TURTLE BEACH CORP Management’s Discussion and Analysis of Financial Condition and Results of Operations (Form 10-K)
The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes. This analysis summarizes the significant factors affecting our results of operations and the financial condition of our business in each of the fiscal years of the three-year period ended.
Turtle Beach Corporation(herein referred to as the "Company," "we," "us," or "our"), headquartered in White Plains, New York, and incorporated in the state of Nevadain 2010, is a premier audio technology company with expertise and experience in developing, commercializing, and marketing innovative products across a range of large addressable markets under the Turtle Beach®, ROCCAT® and Neat Microphone® brands.
use on multiple platforms, including video games and entertainment
consoles, handheld consoles, personal computers (“PCs”), tablets and mobiles
• ROCCAT is a brand of gaming headsets, keyboards, mice and other accessories
focused on the personal computer peripheral market.
• Neat Microphones is an innovative brand of USB and
analog microphones Business Trends Console Headset Market The global market for console headsets in 2021 was approximately
$1.7 billionin which we are the market leader. This market experienced unprecedented growth in 2020 driven by the initial COVID-19 stay-at-home orders when new gamers entered the market, lapsed gamers started playing again, existing gamers played more, and non-gamers bought headsets for remote learning. In 2021, this market experienced a decline due to weaker retail traffic, a slower holiday season from disappointing triple A video game releases and console supply constraints. Traditionally, the gaming market has grown as new gamers enter and existing gamers upgrade headsets. However, the emergence of battle royale games that are highly social, collaborative, and competitive, contributed to a higher growth in the video game industry and a higher proportion of gamers using headsets. And given that most of the gaming headset market is driven by replacement and upgrading, this large influx of new gaming headset users is expected to drive an increase in demand for gaming headsets in future years. Additionally, with the ongoing COVID-19 pandemic, use of gaming headsets has seen increased demand driven by an overall increase in gaming, and by work-from-home, school/learn-from-home, and because chatting with friends during online play continues to be an important form of daily interactivity and communication for many, progressed by pandemic-related containment measures.
PC accessories market
The market for PC gaming headsets, mice, and keyboards is estimated to have grown in 2021 to
$3.8 billion. PC gaming in the U.S.has seen a resurgence in popularity the past few years and continues to be a main gaming platform internationally, driven by big AAAgame launches, PC-specific esports leagues, teams and players, content creators and influencers, cross platform play, and more. While most games are available on multiple platforms, gaming on PC offers advantages that include improved graphics, increased speed and precision of mouse/keyboard controls, and the ability for customization. Gaming mice and keyboards are engineered to provide gamers with high-end performance and a superior gaming experience through benefits including faster response times, improved materials and build quality, programmable buttons and keys, and software suites to customize and control devices and settings.
In 2021, the Company completed the acquisition of Neat, a brand that creates, manufactures, and sells high-quality digital USB and analog microphones. Neat's accomplished leadership team includes the former founders of Blue Microphones, inventors of the first high-performance USB microphone, and pioneers behind other award-winning microphones that have revolutionized how professionals and consumers capture their voice, music and more. The acquisition enabled our entry into the
$2.3 billionglobal microphone market, which is experiencing rapid growth in the digital/USB accessories segment where Neat's product innovation is focused.
Game simulation controllers and markets
During 2021, the Company expanded into the gaming simulation and gaming controller markets with the launch of the VelocityOne Flight™ simulation control system and the Xbox Recon Controller, respectively. These markets will increase our total addressable market by
$1 billion, with third-party game controllers at roughly $600 millionand PC/console flight simulation hardware at roughly $400 millionin global market. 24
Our gaming accessories business is seasonal with a significant portion of sales and profits typically occurring around the holiday period. Historically, more than 45% of revenues are generated during the period from September through December as new products are introduced and consumers engage in holiday shopping. However, in the past few years, normal seasonal patterns have been significantly changed due to pandemic-driven shifts in consumer demand. In connection with the seasonality of the business, historically the Company's borrowings on the revolving credit facility increase as a result of the holiday inventory build leading up to year-end and decline on gross receipts during the first quarter of the following year. In 2021, the Company ended the year with no outstanding borrowings under its revolving credit facility as cash flows from operations were sufficient to fund the Company's working capital needs.
During 2020, as the pandemic resulted in stay-at-home guidance, the gaming accessory market experienced a significant surge in demand as existing gamers began gaming more and new gamers entered the market. In addition, the increase in working from home and learning from home created additional demand for accessories, particularly gaming headsets which work well for video and audio calls. As a result, the Company's 2020 revenues exceeded historical levels as the overall gaming and headset markets experienced an unprecedented surge in demand. Through 2021 and going forward, the effects of the global pandemic and the measures being taken in response are uncertain and difficult to predict. While there were likely certain one-time purchases caused by the stay-at-home orders, we believe millions of new gamers have joined the market which created an ongoing, larger installed base of players in 2021.
Supply chain and logistics outlook
The ongoing global economic recovery from the COVID-19 pandemic as well as a surge in imports and high demand for electronics, has created significant challenges for global supply chains resulting in inflationary cost pressures and component shortages. We have also experienced logistical challenges related to transportation delays and have incurred incremental costs for commodities and components used in our products as well as component shortages that have negatively impacted our sales and results of operations. We expect that these challenges will continue to have an impact on our businesses for the foreseeable future. As a result, we continue to take proactive steps to continue to limit the impact of these challenges and, are working closely with our suppliers to manage availability of products and implement other cost savings initiatives. Results of Operations Management Overview In 2021, our reported net income was
$17.7 million, or diluted net income per share of $0.97. We grew from our record year in 2020 due to growth in non-console products including PC accessories, controllers, and flight simulation. The non-console products represented approximately 20% of total revenues in 2021. The console market declined year over year due to semiconductor constraints and weaker game performance. Our console business was negatively impacted by semiconductor constraints with our wireless products. In spite of this Turtle Beachconsole market share continues to be higher than the next three competitors.
Not only are we continuing to advance our best-selling gaming audio business with new headsets like the Recon 200 Gen 2, but we’ve also entered the
Looking forward, we have expanded our gaming accessory offerings, operating in seven gaming market categories with addressable markets of over
$8.5 billion. As a result, we exceeded 20% of our revenues in categories outside the console gaming headset category, in which we have been a leader for over ten years, and we believe we are on-target to achieve the Company's goal of $100 millionnon-console headset revenues in 2022. 25 --------------------------------------------------------------------------------
Key Performance Indicators and Non-GAAP Measures
Management routinely reviews key performance indicators including revenue, operating income and margins, and earnings per share, among others. In addition, we believe certain other measures provide useful information to management and investors about us and our financial condition and results of operations for the following reasons: (i) they are measures used by our Board of Directors and management team to evaluate our operating performance; (ii) they are measures used by our management team to make day-to-day operating decisions; (iii) the adjustments made are often viewed as either non-recurring or not reflective of ongoing financial performance and/or have no cash impact on operations; and (iv) the metrics are used by securities analysts, investors and other interested parties as a common operating performance measure to compare results across companies in our industry by adjusting for potential differences caused by variations in capital structures (affecting relative interest expense), and the age and book value of facilities and equipment (affecting relative depreciation and amortization expense). These metrics, however, are not measures of financial performance under accounting principles generally accepted in
the United States of America("GAAP") and given the limitations of these metrics as analytical tools, should not be considered a substitute for gross profit, gross margins, net income (loss) or other consolidated income statement data as determined in accordance with GAAP. We consider the following non-GAAP measures, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators:
• Adjusted EBITDA is defined as net earnings (loss) before interest, taxes,
depreciation and amortization, stock-based compensation (non-cash) and
certain one-time special items that we believe are not representative
of core operations. • Cash Margins is defined as gross margin excluding depreciation, amortization, and stock-based compensation.
Adjusted EBITDA (and a reconciliation to net income, the nearest GAAP financial measure) for the years ended
December 31, 2021, 2020 and 2019 are as follows: Year Ended December 31, 2021 2020 2019 (in thousands) Net income $ 17,721 $ 38,746 $ 17,944Interest expense 383 467 929 Depreciation and amortization 5,313 5,248 5,198 Stock-based compensation 7,656 5,549 3,558 Income tax expense (benefit) 2,428 13,711 (6,237 ) Unrealized loss (gain) on financial instrument obligation - - (1,601 ) Acquisition-related settlement - (1,702 ) - Change in fair value of contingent consideration (1,928 ) (1,121 ) (471 ) Business transaction expense 78 550 3,516 Non-recurring business costs 4,934 - - Adjusted EBITDA $ 36,585 $ 61,448 $ 22,836
Comparison of the year ended
Net income for the year ended
December 31, 2021was $17.7 millioncompared to a net income of $38.7 millionin the prior year for the years ended December 31, 2021and 2020, respectively. For the year ended December 31, 2021, Adjusted EBITDA was $36.6 millioncompared to $61.4 million, for the year ended December 31, 2020. Net income and Adjusted EBITDA decreased reflecting higher freight and supply chain costs, annualized run-rate increases in operating expenses due to larger size of the business, and growth investments.
Comparison of the year ended
Net income for the year ended
For the year ended
December 31, 2020, Adjusted EBITDA was $61.4 millioncompared to $22.8 million, for the year ended December 31, 2019. Net income and Adjusted EBITDA increased primarily due to higher revenue and favorable business mix as the Company capitalized on the surging stay-at-home driven gaming consumer demand and outpaced the market based on brand strength and product availability. 26 --------------------------------------------------------------------------------
The following table sets forth the Company's statements of operations for the periods presented: Year Ended December 31, 2021 2020 2019 (in thousands) Net revenue
$ 366,354 $ 360,093 $ 234,663Cost of revenue 237,971 226,305 155,950 Gross profit 128,383 133,788 78,713 Gross margin 35.0 % 37.2 % 33.5 % Operating expenses 107,952 84,621 68,286 Operating income 20,431 49,167 10,427 Interest expense 383 467 929 Other non-operating expense (income), net (101 ) (3,757 ) (2,209 ) Income before income tax 20,149 52,457 11,707 Income tax expense (benefit) 2,428 13,711 (6,237 ) Net income $ 17,721 $ 38,746 $ 17,944Net Revenue and Gross Profit The following table summarizes net revenue and gross profit for the periods presented: Year Ended December 31, 2021 2020 2019 (in thousands) Net Revenue $ 366,354 $ 360,093 $ 234,660Gross Profit $ 128,383 $ 133,788 $ 78,713Gross Margin 35.0 % 37.2 % 33.5 % Cash Margin (1) 35.6 % 38.1 % 34.4 %
(1) Excludes non-cash charges of
Comparison of the year ended
Net revenue for year ended
December 31, 2021was $366.3 million, a $6.3 million, or 1.7%, increase from $360.1 millionin 2020 driven by PC accessories growth and the entry into gaming controllers and flight simulation hardware, which offset the weaker console headset demand mostly due to weaker retail traffic, a slower holiday season from disappointing triple A video game releases and console supply constraints.
For the year ended
Comparison of the year ended
Net revenue for year ended
December 31, 2020increased $125.4 million, or 53.5% from 2019. This was due to a surge in gaming activity, including an influx of new gamers, returning gamers, and non-gaming headset use, ignited by state and local stay-at-home orders in place for a significant part of 2020 along with strong execution to rapidly increase supply to meet the increase in demand. For the year ended December 31, 2020, gross profit as a percentage of net revenue increased to 37.2% from 33.5% in the prior year. Margins were positively impacted by lower promotional activity, favorable business mix, and volume-driven fixed costs leverage, partially offset by certain air freight to enable retail supply and higher tariff costs. 27 --------------------------------------------------------------------------------
Operating Expenses Year Ended December 31, 2021 2020 2019 (in thousands) Selling and marketing
$ 58,883 $ 46,779 $ 38,634Research and development 17,490 12,265 7,856
General and administrative expenses 31,501 25,027 18,280 Acquisition integration costs 78,550 3,516 Total operating expenses
Selling and Marketing Selling and marketing expense for the year ended
December 31, 2021totaled $58.9 million, or 16.1% as a percentage of net revenues, compared to $46.8 million, or 13.0% as a percentage of net revenues, for the prior year. This increase was primarily due to marketing initiatives to support product portfolio expansion, expansion of geographies, and entry into new product categories. Selling and marketing expense for the year ended December 31, 2020totaled $46.8 million, or 13.0% as a percentage of net revenues, compared to $38.6 million, or 16.5% as a percentage of net revenues, for the year ended December 31, 2019. This increase was primarily due to the inclusion of acquired ROCCAT-related headcount, volume-based direct sales related fees and commissions, and increased digital media spend to build ROCCAT brand awareness, partially offset by decreases in marketing event spend, retail marketing initiatives and advertising display depreciation. Research and Development For the year ended December 31, 2021, we invested $17.5 millionin research and development, an increase from prior years attributable to additional resources and infrastructure to support product expansion including new category introductions: the VelocityOne Flight™ simulation control system, the Xbox Recon Controller and Neat microphones. For the years ended December 31, 2020and 2019, we expended $12.3 millionand $7.9 million, respectively. For the year 2020, this increase was attributable to the expansion of PC accessories development capability and, the Stealth 600 and Stealth 700 Gen 2 wireless gaming headsets for Xbox and PlayStation®5 platforms, investments to increase the company's software capabilities, and investments to begin work on several new product categories that launched in 2021. For the year 2019, expenses were reflective of new product initiatives, patent related costs and ROCCAT headcount expenses.
General and administrative
General and administrative expenses for the year ended
General and administrative expenses for the year ended
December 31, 2020increased $6.7 millionto $25.0 millioncompared to $18.3 millionfor the year ended December 31, 2019. The year-over-year increase was primarily due to the inclusion of acquired ROCCAT-related expenses ( $1.5 million), higher variable compensation costs, increased professional and legal services, and certain legal settlements. Income Taxes Income tax expense for the year ended December 31, 2021was $2.4 millionat an effective tax rate of 12.1% compared to income tax expense of $13.7 millionfor the year ended December 31, 2020at an effective tax rate of 26.1%. The effective tax rate was primarily impacted by tax benefits attributable to stock option exercises and restricted stock vestings, Research and Development ("R&D") credits and the reduced tax rate on our Foreign Derived Intangible Income ("FDII"). These tax benefits were partially offset by the impact of disallowed compensation and state income tax expense. During 2021, we substantially completed a federal R&D study for the 2018-2020 tax years, recognizing tax benefits of $0.5 millionnet of reserves. An estimate of $0.2 millionR&D credits, net of reserves, was included for 2021. In addition, we completed an analysis of our foreign sales and recognized a tax benefit of $1.0 millionon our FDII. Income tax expense for the year ended December 31, 2020was $13.7 millionat an effective tax rate of 26.1% compared to income tax benefit of $6.2 millionfor the year ended December 31, 2019at an effective tax rate of (53.3%). The effective tax rate was primarily impacted by permanent items including state taxes, executive compensation, and reserves for uncertain tax positions. 28 --------------------------------------------------------------------------------
Other non-operating expenses (income)
Other non-operating income totaled
$0.1 millionfor the year ended December 31, 2021, including a $1.9 millionfair value of contingent consideration reversal, compared to other non-operating income of $3.8 millionfor the year ended December 31, 2020, which included a $1.7 millionacquisition-related settlement gain and $1.2 millionfair value of contingent consideration reversal. Other non-operating income totaled $3.8 millionfor the year ended December 31, 2020, including a $1.7 millionacquisition-related settlement gain and $1.2 millionfair value of contingent consideration reversal, compared to other non-operating income of $2.2 millionfor the year ended December 31, 2019, which included $1.6 millionunrealized gain related to the change in fair value of a financial instrument obligation.
Cash and capital resources
Our primary sources of working capital are cash flow from operations and the availability of capital under our revolving credit facility, which has been infrequently used over the past year. We have funded transactions and acquisitions in recent periods with cash flow from operations and proceeds from debt and equity financings.
The following table summarizes our sources and uses of cash:
Year Ended December 31, 2021 2020 2019 (in thousands) Cash and cash equivalents at beginning of period
$ 46,681 $ 8,249 $ 7,078Net cash provided by (used for) operating activities (327 ) 51,049
Net cash used for investing activities (8,121 ) (5,663 ) (14,579 ) Net cash used for financing activities (56 ) (7,412 ) (24,180 ) Effect of foreign exchange on cash (457 ) 458
Cash and cash equivalents at the end of the period
$ 8,249Operating activities Cash used for operating activities for the year ended December 31, 2021was $0.3 million, a decrease of $51.4 millionas compared to cash provided by operating activities totaling $51.0 millionfor the year ended December 31, 2020. The decrease is primarily the result of lower operating results increased inventory levels in response to supply chain and logistic headwinds. Cash provided by operating activities for the year ended December 31, 2020was $51.0 million, an increase of $11.7 millionas compared to cash provided by operating activities of $39.4 millionfor the year ended December 31, 2019. This is primarily the result of higher gross receipts, partially offset by increased product purchases, and related air freight costs, to align inventory levels with elevated consumer demand. Investing activities Cash used for investing activities was $8.1 millionof capital expenditures related to in-store advertising displays and new product manufacturing tooling, as well as $2.5 millionrelated to the Neat Microphones acquisition, during the year ended December 31, 2021compared to $5.7 millionin 2020 of capital expenditures primarily related to in-store advertising displays, new product manufacturing tooling and internal system upgrades. Cash used for investing activities was $5.7 millionduring the year ended December 31, 2020compared to $14.6 millionin 2019. 2020 expenditures consisted mainly of in-store advertising displays, new product manufacturing tooling and internal system upgrades, while 2019 expenditures included $12.7 millionrelated to the ROCCAT acquisition and $1.9 millionof capital expenditures.
Net cash used for financing activities was
$0.1 millionduring the year ended December 31, 2021compared to net cash used for financing activities of $7.4 millionand net cash used for financing activities of $24.2 millionduring the years ended December 31, 2020and 2019, respectively. Financing activities during the year ended December 31, 2021included stock option exercise proceeds of $5.3 millionand repurchases of common stock of $4.9 million.
Financing activities in 2020 included net repayments on our revolving credit facility of
Financing activities in 2019 included net repayments on our revolving credit facility of
Management’s assessment of liquidity
Management believes that our current cash and cash equivalents, the amounts available under our revolving credit facility and cash flows derived from operations will be sufficient to meet anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity, or capital requirements.
Foreign currency cash balances at
Issue of common shares in the market
August 7, 2020, the Company entered into an ATM Equity Offering Sales Agreement (the "Sales Agreement") with BofA Securities, Inc.(the "Sales Agent"). Pursuant to the terms of the Sales Agreement, the Company may sell from time to time through the Sales Agent shares of the Company's common stock, par value $0.001per share, having an aggregate offering price of up to $30 million. The Company intends to use the net proceeds from the offering, after deducting the Sales Agent's commissions and the Company's offering expenses, to support its strategic growth plans, as well as for general corporate purposes.
There was no activity under the sales contract during the year ended
Revolving Credit Facility On
December 17, 2018, Turtle Beachand certain of its subsidiaries entered into an amended and restated loan, guaranty, and security agreement ("Credit Facility") with Bank of America, N.A. (" Bank of America"), as Agent, Sole Lead Arranger and Sole Bookrunner, which replaced the then existing asset-based revolving loan agreement. The Credit Facility, which expires on March 5, 2024, provides for a line of credit of up to $80 millioninclusive of a sub-facility limit of $12 millionfor TB Europe, a wholly-owned subsidiary of Turtle Beach. In addition, the Credit Facility provides for a $40 millionaccordion feature and the ability to increase the borrowing base with a FILO Loan of up to $6.8 million. On May 31, 2019, the Company amended the Credit Facility to provide for, amongst other items, (i) the addition of TBC Holding Company LLC, a wholly-owned subsidiary of VTB, as an obligor and (ii) the ability to make investments in TB Germany GmbH, a wholly-owned subsidiary of TB Europe, of up to $4 millionin connection with the acquisition of ROCCAT and up to an additional $4 millionannually. The maximum credit availability for loans and letters of credit under the Credit Facility is governed by a borrowing base determined by the application of specified percentages to certain eligible assets, primarily eligible trade accounts receivable and inventories, and is subject to discretionary reserves and revaluation adjustments. The Credit Facility may be used for working capital, the issuance of bank guarantees, letters of credit and other corporate purposes. Amounts outstanding under the Credit Facility bear interest at a rate equal to either a rate published by Bank of Americaor the LIBOR rate, plus in each case, an applicable margin, which is between 0.50% to 1.25% for base rate loans, 1.25% to 2.00% for U.S.LIBOR loans and U.K.loans and 2.00% and 2.75% for the FILO Loan. In addition, Turtle Beachis required to pay a commitment fee on the unused revolving loan commitment at a rate ranging from 0.25% to 0.50%, and letter of credit fees and agent fees. As of December 31, 2021, interest rates for outstanding borrowings were 3.75% for base rate loans and 3.00% for LIBOR rate loans. The Company is subject to financial covenant testing if certain availability thresholds are not met or certain other events occur (as defined in the Credit Facility). The Credit Facility requires the Company and its restricted subsidiaries to maintain a fixed charge coverage ratio of at least 1.00 to 1.00 as of the last day of each fiscal quarter. The Credit Facility also contains affirmative and negative covenants that, subject to certain exceptions, limit our ability to take certain actions, including our ability to incur debt, pay dividends and repurchase stock, make certain investments and other payments, enter into certain mergers and consolidations, engage in sale leaseback transactions and transactions with affiliates and encumber and dispose of assets. Obligations under the Credit Facility are secured by a security interest and lien upon substantially all of the Company's assets.
30 -------------------------------------------------------------------------------- In 2017, the
United Kingdom's Financial Conduct Authorityannounced that it intends to stop persuading or compelling banks to submit LIBOR rates. LIBOR's administrator ceased publishing one-week and two-month U.S.Dollar LIBOR immediately after the LIBOR publication on December 31, 2021, and is scheduled to cease publication of the remaining U.S.Dollar LIBOR tenors immediately after the publication on June 30, 2023. The Company has been and will continue to monitor LIBOR-related market, regulatory and accounting developments. Pursuant to the credit agreement, the Companies may borrow at interest rates determined with reference to a rate published by Bank of Americaor the LIBOR rate, plus in each case, an applicable margin.
Our principal commitments primarily consist of obligations for minimum payment commitments to lessors for office space and the revolving credit facility. As of
December 31, 2021, the future non-cancelable minimum payments under these commitments were as follows: Payments Due by Period Less Than More Than (in thousands) Total One Year 1 - 3 Years 3 - 5 Years Five Years Contractual Obligations: (1) (3) Operating lease obligations (2) $ 9,047 $ 1,125 $ 3,458 $ 2,0782,386 Total $ 9,047 $ 1,125 $ 3,458 $ 2,078 $ 2,386
(1) The contractual obligations exclude the tax debts of
uncertain tax positions because we are unable to make a reasonably reliable valuation
estimate of the timing of settlement, if any, of such future payments.
(2) Operating leases represent payment obligations
non-cancellable leases for its facilities.
which expires on
Credit facility because the amount that will be borrowed in future years is
Critical accounting estimates
Our discussion and analysis of our results of operations and capital resources are based on our consolidated financial statements, which have been prepared in conformity with GAAP. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and the disclosure of contingent assets and liabilities. Management bases its estimates, assumptions, and judgments on historical experience and on various other factors that it believes to be reasonable under the circumstances.
Different assumptions and judgments would change the estimates used in the preparation of the condensed consolidated financial statements, which, in turn, could change the results from those published. Management evaluates its estimates, assumptions and judgments on an ongoing basis.
Based on the foregoing, we have determined that our most critical accounting policies are those related to revenue recognition and sales return reserve, inventory valuation, asset impairment and income taxes.
Revenue recognition and sales return reserve
Net revenue consists primarily of revenue from the sale of gaming headsets and accessories to wholesalers, retailers and to a lesser extent, on-line customers. Our products function on a standalone basis (in connection with a readily available gaming console, personal computer, or stereo) and are not sold with additional services or rights to future goods or services. Revenue is recorded for a contract through the following steps: (i) identifying the contract with the customer; (ii) identifying the performance obligations in the contract; (iii) determining the transaction price; (iv) allocating the transaction price to the performance obligations; and (v) recognizing revenue when or as each performance obligation is satisfied. Each contract at inception is evaluated to determine whether the contract should be accounted for as having one or more performance obligations. Revenue is recognized when obligations under the terms of a contract with our customer are satisfied; generally this occurs at a point in time when the risk and title to the product transfers to the customer. Our standard terms of delivery are included in our contracts of sale, order confirmation documents, and invoices. The Company excludes sales taxes collected from customers from "Net Revenue" in its Consolidated Statements of Operations. Certain customers may receive cash-based incentives (including cash discounts, quantity rebates, and price concessions), which are accounted for as variable consideration. Provisions for sales returns are recognized in the period the sale is recorded based upon our prior experience and current trends. These revenue reductions are established by the Company based upon management's best estimates at the time of sale following the historical trend, adjusted to reflect known changes in the factors that impact such reserves and allowances, and the terms of agreements with customers. We do not expect to have significant changes in our estimates for variable considerations. 31 --------------------------------------------------------------------------------
Inventories are valued at the lower of weighted average cost or market, at the individual item level. Market is determined based on the estimated net realizable value, which is generally the selling price. Inventory levels are monitored to identify slow-moving items and markdowns are used to increase sales of such products. Physical inventory counts are performed annually in January and estimates are made for any shortage between the date of the physical inventory count and the balance sheet date.
Historically, we have had significant long-lived tangible and intangible assets, including goodwill with indefinite lives, which are susceptible to valuation adjustments as a result of changes in various factors or conditions. We assess the potential impairment of intangible and fixed assets whenever events or changes in circumstances indicate that full recoverability of net asset balances through future cash flows is in question.
Goodwilland indefinite-lived intangible assets are assessed at least annually, but also whenever events or changes in circumstances indicate the carrying values may not be recoverable. Factors we consider important, which could trigger an impairment of such assets include significant underperformance relative to historical or projected future operating results; significant changes in the manner of use of the acquired assets or the strategy for our overall business; significant negative industry or economic trends; significant decline in our stock price for a sustained period; and a decline in our market capitalization below net book value. Management estimates future pre-tax cash flows based on historical experience, knowledge, and market data. Estimates of future cash flows require that we make assumptions and apply judgment, including forecasting future sales and expenses and estimating useful lives of the assets. These estimates can be affected by factors such as future product development and economic conditions that can be difficult to predict, as well as other factors such as those outlined in "Risk Factors." If the expected future cash flows related to the long-lived assets are less than the assets' carrying value, an impairment loss would be recognized for the difference between estimated fair value and carrying value. There are inherent assumptions and estimates used in developing future cash flows requiring management judgment including projecting revenues, interest rates and the cost of capital. Many of the factors used in assessing fair value are outside our control and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments. Income Taxes We account for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying value of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates and laws expected to be in effect when the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. Inherent in the measurement of these deferred balances are certain judgments and interpretations of existing tax law and other published guidance as applied to our operations. Our effective tax rate considers our judgment of expected tax liabilities in the various jurisdictions within which we are subject to tax.
In determining the need for a valuation allowance on deferred tax assets, management must make assumptions and exercise judgment, including forecasting future earnings, taxable income and the composition of earnings in the jurisdictions in which we operate.
The tax effects of uncertain tax positions taken or expected to be taken in income tax returns are recognized only if they are "more likely-than-not" to be sustained on examination by the taxing authorities based on the technical merits as of the reporting date. The tax benefits recognized in the financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. We recognize estimated accrued interest and penalties related to uncertain tax positions in income tax expense. There have been no material changes to the critical accounting policies and estimates. See Note 1, "Summary of Significant Accounting Policy," in the notes to the consolidated financial statements for a complete discussion of recent accounting pronouncements. We are currently evaluating the impact of certain recently issued guidance on our financial condition and results of operations in future periods. 32
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