Directed Electronics (DEIX)

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

For the fiscal year ended December 31, 2007

Commission File Number 000-51664

 

 

Directed Electronics, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

 

(760) 598-6200

(Registrant’s telephone number, including Area code)

 

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

 

 

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

 

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o     No þ

 

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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

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

 

The aggregate market value of common stock held by non-affiliates of the registrant (15,298,264 shares) based on the closing price of the registrant’s common stock as reported on the Nasdaq Stock Market on June 30, 2007, which was the last business day of the registrant’s most recently completed second fiscal quarter, was $135,263,654. For purposes of this computation, all officers, directors, and 10% beneficial owners of the registrant are deemed to be affiliates. Such determination should not be deemed to be an admission that such officers, directors, or 10% beneficial owners are, in fact, affiliates of the registrant.

 

As of March 10, 2008, there were outstanding 25,452,337 shares of the registrant’s common stock, par value $.01 per share.

 

Documents Incorporated by Reference

 

Portions of the registrant’s definitive proxy statement for the 2008 Annual Meeting of Shareholders are incorporated by reference into Part III of this report.

 

 

DIRECTED ELECTRONICS, INC.

ANNUAL REPORT ON FORM 10-K
Fiscal Year Ended December 31, 2007

TABLE OF CONTENTS

 

 

Directed^®, Viper^®, Polk Audio^®, Definitive Technology^®, Clifford^®, Python^®, Orion^®, Precision Power^®, I-Sonic^®, Avital^®, Valet^®, Hornet^®, Automate^®, No One Dares Come Close^®, Responder^®, Astroflex^®, Autostart^®, Cobalt^® and The Speaker Specialist^® are registered United States trademarks of Directed Electronics, Inc. or one of its wholly owned subsidiaries; and Ready Remotetm and The Science of Security^tm are an unregistered trademarks of Directed Electronics, Inc. or one of its wholly owned subsidiaries. Other trademarks, service marks, and trade names appearing in this report are the property of their respective holders.

 

Statement Regarding Forward-Looking Statements

 

The statements contained in this report on Form 10-K that are not purely historical are forward-looking statements within the meaning of applicable securities laws. Forward-looking statements include statements regarding our “expectations,” “anticipation,” “intentions,” “beliefs,” or “strategies” regarding the future. Forward-looking statements relating to our future economic performance, plans and objectives for future operations, and projections of revenue and other financial items, are based on our beliefs as well as assumptions made by us and information currently available to us. Actual results could differ materially from those currently anticipated as a result of a number of factors, including those discussed in Item 1A, “Risk Factors.”

 

 

Introduction

 

We believe we are the largest designer and marketer in North America of premium home theater loudspeakers, consumer branded vehicle security, and remote start systems, and we believe we are the largest supplier of aftermarket satellite radio receivers, based upon sales. We are also a major aftermarket supplier of mobile audio and mobile video systems. In the home audio market, we design and market award-winning Polk Audio^® and Definitive Technology^® premium loudspeakers. Our broad portfolio of vehicle security, remote start, and GPS tracking systems are sold under leading brands including Viper^®, Clifford^®, Python^®, Autostart^®, and Astroflex^®. Our mobile audio and video products include speakers, subwoofers, amplifiers, and video screens sold under our Polk^®, Orion^®, Precision Power^®, Directed^®, and Automate^® brand names.

 

We have grown our business organically as well as through strategic acquisitions and partnerships, which has resulted in expanding our product offerings, distribution channels, and base of contract manufacturers. We also increased our business by entering into an arrangement with SIRIUS Satellite Radio Inc. in 2004 to sell and market SIRIUS-branded satellite radio products, thus increasing our penetration of national electronics retailers and further diversifying our product mix. We have a demonstrated track record of identifying and acquiring businesses such as our acquisition of Polk Holding Corp. in 2006.

 

We sell our products through numerous distribution channels, including independent specialty retailers, national and regional retail electronics chains, mass merchants, automotive parts retailers, car dealers, regional distributors, and international distributors. In 2007, we sold to over 10,000 storefronts. We have exclusive rights to market and sell certain SIRIUS-branded satellite radio receivers and accessories to our existing U.S. retailer customer base. We also sell products directly to SIRIUS Satellite Radio for direct to consumer resale.

 

We have a proven track record of enhancing our existing products and developing innovative new products, as evidenced by the 57 Consumer Electronics Association innovation awards we have earned. We hold an extensive portfolio of patents, primarily in vehicle security and also in audio. We license a number of these patents to leading automobile manufacturers and electronics suppliers, which provides us with an additional source of income. We outsource all of our manufacturing to third parties located primarily in Asia. We believe this manufacturing strategy supports a scalable business model, reduces our capital expenditures, and allows us to concentrate on our core competencies of brand management and product development.

 

We were founded in 1982 and incorporated in Florida in 1999. We maintain our executive offices at 1 Viper Way, Vista, California 92081, and our telephone number is (760) 598-6200. Our website is located at www.directed.com. Through our website, we make available free of charge our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, our proxy statements, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These reports are available as soon as reasonably practicable after we electronically file those reports with the United States Securities and Exchange Commission, or the “SEC”. We also post on our website the charters of the audit, compensation, and nominations committees; our Code of Conduct, and our Code of Ethics for the Chief Executive Officer and Senior Financial Officer, and any amendments or waivers thereto; and any other corporate governance materials contemplated by SEC or The Nasdaq Stock Market regulations. These documents are also available in print to any shareholder requesting a copy from our corporate secretary at our principal executive offices. You may also find our annual, quarterly and current reports and other information filed with the SEC. You may read and copy any documents that we file at the SEC’s public reference room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information about the public reference room. In addition, the SEC maintains an Internet website (www.sec.gov) that contains reports and other information about issuers that file electronically with the SEC, including our company.

Industry

 

We compete within selected categories in the wholesale consumer electronics industry, which was estimated to be approximately $160 billion in 2007. The consumer electronics industry is large and diverse and encompasses a broad range of products. The introduction of new products and technological advancements are the major growth drivers in the electronics industry. We currently have one reportable segment which is organized by product category. The categories in which we currently participate are security and entertainment and satellite radio products. The security and entertainment category includes aftermarket vehicle security and convenience, home audio, mobile audio, and mobile video products.

 

Security and Convenience.  Security products consist of vehicle alarm systems designed to deter theft of both vehicles and vehicle contents. Convenience products allow drivers to perform various functions remotely, such as starting a vehicle in order to heat or cool it prior to driving or remotely locking or unlocking the vehicle. Hybrid devices have the capability to control both security and convenience functions. These markets continue to be characterized by technical innovation. Recent product introductions include long range two-way security systems, which report vehicle status to the user via an LCD screen on the remote, and GPS tracking systems, which allow for vehicle locating and tracking via the telephone or internet.

 

Home Audio.  We participate in the premium home loudspeaker market, a category within the separate home audio components wholesale market. There are a number of well entrenched competitors in this market. Growth in this category has been driven by increased consumer demand for home audio products that complement flat screen televisions and consumer desire to have a home theater experience in their homes. A growing segment of this market includes docking stations for portable MP3 players.

 

Mobile Audio.  We participate in a portion of the total mobile audio wholesale aftermarket that consists of speakers, subwoofers, and amplifiers. The market in which we participate generally offers higher margins than the “head units” used to control the audio system and play CDs. More than 100 companies participate in this portion of the market.

 

Mobile Video.  We participate in the mobile video wholesale aftermarket. This category consists of video systems installed in the vehicle to provide entertainment such as video and games for passengers in the rear of the vehicle.

 

Satellite Radio.  Satellite radio service provides music, entertainment, and information programming on a subscription basis. There are currently two satellite radio service providers operating in the United States, SIRIUS Satellite Radio and XM Radio. In February 2007, SIRIUS and XM Radio announced a definitive agreement pursuant to which SIRIUS and XM Radio will combine their businesses. SIRIUS and XM Radio shareholders have approved the transaction, but it requires government approval. These companies focus on providing the programming and have partnered with hardware suppliers to sell the hardware used to receive satellite broadcasts. We have exclusive rights to market and sell certain SIRIUS-branded satellite radio receivers and accessories to our existing U.S. retailer customer base. We also sell satellite radio products directly to SIRIUS. The target market for satellite radio includes more than 200 million registered vehicles and over 100 million households in the United States. Satellite radio has experienced dramatic subscription growth in the past 5 years. While the rate of subscription growth has slowed, as of December 31, 2007, SIRIUS reported more than 8.3 million subscribers.

 

Our Competitive Strengths

 

We believe that the following key competitive strengths will contribute to our continued success:

 

Strong Market Positions

 

Over time, we have leveraged our security and convenience platform to enter other complementary product categories in which we have also built strong market positions. We acquired Definitive Technology, LLP in 2004, which significantly increased our home audio product sales. Combining our existing Definitive Technology sales with sales from our 2006 acquisition of Polk Holding Corp., we believe we have gained the number one market share in North America of premium home theater loudspeakers based on sales. We believe we have achieved the leading aftermarket share in satellite radio hardware through our relationship with SIRIUS to distribute SIRIUS-

branded receivers. We also expanded our security and convenience product sales and established direct sales in Canada through our acquisitions of Astroflex, Inc., Autostart, and Trilogix Electronic Systems, Inc.

 

We believe our extensive portfolio of 164 patents and 184 U.S. and 340 foreign trademark registrations, and our proprietary database of approximately 6,000 vehicle wiring diagrams, help protect our position in the security and convenience market. Furthermore, we believe that the customer service and technical service we provide contribute to maintaining our strong market positions. We also believe our extensive distribution network and relationships with specialty and national retailers give us an advantage over our competitors.

 

Broad Portfolio of Established Brands

 

We believe our portfolio of established brands is a significant competitive strength. We believe our core brands are well-known and desired by important retailers of consumer electronics as well as by consumers. Our Viper, Python, and Clifford brands enjoy a high-quality reputation and substantial consumer awareness. We have expanded our broad portfolio of brands to include Polk Audio, Definitive Technology, Autostart, Astroflex, Orion, Precision Power, Directed, and Automate to target specific product categories or distribution channels within our markets. In the satellite radio market, SIRIUS enjoys high brand recognition among consumers. We believe this diverse portfolio of brands positions us to compete effectively in the most attractive segments of our various markets.

 

Highly Diverse Customer Base

 

Our products are sold domestically and internationally through numerous channels, including independent specialty retailers, national and regional electronics chains, mass merchants, automotive parts retailers, distributors, and car dealers. We believe our diverse network of over 10,000 storefronts is a competitive strength. We have built strong relationships with the larger national and regional electronics retailers, and we have well-established relationships with thousands of independent retailers.

 

Our products appeal to a broad demographic base of consumers, who are widely distributed across age, gender, marital status, income, and educational levels. In addition, consumers have our security and convenience, mobile audio, and mobile video products installed into a wide range of vehicle makes, models, and model years. We believe that our broad and diverse retailer and consumer bases limit our exposure to any particular segment of our markets and provide a strong platform for growth.

 

Attractive Retailer Proposition

 

We believe our premium brands such as Viper, Python, Clifford, Polk Audio, and Definitive Technology provide retailers with attractive gross margins. Our products are also supported by value-added technical service and an efficient supply chain. We believe our attractive retailer proposition is a critical competitive advantage because retailers typically have significant influence on customer buying decisions in our markets.

 

Scalable, Outsourced Manufacturing Model

 

We outsource nearly 100% of our manufacturing activities to third parties located primarily in Asia. This outsourced manufacturing model requires minimal capital expenditures, which have averaged approximately 1% of sales annually over the past five years. By outsourcing manufacturing, we have the ability to scale our business appropriately in response to changing market conditions. We believe this “asset-light” business model also allows us to focus on our core competencies of brand management and product development while maintaining attractive financial metrics such as high sales per employee.

 

Strong Executive Team with Experience Managing Growth

 

Our senior management team has over 100 years of collective consumer electronics industry experience. The variety of depth of relevant industry experience possessed by Directed’s management team is a key advantage. Collectively, our executives have over 60 years of service at our company, which has been a key factor in our success in establishing long-lasting and valuable relationships with our partners throughout the value chain.

Our Strategy —

 

We intend to further enhance our position as a leading designer and marketer of innovative, branded consumer electronics products. Key elements of our strategy include the following:

 

Leverage Successful Multi-Brand Strategy

 

Our successful multi-brand strategy is a key component of our future growth plans. In security and entertainment products, we believe our Viper, Python, Clifford, Polk Audio, Definitive Technology, Orion, and other brands position us to increase our sales in this profitable market across multiple distribution channels. In our security and entertainment businesses, we believe it will be critical for us to manage and enhance our brand portfolio. As we grow these businesses and increase their penetration within our distribution channels, we intend to utilize, where appropriate, the multi-brand approach that has been successful for us in our security and convenience category. We believe this multi-brand strategy should allow us to grow our existing brands and leverage them into new product categories and distribution channels.

 

Increase Product Penetration

 

We intend to continue increasing the penetration of our products within our existing customer network. Key elements of this strategy are marketing programs that enable better focus on specific product assortments at strategic times of the year and provide additional merchandising benefits.

 

Develop New and Enhanced Products

 

We plan to leverage our expertise in product design and development, our strong intellectual property platform, and our diverse distribution network by continuing to develop and introduce new and enhanced products in our higher margin security and entertainment categories. We plan to grow our security and convenience product sales by continuing to improve our market position in this category. We plan to do this by innovating our core alarm and remote start products by making cosmetic improvements, adding new features, enhancing the battery life, extending the range of the remotes, and by making our products simpler to install. We are also considering expanding our current addressable market by entering into adjacent categories that leverage our technical competencies in RF design and sensor development. We also plan to grow our Polk Audio and Definitive Technology home audio sales with core speaker product development and expansion into related speaker and electronics products such as tabletop radios, iPod docks, outdoor speakers, and custom installation products.

 

Expand Distribution Channels

 

We intend to broaden the distribution of our products by expanding our distribution channels, both domestically and internationally.

 

 

Generate Free Cash Flow to Retire Debt

 

Over the past two years, we have used cash flow to fund working capital investments, principally for our satellite radio business and to complete key strategic acquisitions. With the downturn in the satellite radio business, we have begun to deleverage our balance sheet by retiring debt. In 2007, we reduced our debt, including our revolver and senior notes, by approximately $75.0 million. We plan to continue to focus on working capital initiatives and the integration of our acquisitions in order to realize operating synergies that will allow us to utilize free cash flow to retire debt in the future.

 

Product Lines

 

We categorize our sales as security and entertainment products and satellite radio products. Within the security and entertainment category, we sell products in security and convenience, home audio, mobile audio, and mobile video. Over the course of our history, we have continuously expanded our product offerings through a combination of internally developed product innovation and acquisitions.

 

Security and Entertainment

 

Within the security and entertainment category, we sell products in vehicle security, vehicle remote start and convenience, home audio, mobile audio, and mobile video.

 

Security and Convenience.  We believe we are the largest designer and marketer in North America of consumer branded vehicle security, vehicle remote start, and convenience systems. We offer a full range of products and accessories at various price points. Major products include the following:

 

 

Our security and convenience products offer consumers significant benefits over traditional keyless entry devices, including two-way communication, advanced LCD and LED key fob monitoring devices, high-range Responder radio frequency technology, and more comprehensive control of vehicle systems (such as climate control, locks, diagnostics, and audio systems).

 

Our vehicle security and convenience products are marketed under a number of brands, including the following:

 

Home Audio.  We sell a full line of high-end home loudspeakers under our Definitive Technology and Polk Audio brand names. We believe the combined sales of these brands now represent the number one market share position in the United States. Both Polk Audio and Definitive Technology have established strong positions in the market through a legacy of high performance products with patented technologies, impactful consumer advertising, and favorable product reviews. We currently market the following home audio products:

 

 

Mobile Audio.  We sell mobile audio products under the Polk Audio, Orion, and Precision Power brands. This multi-brand strategy provides us with the ability to offer products at a variety of price points and to target consumers in a number of distinct demographic groups. We offer an extensive selection of high-performance mobile audio products and concentrate on the higher margin categories of the mobile audio market, including the following:

 

 

Mobile Video.  We market a variety of mobile video systems and related accessories. Over the years, we have distinguished our video offerings through the design of desirable features such as detachable and larger screens, headrest units that simplify installation, “all-in-one” overhead units, and a “dockable” DVD player for use in both a vehicle overhead unit and in the home. The majority of our mobile video products are currently sold in mobile specialty retailers under our Directed brand. We currently offer the following products:

 

 

Satellite Radio

 

SIRIUS, a satellite radio company providing over 130 channels of primarily commercial-free music, sports, information, and entertainment, selected us in 2004 as a strategic partner to exclusively market, sell, and distribute certain SIRIUS-branded products. SIRIUS provides and delivers the satellite radio content, and we market and distribute SIRIUS-branded electronic devices that receive and play that content. SIRIUS-branded satellite radio receivers are designed and developed by SIRIUS and manufactured by our contract manufacturers to specifications provided by SIRIUS.

 

We have an agreement with SIRIUS pursuant to which we have exclusive U.S. distribution rights for certain SIRIUS-branded products to our existing U.S. retailer customer base through August 2008. The SIRIUS-branded products that we distribute include the following:

 

 

Distribution

 

Our products are sold through numerous domestic and international channels, including independent specialty retailers, national and regional electronics chains, mass merchants, automotive parts retailers, car dealers, and distributors. We also sell products directly to SIRIUS Satellite Radio for direct to consumer resale on www.sirius.com.

 

Specialty Retailers

 

Mobile specialty retailers are the primary distribution channel for mobile electronics products in the United States. The majority of our independent retailers operate two or fewer locations. We supply mobile specialty retailers with a wide range of security brands from premium Viper, Python, and Clifford products to promotional and do-it-yourself devices under the Valet, Hornet, Avital, and Ready Remote brands. We believe that these retailers should remain an attractive distribution channel for us due to our long-term relationships and their focus on customer service.

 

We provide home audio specialty retailers with a variety of premium home loudspeakers. Similar to our relationship with our mobile retailer network, we are an important supplier to our home audio specialty retailers due to the relatively healthy margins they earn on our Definitive Technology and Polk Audio home audio products.

 

National and Regional Electronics Chains

 

We believe that national and regional electronics chains enable us to efficiently broaden our distribution and scale our business. Accordingly, we have devoted significant resources to increase our penetration with large national and regional chains such as Best Buy, Circuit City, and Magnolia Audio Video. We believe that our history with both Best Buy and Circuit City illustrates the opportunities that are available in this channel.

 

Mass Merchants and Automotive Parts Retailers

 

We believe that mass merchants and automotive parts retailers represent a meaningful opportunity to expand our sales. We currently sell our DIY remote start products and satellite radio products through these channels. As consumer awareness of these products increases, we believe that the mass merchant and automotive parts retailer channels could become an increasingly important part of our distribution strategy. In 2007, we continued to pursue

opportunities with mass merchants and automotive parts retailers, while preserving brand differentiation of our premium products to protect our existing retailer base.

 

Car Dealers

 

We market a wide range of security and convenience products to car dealers both directly and through expeditors contracted to perform installation. Our car dealer customers are generally able to realize higher profit margins when they install our aftermarket products compared to their margins on OEM-installed options.

 

International Distribution

 

We sell our products internationally through our Canadian subsidiaries, U.K. office, and international distributors in 77 countries. We believe there is a significant opportunity to expand our international distribution and that many of the same factors that have driven the growth of our business in the United States could also benefit our international business. Our international growth strategy includes appointing new distributors and working with our security and convenience customers to sell additional product categories. We have established a direct sales force in the United Kingdom, Canada, Asia, and Latin America. We believe that the emerging Chinese automotive market represents a promising long-term consumer market opportunity for our products. Our international sales were approximately $56.1 million in 2007. Our international sales comprised approximately 14% of our 2007 net product sales and 19% of our gross security and entertainment product. Our Canadian sales were approximately 9% of our total net sales. Other than Canada, no single foreign country accounted for more than 1% of our net product sales in 2007.

 

Customers

 

We sell our products to independent specialty retailers, national and regional electronics chains, mass merchants, automotive parts retailers, car dealers, and international distributors. For the year ended December 31, 2007, other than sales to Best Buy, Circuit City, and SIRIUS, no customer accounted for more than 3% of our net product sales. Best Buy, including its subsidiary Magnolia Audio Video, accounted for approximately 21% and Circuit City accounted for approximately 10% of our net product sales for the year ended December 31, 2007. We also sell products directly to SIRIUS Satellite Radio for direct to consumer resale on www.sirius.com. Our sales directly to SIRIUS accounted for approximately 8% of our net product sales for the year ended December 31, 2007.

 

Sales and Marketing

 

We market our products through a direct sales force and through independent sales representatives. Our extensive in-house marketing operation supports our sales force with a comprehensive advertising campaign that includes tradeshows, public relations, point-of-purchase displays, co-marketing and cross-selling initiatives, advertising, and product placement. One of our most important marketing events is our participation in the annual Consumer Electronics Show in Las Vegas, Nevada. Our sales force is focused on encouraging retailers to carry a wide selection of our products and has successfully sold new product categories to our existing retailer base. We have developed the slogan “The Brand Above” to describe the Directed Electronics name and connote our multi-brand strategy. We use “The Brand Above” slogan to market our company to current and potential retailer partners.

 

Our chief executive officer and other key executives directly manage our relationships with Best Buy, Circuit City, and SIRIUS. We utilize direct sales employees except where the geography or lack of retailer density in a particular area makes the use of independent sales representatives more cost effective. We also maintain our own credit staff that reviews new customers for suitability and monitors customer accounts.

 

We believe that consumer awareness of products is important to our future growth and, therefore, we also devote significant effort and expense to consumer education. We believe that relatively few consumers are aware of the limitations of factory-installed security devices, such as kill switches and keyless entry, or the benefits of the more advanced security and convenience features available in the aftermarket. We offer consumers and retailers reliable and comprehensive information about our product offerings and customer services at our corporate website, located at www.directed.com, which contains links to all of our brand websites.

Outsourced Manufacturing and Assembly

 

We outsource the manufacturing and assembly of essentially all of our products to contract manufacturers primarily located in Asia. We perform frequent on-site inspections and quality audits of these manufacturers. We maintain a support office in Hong Kong to manage our supply chain, including contract negotiations with, and quality and production from, our suppliers. We believe our manufacturing strategy supports a scalable business model, reduces our capital expenditures, and allows us to concentrate on our core competencies of brand management and product development.

 

Four of our suppliers accounted for a significant portion of our total inventory purchases. Two of these suppliers manufacture SIRIUS satellite radio receivers in Taiwan and China. Satellite radio receivers are manufactured by several suppliers in Asia and we believe these products can readily be sourced from other suppliers. We have built an extensive and mutually beneficial supply relationship with our largest security and convenience supplier that has lasted nearly 20 years, and we believe that we are by far their largest customer. Our largest supplier of home audio products also accounted for a significant portion of our purchases. We currently receive products from and are engaged in ongoing discussions with numerous other offshore suppliers in order to further expand our outsourcing relationships.

 

We have written agreements with most of our contract manufacturers that specify lead times and delivery schedules but we do not have long-term (more than one year) arrangements with any of our contract manufacturers that guarantee production capacity or prices.

 

Through our supply chain management and product development process, we often identify and negotiate directly with the suppliers who provide certain key components and materials to our contract manufacturers. In this way, we are able to better control the cost of our products while simultaneously reducing our dependence on our contract manufacturers through the establishment of direct relationships with suppliers of certain key components and materials.

 

Product Development and Engineering

 

We focus our product development and engineering efforts primarily on enhancing existing products and creating new products. At December 31, 2007, we employed 70 in-house staff that specialize in product development and engineering, specifically within the areas of radio frequency, bypass/data-bus module, industrial, mechanical, audio circuit design, and transducer (speaker) design. We also use contract engineers on a project basis when appropriate. We have earned 57 Consumer Electronics Association innovation awards and have consistently maintained ISO 9001 certification at our Vista, California headquarters location.

 

Our product development and engineering efforts are a collaborative enterprise between our in-house product development personnel, our sales and marketing staff, our suppliers, and certain third-party design firms. This model allows us to minimize research and development expenditures, as our suppliers dedicate resources on our behalf.

 

SIRIUS-branded satellite radio receivers are designed and developed by SIRIUS, and we have and continue to develop accessories for SIRIUS products under our own brands or co-branded with SIRIUS.

 

Technical Support and Training

 

Ensuring proper installation of our products is critical to the satisfaction of the end user. Our team of technical support staff provides phone support to our customers. In addition, we collect and make available to our customers a proprietary database called DirectWire, which contains approximately 6,000 vehicle wiring diagrams to assist with locating and connecting to the proper wires when installing our products. We also generate and provide additional comprehensive and valuable information for dealers and distributors, including product technical briefs and teardowns. Each year our best technicians also conduct field training programs at customer locations. On average, we train 4,000 installers and retail sales staff each year in a classroom environment and teach them about the latest technologies and systems needed to install Directed systems.

Warranty

 

Our products carry standard consumer warranties against defects in material and workmanship. Repair services are also available for certain products that are no longer covered under the original manufacturer’s warranty. We provide a rapid factory direct repair program for our U.S. customers under which we typically ship replacement products within 48 hours of receipt, reducing retailer and consumer inconvenience if our products fail to perform properly. Our international distributors generally assume the warranty obligations on the products they sell for us.

 

Intellectual Property

 

We rely on a variety of intellectual property protections, including patents, trade secrets, trademarks, confidentiality agreements, licensing agreements, and other forms of contractual provisions, to protect and advance our intellectual property. We hold patents in various technological arenas, primarily in vehicle security, home audio, and mobile audio. We also own or have rights to the intellectual property developed by our contract manufacturers on our behalf. In total, we hold 164 issued U.S. patents, which expire at various times between the year 2008 and the year 2024, and have 43 U.S. patents pending. Of our issued U.S. patents, 11 have also been issued as patents in foreign jurisdictions. We consider our patent portfolio to be a key competitive advantage for our business, and we license a number of patents to leading automobile manufacturers and electronics suppliers, which provides us with an incremental source of revenue. These licenses generally extend for the life of the patent.

 

The intellectual property associated with the SIRIUS-branded products we sell is owned by SIRIUS and we have a license from SIRIUS for this technology. For co-branded SIRIUS products that we develop, we license the SIRIUS brand name.

 

We have registered many trademarks and trade names both in the United States and internationally and are committed to maintaining and protecting them. These registrations will continue to provide exclusive rights in perpetuity provided that we continue to use the trademarks and maintain the registrations. We believe certain of our trademarks and trade names are material to our business and are well known among consumers in our principal markets. Our principal trademarks and trade names include the following:

 

 

Competition

 

Our security and convenience products face competition from a limited number of electronics companies. Certain of our other markets, such as mobile audio and mobile video, are very competitive, rapidly changing, and characterized by price competition and rapid product obsolescence. Additionally, certain markets, such as satellite radio, are characterized by rapidly changing technologies and evolving consumer usage patterns. We compete on the basis of brand recognition, quality and reliability, customer service and installation support, distribution capabilities, and, in certain markets, price. Our competitors come predominantly from two categories:

 

 

We consider our principal competitors within our product lines to be those listed below:

 

 

We also compete indirectly with automobile manufacturers, who may improve the quality of the security, convenience, audio, video, and satellite radio equipment they install, which could reduce demand for aftermarket car products. However, if OEMs decide to offer features such as remote start or mobile video on their new vehicles more broadly, we believe the aftermarket industry could be influenced by the attendant advertising and increase in product awareness. OEMs may also change the designs of their cars to make installation of our products more difficult or expensive. Finally, retailer customers such as Best Buy and Circuit City could develop their own private label brands to compete with our products.

 

Some of our competitors have greater financial, technical, and other resources than we possess, and many seek to offer lower prices on competing products. To remain competitive, we believe we must regularly introduce new products, add additional features to existing products, and limit increases in prices or even reduce prices.

 

Government Regulation

 

Our operations are subject to certain international, federal, state, and local regulatory requirements relating to environmental, product disposal, health, materials content, and safety matters. Material costs and liabilities may arise from our efforts to comply with these requirements. In addition, our operations may give rise to claims of exposure to hazardous materials by employees or the public or to other claims or liabilities relating to environmental, product disposal, or health and safety concerns.

 

Our operations, including the paint booth at our training facility, create a small amount of hazardous waste, including various epoxies, gases, inks, solvents, and other wastes. The amount of hazardous waste we produce may increase in the future depending on changes in our operations. The disposal of hazardous waste has received increasing focus from federal, state, and local governments and agencies and has been subject to increasing regulation.

 

Our products, particularly our car security and wireless headphone devices, must comply with all applicable regulations of the Federal Communications Commission, or FCC. Our sales and distribution practices may be governed by federal antitrust regulations. We are also subject to various other regulations, including consumer truth-in-advertising laws, warranty laws, privacy, electronic transmission, and product import/export restrictions.

 

The use of our products is also governed by a variety of state and local ordinances, including noise ordinances and laws prohibiting or restricting the running of a motor vehicle without an operator. We do not believe that such laws have had a material effect on our business or the demand for our products to date. However, the passage of new ordinances, or stricter enforcement of current ordinances, could adversely affect the demand for our products.

 

Employees

 

At December 31, 2007, we employed 581 persons. We consider our relationship with our employees to be good, and none of our employees are represented by a union or collective bargaining agreement.

Executive Officers

 

The following table sets forth certain information regarding our executive officers:

 

 

James E. Minarik has served as our Chief Executive Officer since January 2001. From 1992 to December 2000, Mr. Minarik was employed by business units of the publicly traded and Japan-based Clarion Company Limited, a supplier of audio equipment to global car manufacturers and retailers, including as the Chief Executive Officer of Clarion Corporation of America from 1997 to December 2000. Mr. Minarik currently serves on the board of directors of Escort Inc., a privately held radar detector company, Twin Star, a privately held manufacturer of electric fireplaces, and of the Boys and Girls Club of Vista Foundation. Mr. Minarik has previously served as a member of the Board of the Consumer Electronics Association from 1992 through 2007 and as a member of the Board of Governors of the Electronics Industry Association from 2001 through 2006. Mr. Minarik received both a Bachelors Degree and a Masters of Business Administration from the Pennsylvania State University.

 

Kevin P. Duffy has served as our Executive Vice President and Chief Financial Officer since November 2007. Mr. Duffy previously served our company as Senior Vice President — Corporate Development and Marketing from March 2006 to November 2007, and Vice President from June 2003 to March 2006. From July 2002 to June 2003, Mr. Duffy served as a consultant to our company. From August 2001 to June 2003, Mr. Duffy attended the Stanford Graduate School of Business where he received a Masters of Business Administration. From August 2000 to January 2002, Mr. Duffy worked for ThinkTank Holdings LLC, a private venture capital firm located in Southern California, and one of its portfolio companies, as Vice President of Business Development and then as Executive Vice President. Mr. Duffy’s previous experience includes serving as Director of Strategy at Clarion Corporation of America, as well as consulting with Bain & Company and Deloitte & Touche. Mr. Duffy also holds an A.B. in Economics from Princeton University.

 

Richard J. Hirshberg has served as our Senior Vice President — Finance and Treasurer since November 2007. Prior to his appointment to this position, Mr. Hirshberg served as our Vice President — Treasurer from March 2007 to November 2007 and Vice President — Internal Audit and Compliance from September 2005 to March 2007. Prior to that, Mr. Hirshberg served as our Chief Financial Officer and Vice President — Finance from March 2001 to September 2005. From January 1998 to March 2001, Mr. Hirshberg worked for several start-up companies in the capacity of Chief Financial Officer. From January 1991 to December 1997, Mr. Hirshberg served in various capacities, culminating in the position of Chief Financial Officer, for McGaw, Inc., a publicly traded pharmaceutical manufacturer. Mr. Hirshberg is a Certified Public Accountant and spent over 11 years at Arthur Andersen & Co. in various capacities. Mr. Hirshberg received a Bachelors Degree from Northwestern University and a Masters of Business Administration from Northwestern University’s Kellogg Graduate School of Management.

 

Glenn R. Busse has served as our Senior Vice President — Sales since January 2007. Prior to that, Mr. Busse served as our Vice President of Sales or Vice President of Sales and Marketing since joining our company in 1986. Prior to joining our company, Mr. Busse served as the National Sales Manager of Black Bart Systems, a vehicle security company. Mr. Busse received his baccalaureate certification from Lycee Paul Langevin in Surenes, France and is fluent in French.

 

Mark E. Rutledge has served as our Senior Vice President — Engineering and Product Development since March 2006, and served as Vice President from January 2001 to March 2006. Mr. Rutledge has been employed with

our company in various capacities since 1994. Prior to joining our company, Mr. Rutledge served as a mobile electronics specialist in both retail sales and installations. Mr. Rutledge received a Bachelors of Science and Masters in Electrical Engineering from the University of California at San Diego. Mr. Rutledge also received a Masters of Science in Executive Leadership from the University of San Diego.

 

Michael N. Smith has served as our Vice President — Operations since March 2007. Prior to that, Mr. Smith served as our Vice President — Operations and IT from March 2006 to March 2007, as Vice President — Operations, Human Resources and Information Technology from February 2005 to March 2006, and as a Vice President — Marketing from April 2002 to February 2005. From 1990 until April 2002, Mr. Smith served in various capacities for Ford Motor Company, including information technology, mergers and acquisitions, business strategy, and the Wingcast division. Mr. Smith holds a Bachelors Degree, with Highest Honors, in Business Administration/Operations Management from Auburn University and a Masters Degree in Business Administration/Information Technology from the University of Texas at Austin.

 

KC Bean has served as our Vice President and General Counsel since July 2004 and as our Secretary since November 2005. From August 2003 to July 2004, Mr. Bean served as our General Counsel, and from September 2000 to August 2003, Mr. Bean served as our Director of Intellectual Property. From September 1997 to September 2000, Mr. Bean attended Thomas Jefferson School of Law, where he earned his Juris Doctor. Mr. Bean holds a Bachelor of Science Degree from Boise State University and is licensed to practice law in the State of California and before the United States Patent and Trademark Office.

 

J. Steven Wood has served as our Vice President — Sales since July 2006. Prior to joining our company, Mr. Wood served as the Senior Vice President of Merchandising and Marketing for Bernie’s, a retailer of appliances and televisions in New England, from July 2005 to July 2006. Prior to that, Mr. Wood served as Vice President of Merchandising for Ultimate Electronics, a retailer of consumer electronics products from March 2000 to March 2005. Mr. Wood is a 31-year veteran of the consumer electronics industry with experience in many different facets of the industry, primarily in retail.

 

Alan P. Heim has served as our Vice President — Human Resources since November 2007. Prior to joining our company, Mr. Heim served as the Director of Human Resources of RF Magic, Inc (now Entropic Communications) from September 2006 to September 2007. From January 2004 to August 2006, Mr. Heim served as Vice President for HR Interactive, a management consulting firm. Mr. Heim served as Vice President of Operations and HR for Lathian Systems, a software development company, from January 2000 to November 2006, and as Corporate Director, Human Resources for ICN Pharmaceuticals. Mr. Heim held multiple leadership positions over a 23-year career as an Officer in the United States Marine Corps and retired at the rank of Colonel. During his Marine Corps experience, Mr. Heim was awarded a Research Fellowship at Harvard where he studied and wrote on leadership and change. Mr. Heim holds a BA degree from Salem State College, and a MA in HR Management from Pepperdine University. He was awarded his SPHR (Senior Professional of Human Resources) certification in 1997.

 

 

You should carefully consider the following factors, together with all other information included in this report, in evaluating our company and our business.

 

Risks Related to Our Business

 

We operate in the highly competitive branded consumer electronics industry.

 

In certain markets, such as home audio and satellite radio, we compete directly or indirectly with a large number of competitors, including some of the world’s most recognized branded consumer electronics companies. Many of these companies have greater market recognition, larger customer bases, and substantially greater financial, technical, marketing, distribution, and other resources than we possess, which afford them competitive advantages over us. Further, the mobile video market is intensely competitive and is characterized by price erosion, rapid technological change, and competition from major domestic and international companies. OEMs offer certain products with which we compete, such as mobile audio and mobile video, and could attempt to offer additional

competing products or our customers could determine to adopt a private label sales strategy, either of which could reduce our sales.

 

Our ability to compete successfully depends on a number of factors, both within and outside our control. These factors include the following:

 

 

The success of competing products or technologies could substantially reduce the demand for our products and cause our sales to decline.

 

If we do not continue to improve our core products or develop new products that meet the constantly changing demands of our customers, our sales may decline.

 

Our ability to succeed is based in large part on meeting the demands of the branded consumer electronics market. We must regularly improve our core products and introduce new products and technologies that gain market acceptance, such as our introduction of two-way security and convenience devices, mobile video, mobile navigation, and satellite radio products in recent years. Our future operating results will depend to a significant extent on our ability to provide products that compare favorably on the basis of time to introduction, cost, and performance with the products of our competitors.

 

We may experience difficulties that delay or prevent the development, introduction, or market acceptance of new products and technologies. Some or all of our products may not achieve commercial success as a result of technological problems, competitive cost issues, and other factors. Our delivery schedules for new products may be delayed due to manufacturing or other difficulties. In addition, our retailers may determine not to introduce or may cease to sell our new products for a variety of reasons, including the following:

 

 

We may be unable to recover any expenditures we make relating to one or more new products or technologies that ultimately prove to be unsuccessful for any reason. In addition, any investments or acquisitions made to enhance our technologies may prove to be unsuccessful.

 

We depend upon certain key customers for a large portion of our sales, and the loss of any of those customers could harm our business.

 

For the year ended December 31, 2007, sales to our top five customers, including our international distributors, accounted for approximately 45% of our net product sales of which Best Buy (including its subsidiary Magnolia Audio Video) accounted for approximately 21% of our net product sales. In addition, Circuit City accounted for approximately 10% our net product sales for the year ended December 31, 2007. Reliance on key customers may make fluctuations in revenue and earnings more severe and make business planning more difficult.

Our customers do not provide us with firm, long-term volume purchase commitments. As a result, customers can cancel purchase commitments or reduce or delay orders on relatively short notice. Any material delay, cancellation, or reduction of orders from any of our key customers could harm our business, financial condition, and results of operations. The adverse effect would be more pronounced if our other customers did not increase their orders or if we were unsuccessful in generating new customers.

 

Adverse developments affecting SIRIUS Satellite Radio could cause our sales to decline and harm our business.

 

In August 2004, we began selling, marketing, and distributing products for SIRIUS Satellite Radio, a subscription-based satellite radio company that provides content to compatible receivers, including the SIRIUS-branded receivers we distribute. The agreement also permits SIRIUS to distribute SIRIUS products directly to consumers. The sale of SIRIUS products currently accounts for a significant (approximately 29% for the year ended December 31, 2007) portion of our net product sales, including sales of satellite radio products that we sell directly to SIRIUS. Our agreement with SIRIUS expires in August 2008 and, unless extended, our sales would decline significantly upon expiration of that agreement.

 

In February 2007, SIRIUS and XM Radio announced a definitive agreement pursuant to which SIRIUS and XM Radio will combine their businesses. While SIRIUS and XM Radio shareholders have approved the transaction, it will require governmental approval. Although our business relationship with SIRIUS remains strong, the impact of the proposed business combination on our future relationship with SIRIUS is uncertain.

 

In general, the satellite radio business is still a relatively new and unproven business, and SIRIUS Satellite Radio has incurred substantial losses since its inception. The satellite radio market in general, and SIRIUS in particular, may fail to develop and may never reach profitability, which could cause SIRIUS to discontinue its business. If SIRIUS is forced to discontinue its operations, our sales would decline and our business could be harmed. In addition, SIRIUS could change its hardware distribution strategy in the future, including entering into arrangements with one or more of our competitors in addition to or instead of us, or could determine to sell the hardware itself.

 

To increase satellite radio subscriptions, satellite radio receivers are being heavily promoted by SIRIUS, XM Radio, and retailers at reduced retail prices. While our performance is based on negotiated wholesale prices and manufacturing costs, we must generate higher unit sales volume to maintain revenue and profits from these products in this promotional environment.

 

A decline in discretionary spending would likely cause our sales to decline.

 

The consumer products that we sell constitute discretionary purchases. As a result, a recession in the general economy or other conditions affecting disposable consumer income and retail sales would likely reduce our sales. Consumer spending is volatile and is affected by many factors, including interest rates, consumer confidence levels, tax rates, employment levels and prospects, and general economic conditions.

 

We rely on contract manufacturers, and their failure to maintain satisfactory delivery schedules could increase our costs, disrupt our supply chain, and result in our inability to deliver our products, all of which would adversely affect our operating results.

 

Essentially all of our products are manufactured and assembled by outsourcing partners, which are primarily located in China, Taiwan, and South Korea. Four of our suppliers account for a significant portion of our purchases. Two of these suppliers manufacture SIRIUS satellite radio receivers in Taiwan and China. Our largest security and convenience supplier and our largest home audio supplier also account for a significant portion of our purchases. We do not have long-term (more than one year) arrangements with any of our contract manufacturers that guarantee production capacity or prices. Certain of our contract manufacturers serve other customers, a number of which have greater production requirements than we do. As a result, our contract manufacturers could determine to prioritize production capacity for other customers or reduce or eliminate services for us on short notice. Qualifying new manufacturers is time-consuming and could result in unforeseen manufacturing and operational problems. The loss of our relationships with our contract manufacturers or their inability to conduct their manufacturing services for us

as anticipated in terms of cost, quality, and timeliness could adversely affect our ability to fill customer orders in accordance with required delivery, quality, and performance requirements. Additionally, rapid increases in orders from any of our larger customers could cause our requirements to exceed the capacity of our contract manufacturers. If any of these events were to occur, the resulting decline in revenue would harm our business.

 

Shortages of components and materials may delay or reduce our sales and increase our costs.

 

The inability of our contract manufacturers to obtain sufficient quantities of components and other materials, such as LCD panels and controller chips, necessary to make our products could result in delayed sales or lost orders. We may be faced with increased costs, supply interruptions, and difficulties in obtaining certain components. Materials and components for some of our major products may not be available in sufficient quantities to satisfy our needs because of shortages of these materials and components. Any supply interruption or shortages could harm our reputation with our customers and may result in lost sales opportunities.

 

Because we outsource essentially all of our manufacturing to third parties, which are primarily located in China, Taiwan, and South Korea, we are subject to the economic risks associated with changes in the social, political, regulatory, and economic conditions inherent in these countries.

 

Substantially all of our products are manufactured outside of the United States. Transportation delays or interruptions, such as those caused by labor strikes, natural disasters, terrorism, inspection delays, or import restrictions, could impede our ability to timely deliver our products to our customers. These interruptions could also increase our costs, if, for example, we were forced to ship our products from our suppliers via air rather than via ocean carrier. A disruption in our ability to import our products could increase our costs, cause our sales to decline, and harm our business.

 

Changes in policies by the United States or foreign governments resulting in, among other things, increased duties, higher taxation, currency conversion limitations, restrictions on the transfer or repatriation of funds, limitations on imports or exports, or the expropriation of private enterprises also could have a material adverse effect on us or our suppliers. In addition, U.S. trade policies, such as the granting or revocation of “most favored nation” status and trade preferences for certain Asian nations, including China, Taiwan, and South Korea, could affect our business and sales of our products.

 

In addition, because a large portion of our products are manufactured by companies located in both China and Taiwan, we are subject to additional risks due to the tense relationship between the Taiwanese and Chinese governments, which has been strained in recent years. Any significant deterioration of relations between Taiwan and China, or between the United States and China, could have far-reaching effects on companies that import major portions of their supplies or finished products from China, including us, and could impact the operations of our suppliers in Taiwan and China. This would adversely affect our ability to obtain a majority of our products on a timely basis, at reasonable costs, or at all.

 

We do not have long-term arrangements with any of our contract manufacturers that guarantee production capacity or prices. As a result, increases in the cost of doing business in China, including increases due to changes in environmental and political regulations, increased competition for employees, increased costs of other raw materials, and any appreciation of the Renminbi against the U.S. dollar could increase our cost of sales and adversely affect our gross margins and results of operations.

 

If we do not successfully maintain the quality of the installation of our automotive products by our retailer partners, our reputation could suffer and our sales could decline.

 

The successful use of our automotive products depends substantially upon the proper installation of those products. This installation is generally performed by our retailer customers. Our efforts to improve the installation skills of our third party installers may not succeed. The failure by third parties to properly install our products could harm our reputation, which in turn could cause our sales to decline and could increase warranty claims and costs.

If we become subject to product returns or product liability claims resulting from defects in our products, we may face an increase in our costs, a loss of customers, or a delay in the market acceptance of our products.

 

Our products are complex and may contain undetected defects or experience unforeseen failures when first introduced or as new versions are introduced. For example, we recently began selling remote start products intended for installation in manual transmission vehicles. Despite testing by us and our manufacturers, defects may be found in existing or new products. Any such defects could cause us to incur significant re-engineering costs, divert the attention of our engineering personnel from product development efforts, and cause significant customer relations and business reputation problems. Any such defects could force us to undertake a product recall program, which could cause us to incur significant expenses and could harm our reputation and that of our products. If we deliver products with defects, our credibility and the market acceptance and sales of our products could be harmed.

 

Defects could also lead to liability for defective products as a result of lawsuits against us or against our retailers. We agree to indemnify certain of our retailer customers in some circumstances against liability from defects in our products. Potential claims could include, among others, bodily injury due to an obstructed view by a mobile video screen, unintended vehicle ignition or motion from a remote start product, or the failure of our replacement headrests. A product liability claim brought against us, even if unsuccessful, would likely be time-consuming and costly to defend. If successful, such claims could require us to make significant damage payments in excess of our insurance limits.

 

If we do not successfully address the risks associated with our international operations, our business could be harmed.

 

Our sales and distribution operations in the Canadian, European, Asian, and Latin American markets create a number of logistical and communications challenges for us. Our international sales were approximately $56.1 million in 2007. We plan to increase our international sales in the future. Selling products internationally exposes us to various economic, political, and other risks, including the following:

 

 

Our revenues and purchases are predominantly in U.S. Dollars. However, we collect a portion of our revenue in non-U.S. currencies, such as British Pounds Sterling and Canadian Dollars. In the future, and especially as we expand our sales in international markets, our customers may increasingly make payments in non-U.S. currencies. In addition, we account for a portion of our costs in our U.K. office and Canadian subsidiaries, such as payroll, rent, and indirect operating costs, in British Pounds Sterling or Canadian Dollars, respectively. Fluctuations in foreign currency exchange rates could affect our sales, cost of sales, and operating margins. In addition, currency devaluation can result in a loss to us if we hold deposits of that currency. A majority of our products are made in China, which in 2005 revalued its currency, the Renminbi, upward against the U.S. Dollar. Appreciation of the Renminbi against the U.S. Dollar causes certain of our manufacturers’ costs to rise in U.S. Dollar terms. This could pressure our manufacturers to raise prices and thereby adversely affect our profitability. Hedging foreign currencies can be difficult, especially if the currency is not freely traded. We cannot predict the impact of future exchange rate fluctuations on our operating results.

Any acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute shareholder value, and adversely affect our operating results.

 

We may continue to review opportunities to buy other businesses or technologies that would complement our current product lines, expand the breadth of our markets, enhance our technical capabilities, or otherwise offer growth opportunities. We have completed several acquisitions and are likely to buy businesses, assets, brands, or technologies in the future. If we make any future acquisitions, we could issue stock that would dilute the percentage ownership of our existing shareholders, incur substantial debt, or assume contingent liabilities. Our recent acquisitions, as well as potential future acquisitions, involve numerous risks, including the following:

 

 

We may not be successful in overcoming these and other risks encountered in connection with such acquisitions, and our inability to do so could adversely affect our business. In addition, any strategic alliances or joint ventures we enter into may not achieve their strategic objectives, and parties to our strategic alliances or joint ventures may not perform as contemplated. Problems associated with the management or operation of, or the failure of, any strategic alliances or joint ventures could divert the attention of our management team and have a material adverse effect on our operations and financial position.

 

Our ability to grow through acquisitions will also depend upon various factors, including the availability of suitable acquisition candidates at attractive purchase prices, our ability to compete effectively for available acquisition opportunities, and the availability of funds or common stock with a sufficient market price to complete acquisitions.

 

As a part of our acquisition strategy, we frequently engage in discussions with various companies regarding their potential acquisition by us. In connection with these discussions, we and potential acquisition candidates often exchange confidential operational and financial information, conduct due diligence inquiries, and consider the structure, terms, and conditions of the potential acquisition. Potential acquisition discussions frequently take place over a long period of time and involve difficult business integration and other issues, including in some cases, management succession and related matters. As a result of these and other factors, a number of potential acquisitions that from time to time appear likely to occur do not result in binding legal agreements and are not consummated.

 

Our goodwill and intangible assets have been impaired and may become impaired again in the future.

 

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we test our goodwill and other intangible assets at least annually to determine whether the carrying value of those assets exceeds their fair value. We completed our annual assessment in the fourth quarter of fiscal 2007 and, as a result, recorded non-cash impairment losses of $168.4 million related to goodwill and $26.5 million related to indefinite-lived intangible assets. The goodwill impairment charge was the result of the decline in our stock price as we used our market capitalization in our assessment of the fair value of our goodwill. The process of evaluating the impairment of goodwill and other intangible assets is subjective and requires significant judgment. In estimating the fair value of the business and intangible assets for the purpose of our annual or periodic analyses, we make estimates and judgments about the future cash flows of our business. Although our cash flow forecasts are based on assumptions that are consistent with plans and estimates we are using to manage our underlying business, there is significant

judgment in determining the cash flows attributable to our business. If actual results are different from our forecasts, future tests may indicate additional impairments of goodwill or other intangible assets, which would adversely affect our results of operations. If, in the course of our annual or interim valuation testing procedures, we determine that a portion of the consolidated goodwill balance or other intangible assets are impaired, any non-cash charge would adversely affect our financial results.

 

If we are unable to protect our intellectual property, our ability to compete effectively in our markets could be harmed.

 

We believe that our success depends in part on protecting our proprietary technology. We rely on a combination of patent, trade secret, and trademark laws, confidentiality procedures, and contractual provisions to protect our intellectual property. We also seek to protect certain aspects of our technology under trade secret laws, which afford only limited protection. We face risks associated with our intellectual property, including the following:

 

 

We may not be able to obtain effective patent, trademark, service mark, copyright, and trade secret protection in every country in which we sell our products. We may find it necessary to take legal action in the future to enforce or protect our intellectual property rights, and such action may be unsuccessful. Our means of protecting our proprietary rights in the United States or abroad may not be adequate, and our competitors may independently develop similar technologies. If our intellectual property protection is insufficient to protect our intellectual property rights, we could face increased competition in the markets for our products.

 

We may be required to incur substantial expenses and divert management attention and resources in defending intellectual property litigation against us or prosecuting others for their unauthorized use of our intellectual property.

 

The markets in which we compete can involve litigation regarding patents and other intellectual property rights. We sometimes receive notices from third parties, including groups that have pooled their intellectual property, that claim our products infringe their rights. From time to time, we receive notices from third parties of the intellectual property rights such parties have obtained. We cannot be certain that our products and technologies do not and will not infringe issued patents or other proprietary rights of others. For example, during 2006 and 2007 we incurred substantial litigation and settlement costs in a patent infringement claim filed by Omega Patents, LLC. Any claim, with or without merit, could result in significant litigation costs and diversion of resources, including the attention of management, and could require us to enter into royalty and licensing agreements, all of which could have a material adverse effect on our business. We may be unable to obtain such licenses on commercially reasonable terms, or at all, and the terms of any offered licenses may not be acceptable to us. If forced to cease using such intellectual property, we may not be able to develop or obtain alternative technologies. Accordingly, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing, using, or selling certain of our products, which could have a material adverse effect on our business.

 

Furthermore, parties making such claims could secure a judgment awarding substantial damages as well as injunctive or other equitable relief that could effectively block our ability to make, use, or sell our products in the United States or abroad. Such a judgment would have a material adverse effect on our business. In addition, we are obligated under certain agreements to indemnify our customers or other parties if we infringe the proprietary rights

of third parties. Any required indemnity payments under these agreements could have a material adverse effect on our business.

 

Should any of our competitors file patent applications or obtain patents that claim inventions also claimed by us, we may choose to participate in an interference proceeding to determine the right to a patent for these inventions. Even if the outcome is favorable, this proceeding could result in substantial cost to us and disrupt our business.

 

We sometimes need to file lawsuits to enforce our intellectual property rights, to protect our trade secrets, or to determine the validity and scope of the proprietary rights of others. This litigation, whether successful or unsuccessful, could result in substantial costs and diversion of resources, which could have a material adverse effect on our business.

 

Our substantial indebtedness could adversely affect our business and limit our ability to plan for or respond to changes in our business, and we may be unable to generate sufficient cash flow to satisfy our significant debt service obligations.

 

As of December 31, 2007, our consolidated long-term indebtedness was $262.9 million and we had $4.0 million drawn on our revolving credit facility. We may incur substantial additional indebtedness in the future, including additional borrowings under our revolving credit facility.

 

Our substantial indebtedness and the fact that a substantial portion of our cash flow from operations must be used to make principal and interest payments on this indebtedness could have important consequences, including the following:

 

 

Our ability to incur significant future indebtedness, whether to finance potential acquisitions or for general corporate purposes, will depend on our ability to generate cash. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory, and other factors that are beyond our control. If our business does not generate sufficient cash flow from operations or if future borrowings are not available to us under our senior secured credit facility in amounts sufficient to enable us to fund our liquidity needs, our financial condition and results of operations may be adversely affected. If we cannot make scheduled principal and interest payments on our debt obligations in the future, we may need to refinance all or a portion of our indebtedness on or before maturity, sell assets, delay capital expenditures, or seek additional equity. In the fourth quarters of 2009, 2010, 2011, and 2012 we are required to make substantial balloon payments on our credit facility principal. In September 2013, our remaining principal payment due under our senior credit facility will be substantial. If we cannot satisfy these obligations from operating cash flow, we will be required to refinance all or a portion of our senior credit facility. If we are unable to refinance this or any of our indebtedness on commercially reasonable terms or at all, or to effect any other action relating to our indebtedness on satisfactory terms or at all, our business may be harmed.

Our senior secured credit facility contains restrictive terms and our failure to comply with these terms could put us in default, which would have an adverse effect on our business and operations.

 

Our senior secured credit facility contains a number of significant covenants. These covenants limit our ability to, among other things, do the following:

 

 

Our senior secured credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests at the end of each fiscal quarter. Our ability to meet these financial ratios and tests can be affected by events beyond our control, and we may not meet those tests. A breach of any of these covenants could result in a default under the senior secured credit facility. If the lenders accelerate amounts owing under the senior secured credit facility because of a default and we are unable to pay such amounts, the lenders have the right to foreclose on substantially all of our assets.

 

Our debt obligations have variable rates, which makes us vulnerable to increases in interest rates.

 

As of December 31, 2007, we had approximately $266.9 million of outstanding debt, including $4.0 million drawn on our revolving credit facility, which was subject to variable interest rates. Accordingly, we may experience material increases in our interest expense as a result of increases in interest rates. In January 2007, we entered into an interest rate swap, which effectively fixes the interest rate on $153.0 million of our debt until January 2010. Our annual interest expense on our remaining variable rate debt would increase by $1.1 million for each 1% increase in interest rates, assuming no revolving credit borrowings and considering the fixed rate on $153.0 million due to the interest rate swap.

 

Disruption in our main distribution centers may prevent us from meeting customer demand and our sales and profitability may suffer as a result.

 

We manage our product distribution through several distribution centers in the in the United States, Canada, the United Kingdom, and Hong Kong. A serious disruption, such as an earthquake, flood, or fire, at any of our main distribution centers could damage our inventory and could materially impair our ability to distribute our products to customers in a timely manner or at a reasonable cost. We could incur significantly higher costs and experience longer lead times associated with distributing our products to our customers during the time that it takes for us to reopen or replace a distribution center. As a result, any such disruption could have a material adverse effect on our business.

 

We may seek to raise additional capital in the future to finance our operations, and our inability to raise such capital could restrict our growth and harm our operating results.

 

From time to time we may seek additional equity or debt financing to provide for the capital expenditures required to maintain or expand our facilities and equipment, to meet the changing needs of the consumer electronics market, to finance working capital requirements, or to make acquisitions. For instance, in 2006 we increased the size of our senior secured credit facility to fund the acquisition of Polk and our increased working capital needs associated with our increased sales levels. We cannot predict the timing or amount of any additional capital requirements at this time. If our senior secured credit facility is inadequate to provide for these requirements and additional equity or debt financing is not available on satisfactory terms, we may be unable to maintain or expand our business or to develop new business at the rate desired and our operating results may suffer.

Our executive officers and key personnel are critical to our business, and these officers and personnel may not remain with us in the future.

 

We depend substantially on the efforts and abilities of our senior management and sales personnel, especially our chief executive officer, James E. Minarik. Our success will depend on our ability to retain our current management and to attract and retain qualified personnel in the future. Competition for senior management personnel is intense and we may not be able to retain our personnel or attract additional qualified personnel. The loss of a member of senior management requires the remaining executive officers to divert immediate and substantial attention to fulfilling his or her duties and to seeking a replacement. The inability to fill vacancies in our senior executive positions on a timely basis could adversely affect our ability to implement our business strategy, which would negatively impact our results of operations.

 

We are subject to various governmental regulations that could adversely affect our business.

 

Like many businesses, our operations are subject to certain international, federal, state, and local regulatory requirements relating to environmental, product disposal, materials content, and health and safety matters. We could become subject to liabilities as a result of a failure to comply with applicable laws and incur substantial costs to comply with existing, new, modified, or more stringent requirements. In addition, our past, current, or future operations may give rise to claims of exposure to hazardous substances by employees or the public or to other claims or liabilities relating to environmental, product disposal, or health and safety concerns. For instance, we maintain a paint booth at our Snake Pit training facility, and the training conducted there generates various airborne particulates.

 

Our wireless products, including our satellite radio and security and wireless headphone devices, must comply with all applicable regulations of the Federal Communications Commission, or FCC. Any failure or delay in obtaining required FCC licenses could prevent or delay new product introductions. Failure to comply with applicable FCC regulations could result in significant fines or product recalls. For example, during the second quarter of 2006, we received a letter from the FCC stating that its Office of Engineering and Technology Laboratory had tested certain satellite radios that we distribute, and had determined that the transmitters were not in compliance with either the applicable operating frequency range or the applicable emission limits. As a result, we were forced to stop shipments until the third quarter of 2006, when we received notification that the FCC approved the modifications made to the products and had determined that the radios were in compliance with applicable operating frequency range and emission limits.

 

The use of our products is also governed by a variety of state and local ordinances that could affect the demand for our products. For instance, the passage of new noise ordinances, or stricter enforcement of current noise ordinances, could reduce the demand for our mobile audio products. Additionally, many states currently have in place laws prohibiting or restricting the running of a motor vehicle without an operator, the enforcement of which could adversely affect the demand for our hybrid and convenience products that contain remote start capabilities.

 

Risks Related to Ownership of Our Common Stock

 

The market price for our common stock may continue to be volatile.

 

Since our initial public offering in December 2005, our common stock has experienced significant price fluctuations. Many factors could cause the market price of our common stock to rise and fall, including the following:

 

 

 

In addition, public announcements by our competitors concerning, among other things, their performance, strategy, accounting practices, or legal problems could cause the market price of our common stock to decline regardless of our actual operating performance.

 

Our operating results may experience significant periodic and seasonal fluctuations, which could cause our results to fall short of expectations and cause our stock price to decline.

 

The consumer electronics industry has experienced significant economic downturns at various times, characterized by diminished product demand, accelerated erosion of average selling prices, intense competition, and production overcapacity. In addition, the consumer electronics industry is cyclical in nature. We may experience substantial period-to-period fluctuations in operating results, at least in part because of general industry conditions or events occurring in the general economy.

 

In addition to the variability resulting from the cyclical nature of the consumer electronics industry, other factors may contribute to significant periodic and seasonal quarterly fluctuations in our results of operations. These factors include the following:

 

 

For instance, our 2005 and 2006 revenue increases were attributable in large part to the growth of the satellite radio and home audio markets. With the downturn in the satellite radio business, we have experienced decreased revenue and adverse performance trends. If we cannot add other products to generate revenue growth our business could be adversely affected.

 

Historically, our sales have usually been weaker in the first two quarters of each fiscal year and have, from time to time, been lower than the preceding quarter. Our products are highly consumer-oriented, and consumer buying is traditionally lower in these quarters. Sales of our products are usually highest in our fourth fiscal quarter due to increased consumer spending on electronic devices during the holiday season. Additionally, our remote start products are seasonally affected by colder winter months.

 

The size, timing, and integration of any future acquisitions may also cause substantial fluctuations in operating results from quarter to quarter. Consequently, operating results for any quarter may not be indicative of the results that may be achieved for any subsequent quarter or for a full fiscal year. These fluctuations could adversely affect the market price of our common stock.

 

Accordingly, you should not rely on the results of any past periods as an indication of our future performance. It is possible that in some future periods, our operating results may be below expectations of public market analysts or investors. If this occurs, our stock price may decline.

Our current principal shareholders have significant influence over us, and they could delay, deter, or prevent a change of control or other business combination or otherwise cause us to take action with which you might not agree.

 

Investment funds affiliated with Trivest Partners, L.P. together beneficially own approximately 37% of our outstanding common stock. In addition, two of our directors are affiliated with Trivest Partners, L.P. As a result, Trivest Partners, L.P. has significant influence over our decision to enter into any corporate transaction and may have the ability to prevent any transaction that requires the approval of shareholders regardless of whether or not other shareholders believe that such transaction is in their own best interests. Such concentration of voting power could have the effect of delaying, deterring, or preventing a change of control or other business combination that might otherwise be beneficial to our shareholders.

 

The large number of shares eligible for public sale or subject to rights requiring us to register them for public sale could depress the market price of our common stock.

 

The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market and the perception that these sales could occur may depress the market price. As of December 31, 2007, we had 25,419,738 shares of common stock outstanding, all of which may be sold in the public market, subject to prior registration or qualification for an exemption from registration, including, in the case of shares held by affiliates, compliance with the volume restrictions of Rule 144.

 

In addition, shareholders owning 12,116,680 shares are entitled to require us to register our securities owned by them for public sale. In May 2006, we filed a registration statement to register the 2,750,000 shares issuable under our incentive compensation plan.

 

Sales of common stock pursuant to registration rights may make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.

 

Provisions in our articles of incorporation, our bylaws, and Florida law could make it more difficult for a third party to acquire us, discourage a takeover, and adversely affect existing shareholders.

 

Our articles of incorporation, our bylaws, and the Florida Business Corporation Act contain provisions that may have the effect of making more difficult, delaying, or deterring attempts by others to obtain control of our company, even when these attempts may be in the best interests of shareholders. These include provisions limiting the shareholders’ powers to remove directors or take action by written consent instead of at a shareholders’ meeting. Our articles of incorporation also authorize our board of directors, without shareholder approval, to issue one or more series of preferred stock, which could have voting and conversion rights that adversely affect or dilute the voting power of the holders of common stock. Florida law also imposes conditions on the voting of “control shares” and on certain business combination transactions with “interested shareholders.”

 

These provisions and others that could be adopted in the future could deter unsolicited takeovers or delay or prevent changes in our control or management, including transactions in which shareholders might otherwise receive a premium for their shares over then current market prices. These provisions may also limit the ability of shareholders to approve transactions that they may deem to be in their best interests.

 

 

None.

 

 

We occupy approximately 198,000 square feet in a leased facility in Vista, California, which houses our corporate headquarters. We utilize approximately 47,000 square feet for our sales, marketing, engineering, customer service, technical support, legal, finance, and administrative functions. We utilize approximately 129,000 square feet for our principal distribution facility. Finally, we utilize approximately 22,000 square feet for our training facility known as The Snake Pit. We lease this facility under an agreement that extends through 2016, and have an option to renew the lease for an additional five years.

We also use public warehouses to distribute certain of our products, as well as the following leased facilities:

 

 

 

From time to time, we are involved in other litigation and proceedings in the ordinary course of our business. We are not currently involved in any legal proceeding that we believe would have a material adverse effect on our business or financial condition.

 

 

Not applicable.

PART II

 

 

Market Information for Common Stock

 

Our common stock has been traded on The Nasdaq Stock Market under the symbol DEIX since our initial public offering on December 16, 2005. The following table sets forth high and low sale prices of common stock for each calendar quarter indicated as reported on The Nasdaq Stock Market.

 

 

On March 10, 2008, the closing sale price of our common stock was $1.90 per share. On March 10, 2008, there were approximately 387 record holders and approximately 2,032 beneficial owners of our common stock.

 

Dividend Policy

 

We have not paid any dividends in the two most recent fiscal years and currently do not expect to pay cash dividends or make any other distributions in the future. We currently plan to retain any earnings to finance the growth of our business or repay debt rather than to pay cash dividends. Payments of any cash dividends in the future will depend on our financial condition, results of operations, and capital and legal requirements as well as other factors deemed relevant by our board of directors. Our current debt agreements prohibit us from paying dividends without the consent of our lenders.

 

Equity Compensation Plan Information

 

The following table sets forth information with respect to our common stock that has been authorized for issuance under our 2005 incentive compensation plan as of December 31, 2007.

 

 

Performance Graph

 

This performance graph shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and shall not be deemed incorporated by reference into any filing of our company under the Exchange Act or the Securities Act of 1933, as amended.

The following line graph compares cumulative total shareholder returns for the period from December 16, 2005 through December 31, 2007 for (1) our common stock; (2) the Nasdaq Market Index (U.S.); and (3) an industry peer group. We do not believe that an index exists with companies comparable to those of our company. We have therefore elected to include a peer group consisting of Audiovox Corporation; Garmin Ltd.; LoJack Corporation; Harman International Industries, Incorporated; and Rockford Corporation. The graph assumes an investment of $100 on December 16, 2005, which was the first day on which our stock was listed on The Nasdaq Stock Market. The calculations of cumulative shareholder return on the Nasdaq Market Index and the industry peer group include reinvestment of dividends, but the calculation of cumulative shareholder return on our common stock does not include reinvestment of dividends because we did not pay dividends during the measurement period. The performance shown is not necessarily indicative of future performance.

 

 

 

The consolidated statement of operations data for the fiscal years ended December 31, 2007, 2006, and 2005 and the consolidated balance sheet data as of December 31, 2007 and 2006 have been derived from our audited consolidated financial statements included elsewhere in this report. The consolidated statement of operations data for the fiscal years ended December 31, 2004 and 2003 and the consolidated balance sheet data as of December 31, 2005, 2004, and 2003 have been derived from our audited consolidated financial statements not included herein. Since the consolidated statement of operations only includes the results of operations of our acquired companies since the date of their acquisition, our historical results are not necessarily indicative of our results of operations to be expected in the future. You should read this information in conjunction with our consolidated financial statements, including the related notes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report.

 

 

 

 

 

 

You should read the following discussion and analysis in conjunction with our financial statements and related notes contained elsewhere in this report. This discussion contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including those set forth under Item 1A, “Risk Factors” and elsewhere in this report.

 

Overview

 

We believe we are the largest designer and marketer in North America of premium home theater loudspeakers, consumer branded vehicle security, and remote start systems, and we believe we are the largest supplier of aftermarket satellite radio receivers, based upon sales. We are also a major aftermarket supplier of mobile audio and mobile video systems. In the home audio market, we design and market award-winning Polk Audio^® and Definitive Technology^® premium loudspeakers. Our broad portfolio of vehicle security, remote start, and GPS tracking systems are sold under leading brands including Viper^®, Clifford^®, Python^®, Autostart^®, and Astroflex^®. Our mobile audio and video products include speakers, subwoofers, amplifiers, and video screens, sold under our Polk^®, Orion^®, Precision Power^®, Directed Video^®, and Automate^® brand names.

 

We have grown our business organically as well as through strategic acquisitions and partnerships. Our expansion has resulted in expanding our product offerings, distribution channels, and base of contract manufacturers. We also increased our business by entering into an arrangement with SIRIUS Satellite Radio Inc. in 2004 to sell and market SIRIUS-branded satellite radio products, thus increasing our penetration of national electronics retailers and further diversifying our product mix.

 

We sell our products through numerous distribution channels, including independent specialty retailers, national and regional retail electronics chains, mass merchants, automotive parts retailers, car dealers, regional distributors, and international distributors. In 2007, we sold to over 10,000 storefronts. We have exclusive rights to market and sell certain SIRIUS-branded satellite radio receivers and accessories to our existing U.S. retailer customer base. We also sell products directly to SIRIUS Satellite Radio for direct to consumer resale.

 

We outsource all of our manufacturing activities to third parties located primarily in Asia. Our costs are largely driven by the prices negotiated with our suppliers. Our expenses are also impacted by such items as personnel, sales and marketing, distribution, and occupancy costs.

 

Significant Transactions

 

In September 2006, we expanded our home and mobile audio product offering by acquiring Polk Holding Corp., a leading provider of high performance home and mobile audio equipment, for $138.1 million, including acquisition costs. The acquisition of Polk was funded through a $141.0 million increase in our senior credit facility, which significantly increased our interest expense. As a result of this acquisition, our results of operations are not necessarily comparable on a period-to-period basis.

 

Outlook

 

Although other factors will likely impact us, including some we do not foresee, we believe our performance for 2008 and beyond will be affected by the following opportunities and challenges:

 

sales with core speaker product development and expansion into related speaker and electronics products such as tabletop radios, iPod docks, outdoor speakers, and custom installation products. We also plan to expand our distribution of our Polk Audio home audio products. As previously announced, beginning in 2008, a wide selection of our Polk Audio home audio entertainment products will be available at more than 900 Best Buy locations throughout the U.S. Additionally, certain Polk Audio products will be available in 2008 at more than 170 Apple Store locations and the Apple Online Store.

 

 

Results of Operations

 

The following table sets forth, for the periods indicated, the percentage of net sales of certain items in our financial statements:

 

 

The net sales that we report represent gross product sales to customers less rebates and payment discounts, plus royalty and other revenue. We do not allocate these rebates or payment discounts to specific product categories. As a result, in the discussion below we discuss gross sales by product category. The following table sets forth our gross and net sales information:

 

 

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

 

Net Sales

 

Our net sales decreased approximately $36.7 million, or 8.4%, to $401.1 million in 2007 compared with $437.8 million in 2006. The decrease was the result of an increase of $68.7 million, or 29.9%, in security and entertainment sales, a decrease of $102.2 million, or 46.4%, in satellite radio sales, and an increase of $4.0 million, or 25.8%, in rebates and payment discounts.

 

The increase in security and entertainment product sales resulted primarily from the expansion of home and mobile audio products related to our acquisition of Polk in late September 2006. Within the security and entertainment category, the Polk impact on sales was $73.0 million. Excluding Polk, our security and entertainment sales decreased by $4.3 million due to decreases in our mobile audio and mobile video sales, which were partially offset by increases in our security and convenience and continued strong Definitive Technology home audio sales. Mobile audio, including satellite radio accessories designed by us, and mobile video sales decreased due to

industry-wide softness in these categories. The increase in our security and convenience sales was primarily due to strong performance from our Canadian brands and due to colder weather than in 2006.

 

The decrease in satellite radio product sales was primarily due to reduced prices and reduced demand during 2007 from the residual effect of the slower than expected sell-through of SIRIUS products during the 2006 holiday season, possible consumer uncertainty related to the proposed business combination between SIRIUS and XM Radio.

 

Rebates and payment discounts increased $4.0 million, or 25.8%, to $19.5 million in 2007 compared with $15.5 million in 2006. This increase was primarily related to increased home audio and security and convenience sales due to acquisitions. As a percentage of gross sales, rebates and discounts increased from 3.4% in 2006 to 4.7% in 2007. This increase was primarily due to the change in product sales mix from the increase in sales of security and entertainment products as compared to satellite radio products, on which we do not offer significant rebates.

 

Gross Profit and Income (Loss) from Operations

 

Our gross profit increased approximately $19.1 million, or 15.6%, to $141.7 million in 2007 compared with $122.6 million in 2006. This increase is primarily due to increased sales of security and entertainment products and a change in product sales mix. Our gross profit margin increased from 28.0% in 2006 to 35.3% in 2007. This increase was primarily due to a change in product sales mix of increased sales of higher margin security and entertainment products combined with reduced sales of lower margin satellite radio products. During the period, our security and entertainment margins generally remained at historical levels.

 

Selling, general and administrative expenses increased by approximately $25.8 million, or 39.8%, to $90.6 million in 2007 compared with $64.8 million in 2006. The increase was primarily due to the full year inclusion of operating costs associated with our 2006 acquisitions, which have a higher operating expense as a percentage of net sales. The increase also reflects additional investments in research and development projects related to our security and entertainment business. Our provision for litigation increased by approximately $2.1 million, or 70.0%, to $5.1 million in 2007 compared with $3.0 million in 2006. The increase is related to the settlement of a patent litigation case in the first quarter of 2007. Amortization of intangible assets included in operating expenses increased by approximately $1.8 million, or 56.3%, to $5.0 million in 2007 compared with $3.2 million in 2006 due the inclusion of a full year of amortization expense related to our 2006 acquisitions.

 

During the fourth quarter of 2007, we recorded a non-cash impairment charge of $194.8 million related to goodwill and certain indefinite-lived intangible assets. The impairment charge was necessary due to the decrease in the fair value of goodwill and intangible assets as compared to their carrying values.

 

Net Interest Expense

 

Net interest expense increased approximately $10.1 million, or 57.4%, to $27.7 million in 2007 compared with $17.6 million in 2006. The increase is primarily due to the increased borrowings under our senior credit facility in connection with our acquisition of Polk in September 2006, which resulted in additional borrowings of $141.0 million and a 25 basis point increase in our interest rates. During the fourth quarter, we prepaid approximately $39.2 million of our outstanding debt. In connection with this prepayment, we wrote off unamortized debt issuance costs of $0.8 million.

 

Provision for (benefit from) Income Taxes

 

Our effective tax rate decreased from a provision of 38.5% in 2006 to a benefit of 22.9% in 2007. This decrease resulted primarily from the tax effect of the goodwill impairment. Because a significant portion of our goodwill was acquired in nontaxable transactions, it is not deductible for tax purposes. The loss of the tax benefit related to the nontaxable goodwill resulted in a significant reduction to the effective tax rate benefit in 2007.

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005

 

Net Sales

 

Our net sales increased approximately $133.2 million, or 43.7%, to $437.8 million in 2006 from $304.6 million in 2005 due to our increased satellite radio and home audio product sales and sales attributable to our 2006 acquisitions. Approximately $99.2 million of our total gross sales increase was attributable to satellite radio product sales due to our increase in market share of SIRIUS retail aftermarket sales. These products were primarily sold through national and regional consumer electronics retailers, including Best Buy and Circuit City. We also sell these products directly to SIRIUS Satellite Radio for distribution to their direct consumer business. Security and entertainment product sales increased by $38.9 million primarily due to our expansion of home and mobile audio products related to our acquisition of Polk in September 2006 and our increased sales to our existing retail customers, including Best Buy’s Magnolia stores. Net product sales attributable to our 2006 acquisition of Polk were $28.2 million. We experienced a decline in our mobile video products sales of $2.9 million due to industry-wide softness in this category. Rebates and payment discounts remained consistent as a percentage of gross product sales in 2006 compared with 2005.

 

During the second quarter of 2006 we received a letter from the Federal Communications Commission stating that its Office of Engineering and Technology Laboratory had tested the SIRIUS ST2 and SIRIUS S50-C radios that we distribute, and had determined that the transmitters were not in compliance with either the applicable operating frequency range or the applicable emission limits. As a result, we stopped shipment of these radios. SIRIUS subsequently reported that it had determined that certain of its radios with FM transmitters were not in compliance with FCC rules, and that SIRIUS had taken a series of actions to evaluate, mitigate, and correct the problems. During the third quarter of 2006, we received notification that the FCC approved the modifications made to the SIRIUS ST2 and S50-C radios and had determined that the radios were in compliance with applicable operating frequency range and emission limits. Shipments of these radios resumed in the fourth quarter of 2006.

 

Gross Profit and Income from Operations

 

Our gross profit increased by $23.7 million, or 23.9%, from 2005 to 2006, due to an increase in our net sales. Our gross profit margin decreased from 32.5% in 2005 to 28.0% in 2006, primarily due to increased sales of satellite radio products during 2006, which provide a significantly lower margin than our other products. Our security and entertainment margins in 2006 remained consistent with prior periods.

 

Income from operations increased by $32.4 million, or 167.9%, from $19.3 million in 2005 to $51.7 million in 2006. This increase was due to a decrease in operating expenses of $8.7 million and due to our increased gross profit. Operating expenses decreased due to the fact that we recorded costs of $24.5 million upon completion of our IPO in 2005 related to stock-based compensation expense, costs to terminate certain sale bonus and associate equity gain program arrangements, and other costs incurred as a result of the transaction. These decreases were offset by increases in operating expenses primarily due to costs associated with the increase in our sales base, costs associated with operating as a public company, and legal fees in defending against patent litigation. Amortization of intangible assets included in operating expenses increased approximately $0.5 million to $3.2 million in 2006 due to acquisitions made during 2006.

 

Interest Expense

 

Net interest expense decreased approximately $7.4 million, or 29.7%, from $24.9 million in 2005 to $17.5 million in 2006 primarily due to our payoff of $74.0 million of subordinated debt which was repaid with proceeds from our IPO. In February 2006, we entered into a new senior credit facility, which resulted in a 1% decrease in our interest rates. As more fully described in “Liquidity and Capital Resources” below, in connection with our acquisition of Polk in September 2006, we amended our senior credit facility, which resulted in additional borrowings of $141.0 million and a 25 basis point increase in our interest rates. As a result of the amendment, we wrote off unamortized debt issuance costs of $0.3 million during 2006.

Provision for (benefit from) Income Taxes

 

Our effective tax rate increased from an income tax benefit of 7.7% in 2005 to a provision of 38.5% in 2006. This difference resulted from the non-deductibility of stock-based compensation and certain costs incurred in connection with our initial public offering in 2005. Our 2006 effective tax rate was slightly higher than the combined statutory rate of 37.8%.

 

Liquidity and Capital Resources

 

Our principal uses of cash are for operating expenses, working capital, servicing long-term debt, capital expenditures, acquisitions, and payment of income taxes. Historically, we have financed these requirements from internally generated cash flow and borrowings from our credit facility. Due to our business model, our capital expenditures are generally low. As a result of seasonal demand, our receivables and payables typically peak near the end of the year due to high fourth quarter volume and are typically reduced in the first quarter of the year. We believe, based on our current revenue levels, that our existing and future cash flows from operations, together with borrowings available under our revolving credit facility, will be sufficient to fund our working capital needs, capital expenditures, and interest and principal payments as they become due under the terms of our senior credit facility for the foreseeable future.

 

Net cash provided by operating activities was approximately $87.0 million in 2007, compared to net cash used in operating activities of approximately $20.2 million in 2006. This results in an overall increase of $107.2 million in net cash provided by operating activities in 2007 as compared to 2006. The difference between our 2007 operating cash flow and our $140.0 million net loss was primarily attributable to the $194.8 million non-cash charge for intangible asset impairment, a $60.7 million decrease in inventory, an $81.3 million decrease in our accounts receivable, and a $78.9 million increase in accounts payable and accrued liabilities. As discussed above, our 2007 fourth quarter impairment review under the requirements of SFAS 142 resulted in non-cash impairment charges of $168.4 million related to goodwill and $26.5 million related to certain indefinite-lived intangible assets. The decrease in inventory was primarily related to the downturn in our satellite radio business and the resulting decreased purchases of these products as compared to the prior year, as well as more effective inventory management. The decrease in accounts receivable and the increase in accounts payable and accrued liabilities were primarily due to working capital initiatives in the fourth quarter of 2007 in order to pay down debt. We arranged with certain customers to collect early on receivables for which we implemented short-term payment incentives. We have also arranged for improved payment terms with certain vendors for 2008.

 

Net cash used in operating activities was approximately $20.2 million in 2006, compared with net cash used in operating activities of approximately $19.6 million in 2005. The increase in net cash used in operating activities from 2005 to 2006 occurred primarily as a result of acquisitions in combination with an increase in working capital investments in 2006, particularly accounts receivable and inventory, to fund our satellite radio product sales growth in 2006.

 

As discussed in the “Outlook” above, it is uncertain whether we will renew or extend our agreement with SIRIUS beyond August 31, 2008. Should we or SIRIUS choose not to renew or extend the agreement, our future revenues would decline significantly. We believe we would experience an initial net decrease in working capital that we would use to pay down debt.

 

Net cash used in investing activities was approximately $15.9 million in 2007 compared with $152.8 million in 2006 and $2.7 million in 2005. The changes occurred primarily due to cash paid for acquisitions in 2006. Capital expenditures are expected to be approximately $5.0 million in 2008, an increase of approximately $1.7 million from 2007, to support infrastructure needs.

 

Net cash used in financing activities was approximately $76.3 million in 2007 compared with net cash provided by financing activities of $170.6 million in 2006. The change occurred primarily due increased payments toward outstanding principal balances and decreased proceeds from our credit facility in 2007 as compared with 2006. In the fourth quarter of 2007, we prepaid approximately $39.2 million of our outstanding debt. Net cash provided by financing activities increased from $30.7 million in 2005 to $170.6 million in 2006 primarily due to increased proceeds from our credit facility which were used to fund the acquisition of Polk.

Our principal sources of liquidity are cash from operations and funds available for borrowing under our senior credit facility. In connection with the acquisition of Polk, on September 22, 2006, we entered into a new senior credit facility, which increased our term loan by $141.0 million. The new agreement resulted in a 25 basis point increase in our interest rate to LIBOR plus 2.50%. The credit agreement provided for senior notes in an aggregate principal amount equal to $306.8 million, plus a revolving loan in a maximum principal amount of $100.0 million, of which only $50.0 million is available from March through September. The revolving loan will mature on September 22, 2012 and the senior notes will mature on September 22, 2013. An incremental loan facility is available to us in an aggregate amount up to $75.0 million, provided that (i) no default or event of default shall have occurred and be continuing, and (ii) we are in compliance with all covenants contained in the amended credit agreement. The proceeds of the senior notes were used to refinance our original credit agreement, to finance the acquisition of Polk, and to pay fees and expenses in connection with that acquisition. Our senior credit facility contains certain affirmative and negative covenants related to indebtedness, leverage and fixed charges coverage, and restrictions against paying cash dividends without the lenders’ consent. The revolving loan and incremental loan facility may be used for working capital requirements, general corporate purposes, and certain permitted acquisitions. As of December 31, 2007, the balance of the senior notes was $262.9 million and we had $4.0 million drawn on our revolving credit facility to fund working capital requirements. In April 2007, we were granted an amendment (“Amendment No. 1”) to our senior credit facility that allowed for a higher leverage ratio for the next three years. In connection with Amendment No. 1, we paid fees of $1.0 million.

 

In March 2008, we amended certain terms, conditions, and covenants contained in our senior credit facility (“Amendment No. 2”). Specifically, Amendment No. 2 modifies certain financial covenant requirements contained in our senior credit facility, including total leverage ratio and fixed charge coverage ratio. Amendment No. 2 will increase our interest rate by 100 to 150 basis points, depending upon leverage ratios, from our current rate of LIBOR plus 250 basis points. Amendment No. 2 increased our allowable leverage ratio to 5.25x through March 31, 2009, stepping down to 4.95x through December 31, 2009, with step-downs thereafter consistent with the previous terms of the agreement. In addition, Amendment No. 2 permits additional add-backs to adjusted EBITDA in the calculation of our leverage ratio, modifies principal payment terms and revolving loan availability, and permits the right to execute the sale of certain accounts receivable so long as the proceeds are used to reduce indebtedness. Our revolving loan availability was modified to allow a maximum principal amount of $60.0 million, of which $50.0 million is available all year with an additional $10 million available from October through February due to the seasonality of our business. The amendment also requires us to make quarterly principal payments of $0.7 million commencing in March 2008, with balloon payments of $5.9 million on December 31, 2009 and $11.1 million on December 31, 2010, 2011, and 2012, with the final installment of the total principal due on September 22, 2013. We expect to refinance or extend our senior credit facility prior to September 22, 2013, but we may not be able to obtain such refinancing on acceptable terms or at all.

 

We were in compliance with all the covenants related to our indebtedness as of December 31, 2007. Based upon current earnings and working capital forecasts for 2008, we believe we will continue to remain in compliance with the covenants in our recently completed amendment. In the event that our earnings or working capital fall short of our forecasts, it is possible that we would fail to comply with certain leverage ratio requirements of our senior credit facility. Under the terms of our senior credit facility, such failure would constitute an event of default. Upon the occurrence of an event of default, our lenders could prohibit additional borrowings under our revolving line of credit and could call due all amounts currently outstanding.

 

In the future, the growth of our business may require us to seek additional sources of liquidity such as a larger revolving credit facility. In addition, if we pursue significant acquisitions in the future, this will likely necessitate additional borrowings and, potentially, additional equity. Our ability to use operating cash flow to increase our growth is limited by requirements in our credit agreement to repay debt with excess cash flow as defined therein.

Contractual Obligations

 

The following table lists our commercial commitments as of December 31, 2007:

 

 

On January 1, 2007, we adopted the provisions of FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109.” Under FIN 48, we recognize the tax benefit from an uncertain tax position only if it is more likely than not that such tax position will be sustained upon examination by taxing authorities, based on the technical merits of the position. As of December 31, 2007, we had a liability for unrecognized tax benefits of approximately $2.1 million. We are unable to reasonably estimate the amount or timing of payments for the liability and, as such, this liability is not included in the table above.

 

Contractual obligations for long-term debt include required principal, as scheduled in our recently completed amendment of our senior credit facility, and interest payments. Effective January 4, 2007, we entered into an interest rate swap on $153.0 million of the outstanding balance of our long-term debt. The swap is for a fixed rate of 5.04% and terminates January 4, 2010. Interest on the long-term debt in the table above that is within the term of the swap agreement has been calculated using the swap fixed interest rate. Our interest rates on the remaining debt are variable. The remaining long-term debt in the table above has been computed using the current effective interest rate on our long-term debt of 8.9%. Our annual interest expense on our variable rate debt would change by $1.1 million for each 1% change in interest rates, assuming no revolving credit borrowings and considering the fixed rate on $153.0 million due to the interest rate swap. Future payments due under non-cancelable lease obligations, net of sublease income, relate to our operating leases for our headquarters, sales and distribution facilities, and equipment leases which expire at various times from 2008 to 2016.

 

Quarterly Results of Operations

 

Our business experiences quarterly fluctuations in net sales and operating income, particularly in light of the fluctuation in satellite radio sales in recent years. These fluctuations could have a significant impact on our working capital needs. Sales of our products are highest in our fourth fiscal quarter due to increased consumer spending during the holiday season.

 

Our quarterly results are also influenced by the timing of acquisitions, product introductions, and the periodic assessment of intangible asset impairment. The following table presents unaudited consolidated statement of operations data for each of the eight quarters in the period ended December 31, 2007. We believe that all necessary adjustments have been included to fairly present the quarterly information when read in conjunction with our annual

consolidated financial statements and related notes. The operating results for any quarter are not necessarily indicative of the results for any subsequent quarter.

 

 

 

 

Off-Balance Sheet Arrangements

 

We do not currently have, nor have we ever had, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As a result, we are not materially exposed to any financing, liquidity, market, or credit risk that could arise if we had engaged in these relationships.

 

Recently Issued Accounting Pronouncements

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. The statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. The statement emphasizes that fair value is a market-based measurement and not an entity-specific measurement. It also establishes a fair value hierarchy used in fair value measurements and expands the required disclosures of assets and liabilities measured at fair value. We will adopt the accounting provisions of SFAS No. 157 during the first quarter of 2008 and are currently evaluating its impact of on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities.” SFAS No. 159 provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We adopted the accounting provisions of SFAS No. 159 on January 1, 2008 and do not expect it to have a material impact on our consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 141R, “Business Combinations.” SFAS No. 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, any business combinations we engage in will be recorded and disclosed following existing GAAP until January 1, 2009. We expect SFAS No. 141R will have an impact on our consolidated financial statements when effective, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions we consummate after the effective date.

 

Critical Accounting Policies and Estimates

 

Our 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 generally accepted accounting principles (GAAP) in the United States. During preparation of these consolidated financial statements, we are required to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, bad debts, inventories, long-lived assets, goodwill and other intangible assets, warranties, income taxes, and stock-based compensation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

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

Revenue Recognition

 

Revenue from sales of products to customers is recognized when title and risk of ownership are transferred to customers; when persuasive evidence of an arrangement exists; when the price to the buyer is fixed or determinable; and when collection is reasonably assured in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements.” Prior to the second quarter of 2007, for customers that did not arrange for their own shipping, we recognized revenue upon delivery to the customer as we held outbound shipping insurance and it was determined that the risk of ownership had not transferred to the customer until the product was delivered. Starting in the second quarter of 2007, we no longer insured our shipments to customers on FOB shipping point terms. Rather, all products shipped are insured by the customer. Accordingly, since the second quarter of 2007, we have recognized revenue at the time of shipment for customers with FOB shipping point terms.

 

In accordance with SFAS No. 48, “Revenue Recognition When a Right of Return Exists,” estimated product returns are deducted from revenue, based on historical return rates, the product stage relative to its expected life cycle, and assumptions regarding the rate of sell-through to end users from our various channels based on estimated sell-through rates. While our historical estimates have been materially accurate, actual return rates could vary from our estimates. An increase in the return rate could result from changes in consumer demand or other factors. Should this variance occur, revenues could fluctuate significantly.

 

We account for payments to customers for volume rebates and cooperative advertising as a reduction of revenue, in accordance with EITF Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products.” Reductions to revenue for expected and actual payments to resellers for volume rebates and cooperative advertising are based on actual or anticipated customer purchases, and on fixed contractual terms for cooperative advertising payments. Certain of our volume incentive rebates offered to customers include a sliding scale of the amount of the sales incentive with different required minimum quantities to be purchased. We make an estimate of the ultimate amount of the rebate our customers will earn based upon past history with the customer and other facts and circumstances. We have the ability to estimate these volume incentive rebates, as there does not exist a relatively long period of time for a particular rebate to be claimed. We have historical experience with these sales incentive programs and a large volume of relatively homogenous transactions. Any changes in the estimated amount of volume incentive rebates are recognized immediately on a cumulative basis.

 

In accordance with EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” we account for the proceeds received for sales of SIRIUS-related hardware products as revenue on a gross basis, as we are the primary obligor to our customers, have discretion in pricing with our customers, have discretion in the selection and contract terms with our supplier, and have inventory and credit risk.

 

Our royalty revenue is recognized as earned in accordance with the specific terms of each agreement, which is generally when we receive payment.

 

Accounts Receivable

 

Some of our customers pay C.O.D. or by credit card. For other customers, we perform ongoing credit evaluations and adjust credit limits based upon payment history and the customer’s current creditworthiness. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon historical experience and any specific customer collection issues that have been identified. We record charges for estimated credit losses against operating expenses in our consolidated financial statements. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that have been experienced in the past.

 

Inventories

 

Inventories are valued at the lower of cost or market value. Cost is determined by the average cost method. We record adjustments to our inventory for estimated obsolescence or diminution in market value equal to the difference between the cost of the inventory and the estimated market value, based on market conditions from time to time. These adjustments are estimates, which could vary significantly, either favorably or unfavorably, from

actual experience if future economic conditions, levels of consumer demand, customer inventory levels, or competitive conditions differ from expectations. At the point of the loss recognition, a new lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. Therefore, although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our reported operating results.

 

A portion of our inventory is subject to an agreement that permits us to sell qualifying product at our carrying cost to a third party affiliated with the original manufacturer. In connection with assessing adjustments to our inventory for estimated obsolescence or diminution in market value, we consider the risk related to the carrying value of such qualifying product.

 

Goodwill and Indefinite-Lived Intangible Assets

 

We review goodwill and intangible assets with indefinite lives for impairment annually in the fourth quarter and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. For goodwill, we perform a two-step impairment test. In the first step, the book value of our net assets, which are combined into a single reporting unit for purposes of impairment testing, is compared to the fair value of our net assets. If the fair value is determined to be less than book value, a second step is performed to compute the amount of impairment. The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized as a reduction in the carrying value of goodwill and charged to results of operations. In step one of our 2007 annual goodwill impairment test, we considered the market value of our common stock when estimating the fair value of our net assets. We failed step one of the test, requiring completion of step two, which resulted in a determination that our goodwill was impaired. Accordingly, a non-cash impairment charge of $168.4 million was recorded in 2007. The impairment did not affect our cash position, cash flow from operating activities, or our senior credit facility covenants, and will not have any impact on future operations.

 

For indefinite-lived intangibles, we compare the fair value of the indefinite-lived intangible assets to the carrying value. We estimate the fair value of these intangible assets using the royalty savings approach. An asset’s value is deemed impaired if the discounted cash flows or earnings projections generated do not substantiate the carrying value of the asset. As a result of our 2007 annual impairment test, we recorded a non-cash impairment charge of $26.5 million related to certain indefinite-lived trademarks.

 

Fair values were determined using discounted cash flow models involving several assumptions for our annual impairment review of indefinite-lived trademarks and step two of our annual review of goodwill. Changes in our assumptions could materially impact our fair value estimates. Assumptions critical to our fair value estimates were: (i) present value factors used in determining the fair value of intangible assets; (ii) royalty rates used in our trademark valuations; (iii) projected revenue growth rates used in the models; and (iv) projected long-term growth rates used in the derivation of terminal year values. These and other assumptions are impacted by economic conditions and expectations of management and will change in the future based on period specific facts and circumstances.

 

See Note 6 to our Consolidated Financial Statements for additional information on goodwill and indefinite-lived intangible assets.

 

Impairment of Long-Lived Assets

 

Long-lived assets with finite lives are amortized using the straight-line method over their estimated economic lives, currently ranging from two to twenty years. Long-lived assets are evaluated for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We assess the recoverability of an asset based on the undiscounted future cash flow the asset is expected to generate. Impairment is identified if such cash flow plus net proceeds expected from disposition of the asset, if any, are less than the carrying value of the

asset. When an impairment is identified, we reduce the carrying amount of the asset to its fair value based on a discounted cash flow approach or, when available and appropriate, to comparable market values. We estimate the useful lives of intangible assets by considering various pertinent factors, including the expected use of the asset, legal or contractual provisions that may limit the life of the asset, and the effects of obsolescence and other economic factors. As a result of the impairment of certain of our indefinite-lived intangible assets during the fourth quarter of 2007, we assessed the recoverability of the related long-lived assets. The undiscounted future cash flows related to these assets exceed their carrying amounts. Accordingly, we concluded that our long-lived assets with finite lives were not impaired. Although our cash flow forecasts are based on assumptions that are consistent with plans and estimates we are using to manage our underlying business, there is significant judgment in determining the cash flows attributable to our long-lived assets. If actual results are different from our forecasts, future tests may indicate impairments, which would adversely affect our results of operations.

 

Warranties

 

We offer warranties of various lengths depending upon the specific product. Our standard warranties require us to repair or replace defective products returned to us by both end users and our retailer customers during specified warranty periods at no cost to the end users or retailer customers. We return defective products that were returned to us under warranty to our manufacturers to the extent that we cannot repair or sell the refurbished products. We record an estimate for warranty related costs in cost of sales based upon our actual historical return rates and repair costs at the time of sale. The estimated liability for future warranty expense has been included in accrued expenses. We cannot guarantee that we will continue to experience the same warranty return rates or repair costs that we have experienced in the past. A significant increase in product return rates, or a significant increase in the costs to repair our products, could have a material adverse impact on our operating results for the period or periods in which such returns or additional costs materialize.

 

Income Taxes

 

We provide for income taxes utilizing the liability method. Under the liability method, current income tax expense or benefit is the amount of income taxes expected to be payable or refundable for the current year. A deferred income tax asset or liability is computed for the expected future impact of differences between the financial reporting and tax bases of assets and liabilities and for the expected future tax benefit to be derived from tax credits. Tax rate changes are reflected in the computation of the income tax provision during the period such changes are enacted.

 

Deferred tax assets are reduced by a valuation allowance when, in our opinion, it is more likely than not that some portion or all of the deferred tax assets will not be realized. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. As of December 31, 2007, we had established a valuation allowance against certain state net operating losses and certain other state deferred tax assets in the amount of $0.1 million. The valuation allowance is based on available evidence, including our current year operating loss, evaluation of positive and negative evidence with respect to certain specific deferred tax assets including evaluation sources of future taxable income to support the realization of the deferred tax assets. Based upon the level of historical taxable income and projections for future taxable income over the periods which the deferred tax assets are deductible, we believe it is more likely than not that we will realize the benefits of the remaining deductible differences.

 

We adopted the provisions of FIN 48, “Accounting for Uncertainty in Income Taxes,” on January 1, 2007. Under FIN 48, we recognize the tax benefit from an uncertain tax position only if it is more likely than not that such tax position will be sustained upon examination by taxing authorities, based on the technical merits of the position. See Note 13 to our Consolidated Financial Statements for additional information regarding the adoption of FIN 48.

 

Stock-Based Compensation Expense

 

We account for stock-based compensation in accordance with SFAS No. 123R (revised 2004), “Share Based Payment.” Under the provisions of SFAS No. l23R, stock-based compensation cost is estimated at the grant date based on the award’s fair value as calculated by a Black-Scholes option-pricing model and is recognized as expense

evenly over the requisite service period. The Black-Scholes model requires various judgmental assumptions including dividend yield, expected volatility, risk-free interest rate, and expected option life. If any of the assumptions used in the model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period. See Note 10 to our Consolidated Financial Statements for additional information on the accounting for stock-based compensation.

 

 

Interest Rate Risk

 

Our exposure to interest rate risk is primarily the result of borrowings under our existing senior credit facility. At December 31, 2007, $266.9 million was outstanding under our senior credit facility, including $4.0 million that we had drawn on our revolving credit facility. Borrowings under our senior credit facility are secured by first priority security interests in substantially all of our tangible and intangible assets. Our results of operations are affected by changes in market interest rates on these borrowings. As required by our credit agreement, we entered into an interest rate swap agreement in January 2007 to fix the interest rate on a portion of our term loans. Pursuant to that agreement, the interest rate on an aggregate of $153.0 million of our senior debt is fixed at 5.04% until January 4, 2010. The interest rate swap is recorded at its fair value on our balance sheet. Changes in the fair value of the swap are recorded in accumulated other comprehensive income (loss) on our consolidated balance sheet. See Notes 3 and 7 to our Consolidated Financial Statements for further details regarding the accounting and disclosure of our derivative instruments and hedging activities.

 

A 1% increase in interest rates would result in additional annual interest expense of $1.1 million on our senior credit facility, assuming no revolving credit borrowings and considering the fixed rate on $153.0 million of our debt related to our interest rate swap. We will continue to monitor changing economic conditions. Based on current circumstances, we do not expect to incur a substantial increase in costs or a material adverse effect on cash flows as a result of changing interest rates.

 

Foreign Currency Exchange Risk

 

Our revenues and purchases are predominantly in U.S. Dollars. We account for a portion of our costs in our U.K. and Hong Kong offices and our Canadian subsidiaries, such as payroll, rent, and indirect operating costs, in foreign currencies. Fluctuations in foreign currency exchange rates could affect our sales, cost of sales, and operating margins. In addition, currency devaluation can result in a loss to us if we hold deposits of that currency and could cause losses to our contract manufacturers. We do not currently use derivative instruments to hedge against this risk. We also collect a portion of our revenue in non-U.S. currencies, primarily Canadian Dollars. We use forward contracts that are not designated as hedging instruments under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, to hedge the impact of the variability in exchange rates on a portion of accounts receivable and collections denominated in Canadian Dollars. The derivative instrument is recorded at its fair value on our balance sheet with changes in the fair value recorded in earnings. This derivative instrument was not material as of December 31, 2007. As we plan to expand internationally, we may enter into additional derivative financial instruments in the future. We generally do not hedge the net assets of our international subsidiaries. We do not enter into derivative contracts for trading or speculative purposes. See Notes 3 and 7 to our consolidated financial statements for further details regarding the accounting and disclosure of our derivative instruments and hedging activities.

 

Impact of Inflation

 

We believe that our results of operations are not materially impacted by moderate changes in the inflation rate. Inflation and changing prices did not have a material impact on our operations in 2007, 2006, or 2005. Severe increases in inflation, however, could affect the global and U.S. economies and could have an adverse impact on our business, financial condition, and results of operations.

 

Reference is made to our consolidated financial statements, the notes thereto, and the report thereon, commencing on page F-1 of this report, which consolidated financial statements, notes, and report are incorporated herein by reference.

 

 

Not applicable.

Item 9A.  Controls and Procedures

 

 

Disclosure Controls and Procedures

 

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the SEC and that such information is accumulated and communicated to management, including our chief executive officer, or CEO, and chief financial officer, or CFO, as appropriate, to allow for 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 is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

Management, under the supervision of our CEO and CFO, has designed our disclosure controls and procedures to provide reasonable assurance of achieving desired objectives. As required by Exchange Act Rule 13a-15(b), in connection with filing this Annual Report on Form 10-K, management conducted an evaluation, with the participation of our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Exchange Act Rule 13a-15(e), as of December 31, 2007, the end of the period covered by this report. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of December 31, 2007.

 

(b) Management’s Report on Internal Control over Financial Reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets, (ii) provide reasonable assurance that transactions are recoded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors, and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2007 based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the criteria established in

Internal Control — Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2007.

 

Management’s evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2007 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.

 

 

There were no changes in our internal control over financial reporting that occurred during the period covered by this Annual Report on Form 10-K that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

Not applicable.

PART III

 

 

The information required by this Item relating to our directors is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2008 Annual Meeting of Shareholders. The information required by this Item relating to our executive officers is included in Item 1, “Business — Executive Officers.”

 

 

The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2008 Annual Meeting of Shareholders.

 

 

The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2008 Annual Meeting of Shareholders.

 

 

The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2008 Annual Meeting of Shareholders.

 

 

The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filled pursuant to Regulation 14A of the Exchange Act for our 2008 Annual Meeting of Shareholders.

PART IV

 

 

(a) Financial Statements and Financial Statement Schedules

 

(1) Consolidated Financial Statements are listed in the Index to Consolidated Financial Statements on page F-1 of this report.

 

(2) No financial statement schedules are included because such schedules are not applicable, are not required, or because required information is included in the consolidated financial statements or notes thereto.

 

(b) Exhibits

 

 

 

SIGNATURES

 

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

 

DIRECTED ELECTRONICS, INC.

 

James E. Minarik

President and Chief Executive Officer

Date: March 17, 2008

 

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

 

 

 

To the Board of Directors and Shareholders of Directed Electronics, Inc.

 

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Directed Electronics, Inc. and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the Management’s Report on Internal Control over Financial Reporting under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our audits which were integrated audits in 2007 and 2006. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

The Company’s liquidity and financial condition are discussed in Note 2 to the consolidated financial statements.

 

As discussed in Note 3 to the consolidated financial statements, the Company changed the manner in which it accounts for uncertain tax positions in 2007. As discussed in Note 3 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation in 2006.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

 

San Diego, California

March 17, 2008

DIRECTED ELECTRONICS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

 

 

The accompanying notes are an integral part of the consolidated financial statements.

DIRECTED ELECTRONICS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)