “Risk Factors” in our 10-K filed with the SEC on March 23, 2012. There have been no material changes to the risks discussed in our 10-K other than the additional risks identified below.

Claims that we violate a third party’s intellectual property rights may give rise to burdensome litigation, result in potential liability for damages, impede our development efforts or increase the cost of production for our products.

We cannot assure you that our products or activities do not violate the patents or other intellectual property rights of third parties. Patent infringement, trade secret misappropriation and other intellectual property claims and proceedings brought against us, whether successful or not, could result in substantial costs and harm our reputation. Such claims and proceedings can also distract and divert management and key personnel from other tasks important to the success of our business. Examples of such claims include a filed action asserting that our speaker docks infringe another company’s design patent and another recently filed action in the international trade commission asserting that the magnets in our products infringe certain patents held by Hitachi Ltd. In addition, intellectual property litigation could force us to do one or more of the following:

• cease developing, manufacturing, or selling products that incorporate the challenged intellectual property;

• obtain and pay for licenses from the holder of the infringed intellectual property right, which licenses may not be available on reasonable terms, or at all;

• change manufacturers and suppliers of raw materials;

• redesign or reengineer products, including using different raw materials or components;

• change our business processes; and

• pay substantial damages, court costs and attorneys’ fees, including potentially increased damages for any infringement or violation found to be willful.

In the event of an adverse determination in an intellectual property suit or proceeding, or our failure to license essential technology, our sales could be harmed and/or our costs could increase, which could harm our financial condition.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

None.

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Item 6. Exhibits.

Exhibit No.	Description of Exhibit
10.1	Offer letter, dated September 14, 2012, by and between Skullcandy, Inc. and Kyle Wescoat
10.2	Offer letter, dated July 16, 2012, by and between Skullcandy, Inc. and Sam Paschel
31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
32.1	Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101	The following materials from Skullcandy, Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, formatted in XBRL (eXtensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Operations; (iii) Condensed Consolidated Statements of Comprehensive Income (iv) Condensed Consolidated Statements of Cash Flows; and (v) Notes to Condensed Consolidated Financial Statements, tagged as blocks of text.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	Skullcandy, Inc.
Date: November 7, 2012	By:	/s/    JEREMY ANDRUS
		Jeremy Andrus
		President and Chief Executive Officer
		(Principal Executive Officer)
Date: November 7, 2012	By:	/s/    KYLE B. WESCOAT
		Kyle B. Wescoat
		Senior Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

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