10-Q 1 a06-5039_110q.htm QUARTERLY REPORT PURSUANT TO SECTIONS 13 OR 15(D)

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

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

 

For the quarterly period ended December 31, 2005

 

OR

 

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

 

For the transition period from                to            

 

Commission file number   1-13550

 

HAUPPAUGE DIGITAL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

11-3227864

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

 

 

91 Cabot Court, Hauppauge, New York 11788

(Address of principal executive offices)

 

 

 

(631) 434-1600

(Registrant’s telephone number, including area code)

 

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.

 

ý YES          o NO

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (See definition of “accelerated filer and large accelerated filer’ in Rule 12b-2 of the Exchange Act).

 

o  LARGE ACCELERATED FILER  o  ACCELERATED FILER  ý NON-ACCELERATED FILER

 

Indicate by check mark whether the registrant is a shell company  (as defined in Rule12b-2 of the Exchange act).

 

o YES          ý  NO

 

As of February 6, 2006,  9,559,757 shares of  .01 par value Common Stock of the registrant were outstanding.

 

 



 

HAUPPAUGE DIGITAL, INC. AND SUBSIDIARIES

 

INDEX

 

 

Page No.

PART I. FINANCIAL INFORMATION

2

 

 

Item 1. Financial Statements

2

 

 

Condensed Consolidated Balance Sheets -

2

December 31, 2005 (unaudited) and September 30, 2005 (audited)

 

 

 

Condensed Consolidated Statements of Income -

3

Three Months ended December 31, 2005 (unaudited) and 2004 (unaudited)

 

 

 

Condensed Consolidated Statements of Other Comprehensive Income -

4

Three months ended December 31, 2005 (unaudited) and 2004 (unaudited)

 

 

 

Condensed Consolidated Statements of Cash Flows -

5

Three Months ended December 31, 2005 (unaudited) and 2004 (unaudited)

 

 

 

Notes to Condensed Consolidated Financial Statements

6-14

 

 

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

15-27

 

 

Item 3. Quantitative and Qualitative Disclosures about Market Risks

28-29

 

 

Item 4. Controls and Procedures

30

 

 

PART II. OTHER INFORMATION

30

 

 

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

30

 

 

Item 6. Exhibits

31

 

 

SIGNATURES

32

 



 

PART I. FINANCIAL INFORMATION

 

Item 1.Financial Statements

 

HAUPPAUGE DIGITAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

 

December 31, 2005

 

September 30, 2005

 

 

 

(unaudited)

 

(audited)

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

Current Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

6,192,989

 

$

7,567,393

 

Receivables, net of various allowances

 

20,484,559

 

13,048,076

 

Inventories

 

10,398,235

 

9,806,785

 

Prepaid expenses and other current assets

 

1,037,052

 

1,087,453

 

Total current assets

 

38,112,835

 

31,509,707

 

 

 

 

 

 

 

Property, plant and equipment, net

 

521,618

 

525,108

 

Security deposits and other non current assets

 

80,142

 

81,529

 

Total assets

 

$

38,714,595

 

$

32,116,344

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity :

 

 

 

 

 

 

 

 

 

 

 

Current Liabilities:

 

 

 

 

 

Accounts payable

 

$

16,062,743

 

$

10,750,560

 

Accrued expenses-licensing fees

 

4,794,451

 

4,126,506

 

Accrued expenses

 

1,438,627

 

1,121,842

 

Income taxes payable

 

179,260

 

175,944

 

Total current liabilities

 

22,475,081

 

16,174,852

 

 

 

 

 

 

 

Stockholders’ Equity:

 

 

 

 

 

Common stock $.01 par value; 25,000,000 shares authorized, 10,121,378 and 10,107,936 issued, respectively

 

101,214

 

101,080

 

Additional paid-in capital

 

13,728,530

 

13,603,705

 

Retained earnings

 

4,332,360

 

3,311,888

 

Accumulated other comprehensive (loss) income

 

(164,639

)

682,770

 

Treasury Stock, at cost, 607,547 and 567,067 shares

 

(1,757,951

)

(1,757,951

)

Total stockholders’ equity

 

16,239,514

 

15,941,492

 

Total liabilities and stockholders’ equity

 

$

38,714,595

 

$

32,116,344

 

 

See accompanying notes to condensed consolidated financial statements

 

2



 

HAUPPAUGE DIGITAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

 

 

 

Three months ended December 31,

 

 

 

2005

 

2004

 

 

 

 

 

 

 

Net sales

 

$

25,044,990

 

$

23,360,442

 

Cost of sales

 

19,813,206

 

18,049,079

 

Gross profit

 

5,231,784

 

5,311,363

 

 

 

 

 

 

 

Selling, general and administrative expenses

 

3,381,070

 

3,427,055

 

Research & development expenses

 

794,001

 

557,530

 

Income from operations

 

1,056,713

 

1,326,778

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

Interest income

 

5,206

 

1,511

 

Foreign currency

 

964

 

(8,600

)

Other income (expense)

 

6,170

 

(7,089

)

Income before taxes on income

 

1,062,883

 

1,319,689

 

Tax provision

 

42,411

 

56,000

 

Net income

 

$

1,020,472

 

$

1,263,689

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

Basic

 

$

0.11

 

$

0.14

 

Diluted

 

$

0.10

 

$

0.13

 

 

See accompanying notes to condensed consolidated financial statements

 

3



 

HAUPPAUGE DIGITAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OTHER COMPREHENSIVE INCOME

(UNAUDITED)

 

 

 

Three months ended December 31,

 

 

 

2005

 

2004

 

Net income

 

$

1,020,472

 

$

1,263,689

 

Foreign currency translation (loss)

 

(743,271

)

(279,791

)

Forward exchange contracts marked to market

 

(104,138

)

584,261

 

Other comprehensive income

 

$

173,063

 

$

1,568,159

 

 

See accompanying notes to condensed consolidated financial statements

 

4



 

HAUPPAUGE DIGITAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

 

 

Three months ended December 31,

 

 

 

2005

 

2004

 

Net income

 

$

1,020,472

 

$

1,263,689

 

Adjustments to reconcile net income to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

45,070

 

54,324

 

Non cash stock compensation expense

 

100,878

 

 

Other non cash items

 

1,387

 

 

Changes in current assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(7,436,483

)

(1,612,908

)

Inventories

 

(591,450

)

(2,273,237

)

Prepaid expenses and other current assets

 

50,401

 

(11,665

)

Accounts payable

 

5,312,183

 

1,450,848

 

Accrued expenses and other current liabilities

 

988,046

 

491,287

 

Total adjustments

 

(1,529,968

)

(1,901,351

)

Net cash used in operating activities

 

(509,496

)

(637,662

)

 

 

 

 

 

 

Cash Flows From Investing Activities:

 

 

 

 

 

Purchases of property, plant and equipment

 

(41,580

)

(82,723

)

Net cash used in investing activities

 

(41,580

)

(82,723

)

 

 

 

 

 

 

Cash Flows From Financing Activities:

 

 

 

 

 

Proceeds from exercise of stock options and employee stock purchases

 

24,081

 

199,359

 

Purchase of treasury stock

 

 

(17,448

)

Net cash provided by financing activities

 

24,081

 

181,911

 

Effect of exchange rates on cash

 

(847,409

)

304,470

 

Net decrease in cash and cash equivalents

 

(1,374,404

)

(234,004

)

Cash and cash equivalents, beginning of period

 

7,567,393

 

8,661,589

 

Cash and cash equivalents, end of period

 

$

6,192,989

 

$

8,427,585

 

 

 

 

 

 

 

Supplemental disclosures:

 

 

 

 

 

Income taxes paid

 

$

16,776

 

$

38,863

 

 

See accompanying notes to condensed consolidated financial statements

 

5



 

HAUPPAUGE DIGITAL, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
(Unaudited)

 

Note 1. Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements included herein have been prepared in accordance with generally accepted accounting principles for interim period reporting in conjunction with the instructions to Form 10-Q. Accordingly, these statements do not include all of the information required by generally accepted accounting principles for annual financial statements. In the opinion of management, all known adjustments (consisting of normal recurring accruals and reserves) necessary to present fairly the Company’s consolidated financial position,  results of operations and cash flows as of and for the interim periods have been included. It is suggested that these interim statements be read in conjunction with the financial statements and related notes included in the Company’s September 30, 2005 Form 10-K.

 

The operating results for the three months ended December  31, 2005 are not necessarily indicative of the results to be expected for the September 30, 2006 year end.

 

Certain reclassifications have been made to the prior condensed consolidated financial statements to conform to the current presentation.

 

Note 2. Receivables

 

Accounts and other receivables as of December 31, 2005 and September 30, 2005 consisted of:

 

 

 

December 31,

 

September 30,

 

 

 

2005

 

2005

 

Trade receivables

 

$

14,564,411

 

$

10,186,232

 

Receivable from contract manufacturers

 

8,309,277

 

5,491,524

 

GST and VAT taxes receivables

 

812,647

 

567,820

 

Allowances and reserves

 

(3,257,000

)

(3,257,000

)

Other

 

55,224

 

59,500

 

 

 

$

20,484,559

 

$

13,048,076

 

 

Note 3. Derivative Financial   Instruments

 

For each of the past three fiscal years, at least 50 % of the Company’s sales were generated by our European subsidiary and were:

 

                  Invoiced in local currency-primarily the Euro

 

                  Collected in local currency-primarily the Euro

 

6



 

On the supply side, since the Company predominantly deals with North American and Asian suppliers and contract manufacturers, approximately 75% of the Company’s inventory required to support the Company’s European sales are purchased and paid in U.S. Dollars.

 

The combination of sales billed in Euros supported by inventory purchased in U.S. dollars results in an absence of a natural local currency hedge. Consequently, the Company’s financial results are subject to market risks resulting from the fluctuations in the Euro to U.S. Dollar exchange rates.

 

The Company attempts to reduce these risks by entering into foreign exchange forward contracts with financial institutions. The purpose of these forward contracts is to hedge the foreign currency market exposures underlying the U.S. Dollar denominated inventory purchases required to support the Company’s European sales.

 

The Company does not try to hedge against all possible foreign currency exposures because of the inherent difficulty in estimating the volatility of the Euro. The contracts the Company procures are specifically entered into to as a hedge against forecasted or existing or foreign currency exposure. The Company does not enter into contracts for speculative purposes. Although the Company maintains these programs to reduce the short term impact of changes in currency exchange rates, long term strengthening or weakening of the U.S. dollar against the Euro impacts the Company’s sales, gross profit, operating income and retained earnings. Factors that could impact the effectiveness of the Company’s hedging program are:

 

                                          volatility of the currency markets

 

                                          availability of hedging instruments

 

                                          accuracy of our inventory forecasts

 

Additionally, there is the risk that foreign exchange fluctuations will make our products less competitive in foreign markets, which would substantially reduce our sales.

 

As of December 31, 2005, the Company had foreign currency contracts outstanding of approximately $1,928,150 against the delivery of the Euro. The contracts expire from January 2006 through February 2006. The Company’s accounting policies for these instruments designate such instruments as cash flow hedging transactions. The Company does not enter into such contracts for speculative purposes. The Company records all derivative gains and losses on the balance sheet as a component of stockholders’ equity under the caption “Accumulated other comprehensive income (loss)”. The Company

 

7



 

recorded a loss of $104,138 for the three ended December 31, 2005 on its statement of other comprehensive income. As of December 31, 2005, a deferred gain of $32,280 reflecting the cumulative mark to market gains of the Company’s derivatives, was recorded on the Company’s balance sheet as a component of accumulated other comprehensive income in our equity section.

 

The Company uses the average monthly forward contract exchange rate to translate our Euro denominated sales into the Company’s U.S. dollar reporting currency. For the three months ended December 31, 2005, the use of the monthly average spot rate instead of the average monthly forward contract exchange rate to value Euro denominated sales would have resulted in a decrease in sales of $628,789 for the three months ended December 31, 2005. These sales increases are related to contracts that closed during these periods and the changes in the fair value of our derivative contracts. For the three months ended December 31, 2004, the use of the monthly average spot rate instead of the average monthly forward contract exchange rate to value Euro denominated sales would have resulted in a sales increase of $640,815.

 

Note 4. Inventories

 

Inventories have been valued at the lower of average cost or market on a first in first out basis. The components of inventory consist of:

 

 

 

December 31,

 

September 30,

 

 

 

2005

 

2005

 

 

 

 

 

 

 

Component Parts

 

$

4,712,845

 

$

4,131,732

 

Finished Goods

 

5,685,390

 

5,675,053

 

 

 

$

10,398,235

 

$

9,806,785

 

 

Note 5. Net Income Per Share

 

Basic net income per share includes no dilution and is computed by dividing net income by the weighted average number of shares of common stock outstanding for the period. Diluted net income per share reflects, in the periods in which they have a dilutive effect, the dilution which would occur upon the exercise of stock options. A reconciliation of the shares used in calculating basic and diluted net income per share is as follows:

 

 

 

Three Months Ended
December 31,

 

 

 

2005

 

2004

 

Weighted average shares outstanding-basic

 

9,508,100

 

9,277,944

 

Number of shares issued on the assumed exercise of stock options

 

507,157

 

671,437

 

Weighted average shares outstanding-diluted

 

10,015,257

 

9,949,381

 

 

8



 

Options to purchase 92,876 and 98,757 shares of common stock, at prices ranging $3.88 to $ 8.75 and $5.25 to $10.06, were outstanding for the three months ended December 31, 2005 and 2004, respectively, but were not included in the computation of diluted earnings per share because they were anti-dilutive.

 

Note 6. Accumulated other comprehensive income

 

The Euro is the functional currency of the Company’s European subsidiary, Hauppauge Digital Europe Sarl. Assets and liabilities of this subsidiary are translated to U.S. Dollars at the spot exchange rate in effect at the end of each reporting period, while equity accounts are translated to U.S. Dollars at the historical rate in effect at the date of the contribution. Operating results are translated to U.S. Dollars at the average prevailing exchange rate for the period, with the exception of sales, which are translated to U.S. Dollars at the average monthly forward exchange contract rate. The use of translating accounts at the spot, historical and average exchange rates results in foreign currency translation gains or losses. These translation gains or losses are recorded on the balance sheet under accumulated other comprehensive income.

 

The Company uses forward exchange contracts to reduce its exposure to fluctuations in foreign currencies. Mark to market gains and losses on these open contracts result from the difference between the USD value of the open foreign currency forward contracts at the average contract rate as opposed to the same contracts translated at the month end spot rate. The Company qualifies for cash flow hedge accounting as prescribed under FAS 133, which allows the Company to record the mark to market gains and losses in the equity section of the Company’s balance sheet under accumulated other comprehensive income.

 

As of December 31, 2005, appearing in the equity section under “ Accumulated other comprehensive income” was a loss of $164,639, which consisted of a deferred translation loss of $196,919 and a deferred gain of $32,280 due to the mark to market gains on the difference between the value of the Company’s open forward exchange contracts at the contract rates versus the same contracts valued at the period ending forward rate.

 

The Company’s Asian subsidiary reports its financial position and results of operations in the reporting currency of the Company.

 

9



 

Note 7. Revenue Recognition

 

The Company sells through a sales channel which consist of retailers , distributors and original equipment manufacturers (OEM’s). The Company’s prices are fixed consistently over the entire sales channel. The majority of the Company’s customers are granted lines of credit. The product is shipped on open account with the majority of the Company’s customers given 30 to 60 day payment terms. Those customers deemed as large credit risks either pay in advance or issue us a letter of credit.

 

The Company requires the customer to submit a purchase order to the Company. The price of the product and payment terms are fixed per the terms of the purchase order. Upon shipment of the order to the customer, the title to the goods is passed to the customer. The customer is legally obligated to pay for the order within the payment terms stated on the customer’s purchase order. The obligation to insure the products and the cost of any pilferage while in the customer’s possession is the responsibility of the customer. The Company sells analog, hybrid video recorders and digital computer boards that are stocked on the shelves of retailers, and are subject to the normal consumer traffic that retail stores attract. Aside from normal store promotions such as end-caps and advertisements in the store’s circular, the Company has no further obligation to assist in the resale of the product.

 

The Company offers its customers a right of return, but does not offer stock balancing. The Company’s accounting method complies with SFAS 48 as typically at the end of every quarter the Company, based on historical data, evaluates its sales reserve level based on the previous six months sales. Due to seasonal nature of the business coupled with the changing economic environment, management exercises some judgment with regard to the historical data to arrive at the reserve.

 

Note 8. Product segment and Geographic Information

 

The Company offers three primary types of analog products. The Company’s WinTV® analog TV receivers allow PC users to watch television on their PC screen in a resizable window, and also enable recording of TV shows to a hard disk. The Company’s WinTV®-PVR TV personal video recorder products include hardware MPEG encoders, which improve the performance of TV recording and add instant replay and program pause functions, plus also enable the ‘burning’ of TV recordings onto DVD or CD media. The Company’s Eskape™ Labs myTV.PVR products allow users of Apple®Macintosh® computers to watch and record television on their computer screen.

 

The Company offers four types of digital TV receivers. The Company’s WinTV-NOVA digital receivers can receive digital TV transmissions and display the digital TV show in a re-sizeable window on a user’s PC screen. The Company’s

 

10



 

WinTV-HVR series allow users to watch analog or digital TV on a PC screen. The Company’s Digital Entertainment Center products (“DEC”) allow users to receive digital TV broadcasts and display the digital TV on either a TV set or a PC screen. The Company’s MediaMVP™ product was designed to allow PC users to play digital media such as digital music, digital pictures and digital videos on a TV set via a home network.

 

The Company’s products are either sold, or can be sold, by the same retailers and distributors in our marketing channel. The Company also sells product directly to OEM customers. The Company evaluates its product lines under the functional categories of analog and digital products. Sales by functional category are as follows:

 

 

 

Three months ended December 31,

 

 

 

2005

 

2004

 

Product line sales

 

 

 

 

 

Analog sales

 

$

15,457,032

 

$

18,401,809

 

Digital sales

 

9,587,958

 

4,958,633

 

 

 

$

25,044,990

 

$

23,360,442

 

 

The Company sells its products through an international network of distributors and retailers. Sales percent by geographic region are as follows:

 

 

Three months ended December 31 ,

 

 

 

2005

 

2004

 

Sales percent by geographic region

 

 

 

 

 

United States

 

41

%

38

%

Europe

 

56

%

60

%

Asia

 

3

%

2

%

Total

 

100

%

100

%

 

Note 9. Stock-Based Compensation

 

Prior to October 1, 2005, the Company accounted for employee stock option plans based on the intrinsic value method in accordance with Accounting Principles Board  (APB) Opinion No. 25, “ Accounting for Stock Issued to Employees,” and related Interpretations and had adopted the disclosure requirements of SFAS No. 123, “ Accounting for Stock-Based Compensation” (SFAS No.123). Accordingly, compensation cost for stock options was measured as the excess, if any, of the quoted market price of the Company’s stock at the grant date over the amount an employee must pay to acquire the stock. The Company  granted stock options with exercise prices equal to the market price of the underlying stock on the date of grant, therefore, the Company did not record stock-based compensation expense under APB Opinion No. 25.

 

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, “ Share-Based Payments” to require that compensation cost relating to share-based payment arrangements be recognized in the financial statements.

 

11



 

Effective October 1, 2005, the Company adopted SFAS No. 123R using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. Therefore, prior period financial statements have not been restated. The fair value of stock options were determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for stock options in footnote disclosures required under SFAS No. 123. Such fair value is recognized as expense over the service period, net of estimated forfeitures. The adoption of SFAS No.123R resulted in no cumulative change in accounting as of the date of adoption.

 

The weighted average fair value of options outstanding during the three months ended December 31, 2005 was $2.15. These options vest over a period of five years. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for the three months ended December 31, 2005: risk-free interest rates of 4.25%, volatility factor of the expected market price of the Company’s Common Stock of 50%, assumed dividend yield of 0%, and a weighted-average expected life of the option of 5 years.

 

For the three months ended December 31, 2005, stock compensation expense of $100,878 was charged to operations, consisting of $20,945 for options granted during the first quarter of fiscal 2006 and $79,333 for non vested options granted prior to October 1, 2005. As of December 31, 2005, there was $1,091,678 of total unrecognized compensation cost, net of estimated forfeitures, related to nonvested share-based compensation arrangements, which is expected to be recognized over a weighted-average period of 3.75 years.

 

The following table illustrates the effect on net income and net income per share for the three months ended December 31, 2004 as if the Company has consistently measured the compensation cost for the Company’s stock option programs under the fair value method adopted on October 1, 2005:

 

 

 

December 31,

 

 

 

2004

 

Net income as reported

 

$

1,263,689

 

Deduct: Total stock-based employee compensation expense determined under fair value method, net of related taxes

 

(8,924

)

Pro forma net income

 

$

1,254,765

 

 

 

 

 

Net income per share - as reported:

 

 

 

Basic

 

$

0.14

 

Diluted

 

$

0.13

 

Net income per share - pro forma:

 

 

 

Basic

 

$

0.14

 

Diluted

 

$

0.13

 

 

12



 

Note 10. Arrangements with Off-Balance Sheet Risk - Guarantees

 

FASB Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of the Indebtedness of Others, clarified the requirements of SFAS No. 5, Accounting for Contingencies, relating to a guarantor’s accounting for and disclosures of certain guarantees issued. FIN 45 requires enhanced disclosures for certain guarantees. It also requires certain guarantees that are issued or modified after December 31, 2002, including certain third-party guarantees, to be initially recorded on the balance sheet at fair value. For guarantees issued on or before December 31, 2002, liabilities are recorded when and if payments become probable and estimable. FIN 45 has the general effect of delaying recognition for a portion of the revenue for product sales that are accompanied by certain third-party guarantees. The financial statement recognition provisions became effective prospectively beginning January 1, 2003. The Company has not entered into any new guarantees and the Company has been released from the one guarantee it was subject to prior to February 17, 2004.

 

The Company occupies a facility located in Hauppauge New York which is used for its executive offices and for the testing, storage and shipping of the Company’s products. In February 1990, Hauppauge Computer Works, Inc., a wholly-owned subsidiary of the Company (“HCW”), entered into a lease (the “1990 Lease”), with Ladokk Realty Co., a real estate partnership which is principally owned by Kenneth Plotkin, the Company’s Chairman of the Board, Chief Executive Officer, President, Chief Operating Officer and Vice President of Marketing and the holder of approximately 8.8% of the Company’s Common Stock as of December 31, 2005, Dorothy Plotkin, the wife of Kenneth Plotkin, holder of approximately 5.9% of the Company’s Common Stock as of December 31, 2005 and Laura Aupperle, believed by the Company to be the holder of approximately 10.5% of the Company’s Common Stock, including Common Stock attributed to the Estate of Kenneth R. Aupperle. Ladokk Realty Co., LLC is the successor to Ladokk Realty Co. As of February 2004, the 1990 Lease provided for annual rent of approximately $454,000, payable monthly, and subject to 5% annual increases effective February 1st of each year. The Company was also obligated to pay real estate taxes and operating costs of maintaining the premises subject to the 1990 Lease. Until February 17, 2004, the premises subject to such lease were subject to two mortgages guaranteed by us.

 

On February 17, 2004, HCW and Ladokk terminated the 1990 Lease and HCW entered into a new lease agreement with Ladokk Realty Co., LLC (the “2004 Lease”). The 2004 Lease term is for five years and terminates on February 16, 2009. The annual rent under the 2004 Lease is $360,000, payable monthly. The Company was also obligated to pay real estate taxes and operating costs of maintaining the premises subject to such lease. Concurrently with the new lease, Ladokk completed a refinancing of its mortgages, and the new lender did not require HCW to sign a guarantee. Accordingly, the Company no longer guarantees the landlord’s mortgages.

 

13



 

Our audit committee is in the process of evaluating the 2004 lease.

 

 

 

 

 

 

 

 

 

 

14



 

Item 2. Management’s Discussion and Analysis of   Financial Condition and  Results of Operations
 
Three Month Period ended December  31, 2005 Compared to December 31, 2004
 

Results of operations for the three months ended December 31, 2005 compared to December  31, 2004  are as follows:

 

 

 

Three

 

Three

 

 

 

 

 

 

 

 

 

 

 

Months

 

Months

 

 

 

 

 

 

 

 

 

 

 

Ended

 

Ended

 

Variance

 

Percentage of sales

 

 

 

12/31/05

 

12/31/04

 

$

 

2005

 

2004

 

Variance

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

25,044,990

 

$

23,360,442

 

$

1,684,548

 

100.00

%

100.00

%

 

Cost of sales

 

19,813,206

 

18,049,079

 

1,764,127

 

79.11

%

77.26

%

1.85

%

Gross profit

 

5,231,784

 

5,311,363

 

(79,579

)

20.89

%

22.74

%

-1.85

%

Gross profit %

 

20.89

%

22.74

%

-1.85

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales & marketing

 

2,356,572

 

2,431,591

 

(75,019

)

9.41

%

10.41

%

-1.00

%

Technical support

 

132,079

 

120,324

 

11,755

 

0.52

%

0.52

%

0.00

%

General & administrative

 

824,818

 

875,140

 

(50,322

)

3.29

%

3.75

%

-0.46

%

SG&A stock compensation expense

 

67,601

 

 

67,601

 

0.28

%

0.00

%

0.28

%

Total selling, general and administrative expenses

 

3,381,070

 

3,427,055

 

(45,985

)

13.50

%

14.68

%

-1.18

%

Research & development

 

760,724

 

557,530

 

203,194

 

3.04

%

2.39

%

0.65

%

Research and development stock compensation expense

 

33,277

 

 

33,277

 

0.13

%

0.00

%

0.13

%

Total operating expenses

 

4,175,071

 

3,984,585

 

190,486

 

16.67

%

17.07

%

-0.40

%

Net operating income

 

1,056,713

 

1,326,778

 

(270,065

)

4.22

%

5.67

%

-1.45

%

Other income

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

5,206

 

1,511

 

3,695

 

0.02

%

0.01

%

0.01

%

Foreign currency

 

964

 

(8,600

)

9,564

 

0.00

%

-0.04

%

0.04

%

Total other income (loss)

 

6,170

 

(7,089

)

13,259

 

0.02

%

-0.03

%

0.05

%

Income before taxes

 

1,062,883

 

1,319,689

 

(256,806

)

4.25

%

5.64

%

-1.39

%

Taxes on income

 

42,411

 

56,000

 

(13,589

)

0.17

%

0.24

%

-0.07

%

Net income

 

$

1,020,472

 

$

1,263,689

 

$

(243,217

)

4.08

%

5.40

%

-1.32

%

 

15



 

Net sales for the  three  months ended December 31, 2005  increased $1,684,548 over the three months ended December 31, 2004 as shown in the table below.

 

 

 

Three Months

 

Three Months

 

Increase (Decrease)

 

Increase
(Decrease)

 

Sales by Geographic
region

 

Location

 

Ended 12/31/05

 

Ended 12/31/04

 

Dollar Variance

 

Variance %

 

2005

 

2004

 

Domestic

 

10,204,935

 

8,853,575

 

1,351,360

 

15

%

41

%

38

%

Europe

 

14,176,926

 

14,149,483

 

27,443

 

0

%

56

%

60

%

Asia

 

663,129

 

357,384

 

305,745

 

86

%

3

%

2

%

Total

 

$

25,044,990

 

$

23,360,442

 

$

1,684,548

 

7

%

100

%

100

%

 

The primary factors contributing to the sales increase were:

 

                  Sales of  hybrid video recorder retail product

 

                  Sales of hybrid video recorder OEM product

 

                  Introduction of the hybrid video recorder stick

 

                  Increase in Nova-T-PCI/USB digital product sales

 

                  Increase in PVR-PCI retail  sales

 

                  Increase in our average  Euro to USD contract  rate of about 4.36% (1.2731 versus 1.2199) for the three  months ended December 31, 2005 compared to the three months ended  December 31, 2004, which yielded higher converted Euro to USD sales

 

Offsetting some of the sales increases were:

 

                  Decrease in Digital entertainment center (DEC) sales

 

                  Decrease in PVR-PCI-OEM sales

 

                  Decrease in USB  analog sales

 

                  Decrease in PCI analog  sales

 

                  Decrease in PVR-USB sales

 

                  Decrease in Media MVP sales

 

Net sales to domestic customers were 41% of net sales for the three months ended December 31, 2005 compared to 38% for the three months ended December 31, 2004. Net sales to European customers were 56% of net sales compared to 60% for the same period of last year. Net sales to Asian  customers were 3% for the three months ended December 31, 2005 compared to  2% for the three months ended December 31,  2004.

 

16



 

Gross profit decreased  $79,579 for the three months ended December  31, 2005 compared to the prior year’s first quarter.

 

The increases and (decreases) in  the gross profit are detailed below:

 

 

 

Increase

 

 

 

(decrease)

 

Increased sales

 

$

499 225

 

Higher gross profit on retail sales mix

 

114,883

 

Effect on gross profit due to sales mix of OEM sales

 

(431,484

)

Due to increases in labor related and other costs

 

(262,203

)

Total decrease in gross profit

 

$

(79,579

)

 

Gross profit percentage for the  three months ended  December  31, 2005  was  20.89% compared to 22.74% for the  three months ended December 31, 2004, a decrease of 1.85%.

 

The increases and (decreases) in  the gross profit  percent are detailed below:

 

 

 

Increase

 

 

 

(decrease)

 

Higher gross profit on retail sales mix

 

0.62

%

Effect on gross profit due to lower margin OEM sales

 

(1.89

)%

Labor related and other costs

 

(0.58

)%

Net decrease in gross profit %

 

(1.85

)%

 

The decrease  in the gross profit percent of 1.85 % for the three months ended December 31, 2005 compared to the three months ended  December 31, 2004 was primarily due to:

 

                                          Sales growth of lower gross profit OEM sales contributed to a 1.89% decrease in gross profit. The percentage of OEM sales for the three months ended December 31, 2005 increased  over the three months ended December 31, 2004. OEM sales require less sales, advertising and product support than retail sales, but the  gross profit for OEM sales is lower than our retail products.

 

                                          Favorable sales mix of higher gross profit retail sales contributed to a 0.62% increase in gross profit.

 

                                          Labor related and other costs contributed to a  0.58% decrease  in gross profit percent compared to three months ended December 31,  2004. The increase in net sales was  about 7% while the  increase in labor related and other costs was about  16%.

 

17



 

The chart below illustrates the components of selling, general and administrative expenses:

 

 

 

Three months ended December 31,

 

 

 

 

 

 

 

 

 

Dollar Costs

 

Increase

 

Percentage of Sales

 

Increase

 

 

 

2005

 

2004

 

(Decrease)

 

2005

 

2004

 

(Decrease)

 

Sales and marketing

 

$

2,356,572

 

$

2,431,591

 

$

(75,019

)

9.41

%

10.41

%

-1.00

%

Technical support

 

132,079

 

120,324

 

11,755

 

0.52

%

0.52

%

0.00

%

General and administrative

 

824,818

 

875,140

 

(50,322

)

3.29

%

3.75

%

-0.46

%

SG&A stock compensation expense

 

67,601

 

 

67,601

 

0.28

%

0.00

%

0.28

%

Total

 

$

3,381,070

 

$

3,427,055

 

$

(45,985

)

13.50

%

14.68

%

-1.18

%

 

Selling, general and administrative expenses decreased $45,985 from the prior year’s first quarter. As a percentage of sales, selling, general and administrative expenses decreased by 1.18%  when compared to the three months ended December 31, 2004.

 

The decrease in sales and marketing expense of $75,019,  was mainly due to:

 

                                          Lower advertising and promotional  expenses of $107,380

 

                                          Increased commission expense of $8,335 due to higher sales

 

                                          Increased compensation due to increases in  European and  Asian  outside sales rep cost  of $32,612

 

The decrease in general and administrative expenses of $50,322 was primarily due to:

 

                                          Lower banking service cost due to higher interest  rates on cash balances lowered costs by $ 26,270

 

                                          Lower legal fees of $30,426 as a result of lower non recurring  fees

 

Research and development expenses increased $203,194. The increase was mainly due to

 

                                          Higher compensation costs of $79,529 due to the hiring of   additional engineering management and staff personnel

 

                                          Increased program development  costs of $120,738 due to higher volume of new product and product enhancement programs

 

Reflected in operating expenses for the three months ended December 31, 2005 was $67,601 charged to sales, general and administrative and $33,277 charged to research and development expenses for a total of  $100,878 in stock compensation expenses related to the issuance of stock options.

 

18



 

Stock-Based Compensation costs

 

Prior to October 1, 2005, the Company accounted for employee stock option plans based on the intrinsic value method in accordance with Accounting Principles Board   (APB) Opinion No. 25, “ Accounting for Stock Issued to Employees,” and related  Interpretations and had adopted the disclosure requirements of SFAS No. 123, “ Accounting for Stock-Based Compensation” (SFAS No.123). Accordingly, compensation cost for stock options was measured as the  excess, if any, of the quoted market price of the Company’s stock at the grant  date over the amount an employee must pay to acquire the stock. The Company    granted stock options with exercise prices equal to the market price of the underlying stock on the date of grant, therefore, the Company did not record  stock-based compensation expense under APB Opinion No. 25.

 

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS  No. 123R, “ Share-Based Payments” to require that compensation cost relating to  share-based payment arrangements be recognized in the financial statements. Effective October 1, 2005, the Company adopted SFAS No. 123R using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the  service period for awards expected to vest. Therefore, prior period financial statements have not been restated. The fair value of stock options were determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for stock options in footnote disclosures required under SFAS No. 123. Such fair value is recognized as expense over the service period, net of estimated  forfeitures. The adoption of SFAS No.123R resulted in no cumulative change in  accounting as of the date of adoption.

 

Reflected in operating expenses for the three months ended December 31, 2005 was $67,601 charged to sales, general and administrative and $33,277 charged to research and development expenses for a total of  $100,878 in stock compensation expense related to the issuance of stock options.

 

Other income (expense)

 

Net other income for the three months ended December 31, 2005  was  $6,170 compared to net other expense  of $7,089 for the three months ended  December 31, 2004 as detailed below:

 

 

 

 

Three months ended December 31,

 

 

 

2005

 

2004

 

Interest income

 

5,206

 

1,511

 

Foreign currency transaction gains (losses)

 

964

 

(8,600

)

Total other income (expense)

 

$

6,170

 

$

(7,089

)

 

19



 

Re-measurement  of accounts denominated in currencies other than the Euro

 

We follow  the rules  prescribed in paragraph 16 of SFAS 52 “Foreign Currency Translation”, which states that accounts denominated in a currency other than an entities functional currency, excluding inter-company accounts which are long term in nature,  need to be re-measured into the entities functional currency, and any gain or loss from this re-measurement are included in the determination of net income  and are booked as other income (loss) section  under  the description foreign currency transaction gains (losses).

 

Accumulated other comprehensive income (loss)

 

The Euro is the functional currency of our  European subsidiary, Hauppauge Digital Europe  Sarl. Assets and liabilities of this subsidiary are translated to U.S. Dollars at the exchange rate in effect at the end of  each reporting period, while equity accounts are translated to U.S. Dollars at the historical rate in effect at the date of the contribution. Operating results are translated  to U.S. Dollars at the average prevailing exchange rate for the period, with the exception of  sales which  are translated to U.S. Dollars at the average monthly forward exchange contract rate. The use of differing exchange rates results in foreign currency translation gains or losses. Since the Euro denominated  accounts on HDE Sarl’s  books result in a net asset position  (total Euro  assets are in excess of Euro  liabilities), an  increase in the Euro value results in a deferred gain while a decrease in the Euro value results in a deferred loss for the translation of   Euro accounts to U.S. Dollars. We had a translation gain of $546,352 recorded on the balance sheet  as of September 30, 2005. For the three months ended December 31, 2005, we recorded on the balance sheet translation losses of  $743,271 resulting in a translation loss of $196,919 recorded as a component of accumulated other comprehensive (loss) as of  December 31, 2005.

 

We use forward exchange contracts to reduce our exposure to fluctuations in foreign currencies. Mark to market gains and losses on these open contracts  result from the difference between the USD value of our open foreign currency forward contracts at the average contract rate as opposed to the same contracts translated at the month end forward rate. We qualify for  cash flow hedge accounting as prescribed  under SFAS 133, which allows us to record the mark to market gains and losses in the equity section of our balance sheet under accumulated other comprehensive income. We had  mark to market losses of $136,418  recorded on the balance sheet  as of September 30, 2005. For the three months ended December 31, 2005, we recorded, as component of other comprehensive income, a mark to market loss of  $104,138, resulting in a mark to market gain of $32,280  for  contracts open as of  December 31, 2005.

 

As stated above,  accumulated other comprehensive income (loss) consists  of two components:

 

                                          Translations gains  and losses

 

                                          FAS 133 mark to market gains and losses  on our open foreign exchange contracts

 

20



 

The table below  details the gains and losses recorded  for the components that make up accumulated other comprehensive  income (loss):

 

Accumulated other comprehensive income (loss)

 

Balance as of
Sept. 30, 2005

 

Oct. 2005 to Dec. 31
2005 losses

 

Balance as of
Dec. 31, 2005

 

Translation gains

 

$

546,352

 

$

(743,271

)

$

(196,919

)

FAS 133 mark to market adjustments

 

136,418

 

(104,138

)

32,280

 

 

 

$

682,770

 

$

(847,409

)

$

(164,639

)

 

Tax provision

 

Our net tax provision  for the three months  ended  December 31, 2005 and 2004 is as follows:

 

 

 

Three months ended December 31,

 

 

 

2005

 

2004

 

AMT Tax attributable to U.S operations

 

$

10,000

 

$

10,000

 

Tax expense European operations

 

27,411

 

41,000

 

State taxes

 

5,000

 

5,000

 

Net tax provision

 

$

42,411

 

$

56,000

 

 

For four out of the  last five fiscal years, our domestic operation has incurred losses. With the close of our fiscal first quarter of 2006,  we analyzed the future realization of our  deferred tax assets as of  December 31, 2005,  and although our domestic operation reported a profit for the three months ended December  31, 2005,  due to the seasonal nature of the business it is uncertain at this time whether our  domestic operation will have a profit for the full year. In light of this, we did not make any  adjustments to our  valuation allowance for the  quarter ended December 31, 2005.

 

As a result of all of the above items mentioned in this Management’s Discussion and Analysis of Financial Condition and Results of Operations,  we recorded  net income of  $1,020,472, for the three  months ended December 31, 2005, which resulted in basic net income per share of $0.11  and diluted net income per share of $0.10  on weighted average basic  and diluted shares of 9,508,100 and  10,015,547, respectively, compared to a net income of $1,263,689 for the three months ended December 31, 2004, which resulted in  basic net income per share of $0.14  and diluted net income per share of $0.13 on weighted average  basic and diluted shares of 9,277,944 and  9,949,381, respectively.

 

Options to purchase 92,876 and 98,757 shares of common stock, at prices ranging $3.88 to $ 8.75 and $5.25 to $10.06, were outstanding for the three months ended December 31, 2005 and 2004, respectively, but were not included in the computation of diluted earnings per share because they were anti-dilutive.

 

21



 

Seasonality

 

As our sales are primarily to the consumer market, we have experienced certain seasonal revenue trends. Our peak sales quarter, due to holiday season sales of computer equipment, is our first fiscal quarter (October to December), followed by our fourth fiscal quarter (July to September). In addition, our international sales, mostly in the European, market, were 54%, 66% and 68 % of sales for the years ended September 30,  2005, 2004 and 2003, respectively. Our fiscal fourth quarter sales (July to September) can be potentially impacted by the reduction of activity experienced in Europe during the July and August summer holiday period.

 

To offset the above cycles, we target a wide range of customer types in order to moderate the seasonal nature  of our  retail sales.

 

Liquidity and Capital Resources

 

Our cash, working capital and stockholders’ equity position as of  December  31, 2005 and September 30, 2005 is set forth below:

 

 

 

December 31, 2005

 

September 30, 2005

 

 

 

 

 

 

 

Cash

 

$

6,192,989

 

$

7,567,393

 

Working Capital

 

15,637,754

 

15,334,855

 

Stockholders’ Equity

 

16,239,514

 

15,941,492

 

 

We had cash and cash equivalents  as of  December 31, 2005 of  $6,192,989, a decrease  of  $1,374,404 from September 30, 2005.

 

22



 

The decrease  in cash was due to :

 

Sources of cash:

 

 

 

Net income adjusted for non cash items

 

$

1,167,807

 

Increase in accounts payable and accrued expenses

 

6,300,229

 

Decrease in prepaid expenses and other current assets

 

50,401

 

Proceeds from employee stock purchases

 

24,081

 

Less cash used for:

 

 

 

Increase in account receivables

 

(7,436,483

)

Effect of exchange rates on cash

 

(847,409

)

Increase in inventories

 

(591,450

)

Capital equipment purchases

 

(41,580

)

Net cash decrease

 

$

(1,374 404

)

 

Net cash of $509,496 used in  operating activities was primarily due to a increases in accounts receivable and  inventory    of $7,436,483 and $591,450, respectively, required to fund the 51.7% increase in sales between the fourth  quarter  of fiscal 2005 and the first quarter of fiscal 2006. These uses of cash were offset by increases in accounts payable and accrued expenses  of  $6,300,229, primarily used to finance  the growth in accounts receivable and inventory,   decreases in prepaid expenses and other current assets of $50,401 and  net income adjusted for non cash items of $1,167,807.

 

Cash of $41,580 was used to purchase fixed assets. Proceeds from the stock purchased by employees through  the exercise of options and the  employee stock purchase plan  provided  cash of $24,081 and the effect of  exchange rates used cash of $847,409.

 

On November 8, 1996, we approved a stock repurchase program. The program, as amended, authorizes us to repurchase up to 850,000 shares of our own stock. We intend to use the repurchased shares for certain employee benefit programs. On December 17, 1997, the stock repurchase program was extended by a resolution of our Board of Directors. As of December 31, 2005, we held 607,547 treasury shares purchased for $1,757,951 at an average purchase price of approximately $2.89 per share.

 

23



 

Line of Credit

 

On December 1, 2005, Hauppauge Computer Works, Inc. (“HCW”), a wholly-owned subsidiary of Hauppauge Digital, Inc. (the “Company”), entered into a $3,000,000  line of credit borrowing facility with the  JP Morgan Chase Bank, N.A. (the “Bank”). The line of credit is subject to renewal on March 31, 2006. The Company, at its option, may borrow money at the Prime Rate  minus one percent (1.0%) or  the adjusted Eurodollar Rate  plus one and 85/100 percent (1.85%).

 

In accordance with the terms of the line, the  Company has entered into a Guaranty with the Bank  and  has entered into a Share Pledge Agreement among the Company, the Bank and Hauppauge Digital Europe S.àr.l., a wholly owned subsidiary of the Company.

 

Pursuant to the Guaranty, the Company guarantees to the Bank the payment of all liabilities of HCW to the Bank, secured by a continuing lien and right of set-off for the amount of the liabilities of HCW to the Bank upon any and all monies, securities, property, deposits and credits of the Company with the Bank, J.P. Morgan Securities Inc. or any other affiliate of the Bank.

 

Pursuant to the Share Pledge Agreement, the Company granted a first priority right of pledge on approximately two-thirds of the outstanding capital shares of Digital Europe in favor of the Bank as security for the payment under the Note or the Share Pledge Agreement.

 

There were no borrowings outstanding as of  the filing date of this Quarterly  Report on Form 10-Q.

 

We believe that our cash and cash equivalents  as of  December 31, 2005, our internally generated cash flow and the line of credit we entered into on December 1, 2005  will provide us with sufficient liquidity to meet our currently foreseeable short-term and long-term capital needs.

 

Future Contractual  Obligations

 

The following table shows our contractual obligations related to lease obligations as of  December 31 , 2005:

 

 

 

Payments due by period

 

 

 

Total

 

Less than 1 year

 

1-3 years

 

3 to 5 years

 

Operating lease obligations

 

$

1,283,295

 

$

506,222

 

$

642,073

 

$

135,000

 

 

24



 

Critical Accounting Policies and Estimates

 

We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of the our financial statements:

 

                                          Revenue Recognition

 

                                          Management’s estimates

 

                                          Hedging program for European subsidiary inventory purchases denominated in U.S. dollars

 

                                          Translation of assets and liabilities  denominated in  non functional currencies on our European financial statements

 

Revenue Recognition

 

Our revenues are primarily derived from the sale of computer boards which enable you to view television programs on your personal computer. Sales of computer boards are commonly classified as computer hardware. Our sales are primarily to retailers, distributors and original equipment manufacturers. Sales to our customers are documented by a purchase order which describes the conditions of sale. Sales are recorded when products are shipped  to our  customers, the product price is  fixed and determinable, collection of the resulting receivable is probable and product returns are reasonably estimable. Revenue from freight charged to customers is recognized when products are shipped. Provisions for  customer returns and other adjustments are provided for in the period the related sales are recorded based upon historical data.

 

Management’s Estimates

 

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires  management to make estimates and judgments that affect the reported amounts of assets, liabilities  and related disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts for  revenues and expenses during the reporting period. On an ongoing basis, management evaluates estimates, including those related to sales provisions, as described above, income taxes, bad debts, inventory reserves  and contingencies. We base  our estimates on historical data, when available, experience, and on various other assumptions that are believed to be reasonable under the circumstances, the combined results of which form the basis for making judgments approximating   the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

 

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Hedging program for sales denominated in a foreign currency

 

For each of the past three fiscal years, at least 50 % of  our sales were generated by our European subsidiary and were:

 

                                          Invoiced in local currency-primarily the Euro

 

                                          Collected in local currency-primarily the Euro

 

On the supply side, since we predominantly deal with North American and Asian suppliers and contract manufacturers, approximately 75% of our inventory required to support our European sales are purchased and paid in U.S. Dollars.

 

The combination of sales billed in Euros supported by inventory purchased in U.S. dollars results in an absence of a natural local currency hedge. Consequently, our financial results are subject to market risks resulting from the fluctuations in the Euro  to  U.S. Dollar exchange rates.

 

We attempt to reduce these risks by entering into foreign exchange forward contracts with financial institutions. The purpose of these forward contracts is to hedge the foreign currency market exposures underlying the U.S. Dollar denominated inventory purchases  required  to support our European sales.

 

We do not try to hedge against all possible foreign currency exposures because of the inherent difficulty in estimating   the volatility of the Euro. The contracts we procure are specifically entered into to as a hedge against forecasted or  existing or  foreign currency exposure. We do not enter into contracts for speculative purposes. Although we maintain these programs to reduce the short term impact of changes in currency exchange rates,  long term strengthening or weakening of the U.S. dollar  against the Euro impacts  our  sales, our gross profit, operating income and retained earnings. Factors that could impact the effectiveness of our hedging program are:

 

                                          volatility of the currency markets

 

                                          availability of hedging instruments

 

                                          accuracy of our inventory forecasts

 

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Additionally, there is the risk that foreign exchange fluctuations will make our products less competitive in foreign markets, which would substantially reduce our sales.

 

Translation  of assets and liabilities denominated in non functional currencies on our European  financial statements

 

The functional currency of our European subsidiary is the Euro. In preparing our consolidated  financial statements,  we are required to translate  assets and liabilities denominated in a non functional currency,  mainly U.S. Dollars,  to Euros on the books of our European subsidiary. This process results in exchange gains and losses  depending on the changes in the Euro to U.S. Dollar exchange rate. Under the relevant accounting guidance, with the exception of gains and losses that are attributable to inter-company accounts which are long term in nature,  we are obligated to include these gains and losses on our  statement of operations, which  we report in other income or expense under  the description “foreign currency”. The extent of these gains and losses can fluctuate  greatly from month to month depending on the change in the exchange rate, causing results to vary widely. Due  to the  past  volatility of the Euro, it is difficult to forecast the long term trend of these gains and losses.

 

Inflation

 

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

 

Euro

 

On January 1, 1999, the Euro was adopted in Europe as the common legal currency among 11 of the 15 member countries of the European Community. On that date, the participating countries established fixed Euro conversion rates (i.e. the conversion exchange rate between their existing currencies and the Euro). The Euro now trades on currency exchanges and is available for non-cash transactions. A new European Central Bank was established to direct monetary policy for the participating countries.

 

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Prior to the adoption of the Euro, we billed our European customers in German Marks or British Pounds, depending upon which currency the customer preferred to be billed in. Effective January 1, 1999, we began invoicing our customers who are located in the eleven member countries in Euros. We continue to bill customers located in the United Kingdom in British Pounds. The benefits to billing customers in Euros were twofold:

 

                                          Our foreign currency hedging program was streamlined to the Euro and the British Pound

 

                                          The pricing from country to country was harmonized, eliminating price differences between countries due to the fluctuating local currencies

 

We handled the conversion to the Euro without any material disruptions to our operations.

 

Item  3. Quantitative and Qualitative Disclosures about Market Risks

 

For each of the past three fiscal years, at least 50 % of our sales were generated by our European subsidiary and were:

 

                                          Invoiced in local currency-primarily the Euro

 

                                          Collected in local currency-primarily the Euro

 

On the supply side, since we predominantly deal with North American and Asian suppliers and contract manufacturers,  approximately  75% of our inventory required to support  our European sales are purchased and paid in U.S. Dollars.

 

The combination of sales billed in Euros supported by inventory purchased in U.S. dollars results in an absence of a natural local currency hedge. Consequently, our financial results are subject to market risks resulting from the fluctuations in the Euro  to  U.S. Dollar exchange rates.

 

We attempt to reduce these risks by entering into foreign exchange forward contracts with financial institutions. The purpose of these forward contracts is to hedge the foreign currency market exposures underlying the U.S. Dollar denominated inventory purchases  required  to support our European sales.

 

We do not try to hedge against all possible foreign currency exposures because of the inherent difficulty in estimating   the volatility of the Euro. The contracts we procure are specifically entered into to as a hedge against forecasted or  existing or  foreign currency exposure. We do not enter into contracts for speculative purposes. Although we maintain these programs

 

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to reduce the short term impact of changes in currency exchange rates,  long term strengthening or weakening of the U.S. dollar  against the Euro impacts  our  sales, our gross profit, operating income and retained earnings. Factors that could impact the effectiveness of our hedging program are:

 

                                          volatility of the currency markets

 

                                          availability of hedging instruments

 

                                          accuracy of our inventory forecasts

 

Additionally, there is the risk that foreign exchange fluctuations will make our products less competitive in foreign markets, which would substantially reduce our sales.

 

As of December 31, 2005, the we had foreign currency contracts outstanding of approximately $1,928,150 against the delivery of the Euro. The contracts expire from January 2006 through February 2006. Our  accounting policy for these instruments designate such instruments as cash flow hedging transactions. We do not enter into such contracts for speculative purposes. We record all derivative gains and losses on the balance sheet as a component of stockholders’ equity under the caption “Accumulated other comprehensive income (loss)”. We recorded a  loss  of $104,138 for the three  months ended December 31, 2005 on our statement of other comprehensive income. As of  December 31,  2005, a deferred gain of $32,280 reflecting the cumulative  mark to market gains of our derivatives was recorded on the Company’s balance sheet as a component of accumulated other comprehensive income in our equity section.

 

We  use the average monthly forward contract exchange rate to translate our Euro denominated sales into the Company’s U.S. dollar reporting currency. For the three months ended  December 31, 2005, the use of the monthly average spot rate instead of the average monthly forward contract exchange rate to value Euro denominated sales would have resulted in a decrease in sales of $628,789 for the three months ended December 31, 2005.  These  sales increases  are related to contracts that closed during these periods and the changes in the fair value of our derivative contracts.  For the three months  ended  December 31, 2004, the use of the monthly average spot rate instead of the average monthly forward contract exchange rate to value Euro denominated sales would have resulted in a sales increase of $640,815.

 

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Item 4. Controls and Procedures

 

Our Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of  December 31, 2005 in alerting them in a timely manner to material information required to be included in our SEC reports. In addition, no change in our internal control over financial reporting occurred during the fiscal quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Special Note Regarding Forward Looking Statements

 

This Quarterly Report contains forward-looking statements as that term is defined in the federal securities laws. The events described in forward-looking statements contained in this Quarterly Report may not occur. Generally these statements relate to business plans or strategies, projected or anticipated benefits or other consequences of our plans or strategies, projected or anticipated benefits from acquisitions to be made by us, or projections involving anticipated revenues, earnings or other aspects of our operating results. The words “may,” “will,” “expect,” “believe,” “anticipated,” “project,” “plan,” “intend,” “estimate,” and “continue,” and their opposites and similar expressions are intended to identify forward-looking statements. We caution you that these statements are not guarantees of future performance or events and are subject to a number of uncertainties, risks and other influences (including, but not limited to, those set forth in our Annual Report on Form 10-K for the year ended September 30, 2005), many of which are beyond our control, that may influence the accuracy of the statements and the projections upon which the statements are based. Any one or more of these uncertainties, risks and other influences could materially affect our results of operations and whether forward looking statements made by us ultimately prove to be accurate. Our actual results, performance and achievements could differ materially from those expressed or implied in these forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether from new information, future events or otherwise. All cautionary statements made in this Annual Report should be read as being applicable to all related forward-looking statements wherever they appear.

 

PART II. OTHER INFORMATION

 

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

 

On November 8, 1996, we approved a stock repurchase program. The program authorizes us to repurchase up to 850,000 shares of our own stock. The stock repurchase program was extended by a resolution of our Board of Directors on December 17, 1997.

 

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The table below summarized repurchases of our common stock under our stock repurchase program:

 

 

 

 

 

 

 

 

 

Maximum

 

 

 

 

 

 

 

Total Number

 

Number

 

 

 

Total

 

Average

 

of Shares

 

of Shares

 

 

 

Number

 

Price

 

Purchased as

 

that May Yet

 

 

 

of Shares

 

Paid per

 

Part of Publicly

 

Be Purchased

 

Period

 

Purchased

 

Share

 

Announced Plan

 

Under the Plan

 

Purchases as of September 30, 2005

 

607,547

 

$

2.89

 

607,547

 

242,453

 

October 1 to December 31, 2005

 

-0-

 

-0-

 

-0-

 

-0-

 

Purchases as of December 31, 2005

 

607,547

 

$

2.89

 

607,547

 

242,453

 

 

Item 6. Exhibits

 

(c) Exhibits

 

31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2 Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

32   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

 

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SIGNATURES

 

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

 

 

HAUPPAUGE DIGITAL INC.

 

Registrant

 

 

 

 

 

Date:

February 14, 2006

 

 

By

/s/ Kenneth Plotkin

 

 

KENNETH PLOTKIN

 

 

Chief Executive Officer, Chairman of the Board, Vice

 

 

President of Marketing (Principal Executive Officer)

 

 

and Director

 

 

 

 

Date:

February 14, 2006

 

 

By

/s/ Gerald Tucciarone

 

 

 

GERALD TUCCIARONE

 

 

Treasurer, Chief Financial Officer and Secretary

 

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