Quarterly Report

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

The following discussion should be read in conjunction with our consolidated condensed financial statements and the related notes. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are based on information currently available to management as well as management’s assumptions and beliefs. These statements are generally identified by the use of words such as “subject to,” “believes,” “anticipates,” “plans,” “expects,” “intends,” “estimates,” “may,” “will,” “should,” “can,” the negatives thereof, variations thereon, similar expressions, or discussions of strategy. These forward-looking statements reflect our current views with respect to future events, based on what we believe are reasonable assumptions; however, such statements are subject to certain risks and uncertainties. In addition to the specific uncertainties discussed elsewhere in this Quarterly Report on Form 10-Q, the risk factors set forth in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006, and those set forth in Part II, “Item 1A. Risk Factors” of this report may affect our performance and results of operations.  Those risks, uncertainties and factors include, but are not limited to the fact that substantially all of our net sales are generated by one product, we may not be able to successfully introduce new product categories, our intellectual property may not restrict competing products that infringe on our patents from being sold, we are dependent upon independent manufacturers, continued changes in fashion trends and consumer preferences and general economic conditions and the other factors described in our filings with the Securities and Exchange Commission. Investors are urged to consider these risks, uncertainties and factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may differ materially from those in the forward-looking statements. We disclaim any intention or obligation to update or review any forward-looking statements or information, whether as a result of new information, future events or otherwise.

Overview

We are a designer, marketer and distributor of innovative, action sports-inspired products under the HEELYS brand targeted to the youth market. Our primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user to seamlessly transition from walking or running to skating by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. For the three and six months ended June 30, 2006, approximately 99% of our net sales were derived from the sale of our HEELYS-wheeled footwear.  For the three and six months ended June 30, 2007, approximately 98% of our net sales were derived from the sale of our HEELYS-wheeled footwear.  We also sell branded accessories such as replacement wheels, helmets and other protective gear, and a limited variety of apparel items.

We introduced HEELYS-wheeled footwear in 2000, and for several years our domestic sales were concentrated with one large, national specialty retailer. Although we initially focused on driving our domestic sales growth, we also established relationships with an independent distributor in each of Japan, South Korea and Southeast Asia. As a result, the sources of our net sales were largely concentrated and we were susceptible to customer-specific and region-specific factors, including competition from counterfeit, knockoff and infringing products in international markets. This concentration caused variability in our results of operations. Since that time, we have diversified our retail customer base in the United States and expanded our international distribution channels to mitigate this concentration.

Since 2003, our domestic net sales have increased rapidly. We believe that this increase has resulted primarily from the growing acceptance of HEELYS-wheeled footwear by consumers, increasing recognition of our HEELYS brand name and expanding distribution of HEELYS-wheeled footwear to existing and new retail customers. We believe that our grass-roots marketing programs, quality products and relationships with our retail customers have contributed to this growing demand. Continued growth of our net sales will depend on consumer demand for HEELYS-wheeled footwear and our ability to satisfy this demand. A number of factors may impact consumer demand for our products, including:

·        the effectiveness of our marketing strategies;

·        our ability to effectively distribute our products;

·        our ability to design products that appeal to our target consumers;

·        our ability to protect our intellectual property rights;

·        general economic conditions, particularly changes in consumer discretionary spending patterns; and

·        changes in the popularity of and participation rates in wheeled sports activities.

We intend to continue to diversify our product offering with new HEELYS-wheeled footwear models, product categories and accessories in order to benefit from the increasing recognition of our HEELYS brand and the growing market for action sports-inspired products. Designing, marketing and distributing new products will require us to devote additional resources to product development, marketing and operations. These additional resources may include hiring new employees to support our growth in these areas and increasing amounts allocated to product advertising and promotion. Each of these additional resource commitments will increase our selling, general and administrative expenses. Because the selling price and unit cost of new products may differ from those of our existing products, sales of these new products may also impact our gross margin. In addition, we may seek to selectively acquire products and companies that offer products that are complementary to ours.

Recent Developments

We have recently experienced challenges related primarily to an over-inventoried position of product at many of our domestic accounts, which could have a significant adverse effect on our fourth quarter 2007 results.  While weekly unit sales at the store level are generally favorable compared to last year, they are lower than the internal projections of many of our

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domestic retailers.  We believe that this can be attributed to:  (1) aggressive sell through expectations of some of our domestic retailers going into the summer months and (2) retail softness in footwear and apparel.  We are working closely with each of our key retail customers to assist them in managing their inventory and sell-through.  This process typically includes providing markdown assistance, rescheduling orders to later dates, accepting cancellations and increasing marketing, promotion and advertising support.  Certain of our major retailers have shown reluctance to place significant fourth quarter 2007 orders until their current inventory is reduced to their targeted levels.

General

Net Sales

Net sales represent primarily sales of HEELYS-wheeled footwear, less an estimated reserve for sales returns, allowances and discounts.  A small portion of our net sales is derived from the sale of accessories such as replacement wheels, helmets and other protective gear and a limited variety of apparel items. Amounts billed to domestic customers for shipping and handling are included in net sales.

We sell our products through distribution channels that merchandise our products in a manner that we believe enhances and protects our HEELYS brand image. Domestically, our products can be found in full-line sporting goods retailers, specialty apparel and footwear retailers and select department stores and online retailers.    For the six months ended June 30, 2007, 87.3% of our net sales were derived from domestic retail customers. Internationally, our products are sold to independent distributors with exclusive rights to specified territories.  Sales to our independent distributors are denominated in U.S. dollars.  No country, other than the United States, accounted for 10% or more of our net sales for the six months ended June 30, 2007.

In July 2007, we hired a Vice President — International, to oversee our international business, including managing our international distributors.

Cost of Sales and Gross Profit

Cost of sales consists primarily of the cost to purchase finished products from our independent manufacturers. Cost of sales also includes commissions paid to our independent sourcing agent, inbound and outbound freight, warehousing expenses, tooling depreciation, royalty expenses related to licensed intellectual property and an inventory reserve for shrinkage and write-downs.

We source all of our products and accessories from manufacturers located in China, Indonesia and South Korea.  Our product costs are largely driven by the prices we negotiate with our independent manufacturers.  Each season, we negotiate a unit price for each model of HEELYS-wheeled footwear.  Factors that influence these prices include raw materials and labor costs and foreign exchange rates. We pay our independent sourcing agent a commission equal to a specified percentage of our per unit cost, with the percentage decreasing when our annual purchases exceed a predetermined unit volume threshold.  We believe that our sourcing model allows us to minimize our capital investment, retain the production flexibility, cost-effectiveness and scalability inherent in the use of independent manufacturers and focus our resources on developing new products and enhancing our HEELYS brand image.  In December 2006, we hired a Vice President — Sourcing, to manage our relationship with our independent sourcing agent and manufacturers.

We have generally avoided selling our products at close-out prices due to strong demand. Should demand for our products slow, we may discount our products to reduce our inventory, which may cause our gross profit as a percentage of net sales, or gross margin, to decline. Our gross margin is affected by our sourcing and distribution costs, our product mix and our ability to avoid excess inventory by accurately forecasting demand for our products. The unit prices that we charge our domestic retail customers are generally higher than what we charge our independent distributors for similar products, because our independent distributors are responsible for distribution and marketing costs relating to our products. The gross margin for products sold to our domestic retail customers and independent distributors are similar, however, due to higher shipping costs and standard customer discounts and allowances related to domestic sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenses consist of wages and related payroll and employee benefit costs, sales and marketing expenses, advertising costs, travel and insurance expenses, product development costs, costs to enforce our intellectual property rights, depreciation, amortization, professional fees, facility expenses and costs associated with operating as a public company.

We adopted SFAS No. 123(R) effective January 1, 2006.  SFAS No. 123(R) requires the measurement of compensation cost of stock-based compensation awards based on the estimated fair value of that award on the date of grant.  We recognize this compensation cost using the straight-line method over the period during with the employee is required to provide service in exchange for the award — the requisite service period.  No compensation cost is recognized for awards for which the employee does not render the required service.  If the requisite service is not provided, all previously recognized compensation cost is reversed.  For all awards granted to-date, the requisite service period is the same as the vesting period of the award.

We expect that our selling, general and administrative expenses will continue to increase in future periods as we continue to hire additional personnel, develop our infrastructure, increase our brand recognition through marketing, increase our product development efforts, secure and enforce our intellectual property rights and incur additional expenses associated with operating as a public company, including compliance with the Sarbanes-Oxley Act of 2002.

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Comparison of the Three Months Ended June 30, 2007 and Three Months Ended June 30, 2006

Net sales.    Net sales increased $43.4 million, or 140.3%, to $74.3 million for the three months ended June 30, 2007 from $30.9 million for the three months ended June 30, 2006. This increase was primarily the result of higher unit sales of our HEELYS-wheeled footwear, which increased by 1.5 million pairs, or 147.1%, to 2.5 million pairs for the three months ended June 30, 2007 from 1.0 million pairs for the three months ended June 30, 2006, partially offset by a lower average selling price due to product mix. For the three months ended June 30, 2007, 91.7% of our net sales were derived from domestic retail customers, compared to 87.9% for the three months ended June 30, 2006. Domestically, our net sales increased $40.9 million, or 150.5%, to $68.1 million for the three months ended June 30, 2007 from $27.2 million for the three months ended June 30, 2006. This increase was primarily the result of higher unit sales of our HEELYS-wheeled footwear to existing and new retail customers, which increased by 1.4 million pairs, or 159.2%, to 2.3 million pairs for the three months ended June 30, 2007 from 877,000 pairs for the three months ended June 30, 2006. Internationally, our net sales increased $2.4 million, or 65.5%, to $6.2 million for the three months ended June 30, 2007, compared to $3.7 million for the three months ended June 30, 2006.

Gross profit.    Gross profit increased $15.6 million to $26.3 million for the three months ended June 30, 2007 from $10.7 million for the three months ended June 30, 2006. Our gross margin was 35.4% for the three months ended June 30, 2007 compared to 34.6% for the three months ended June 30, 2006.   The increase in gross margin was attributed to reduced freight costs and product mix, partially offset by the markdown assistance we recorded during the quarter.  This markdown assistance resulted in a decrease in our gross margin of 1.1%.

Sales and marketing expense.    Sales and marketing expense increased $961,000 to $3.9 million for the three months ended June 30, 2007 from $3.0 million for the three months ended June 30, 2006. This increase was primarily the result of a $365,000 increase in sales commissions related to our increased domestic net sales partially offset by a decrease in commission rates, a $190,000 increase in payroll and payroll related expenses resulting from an increase in the number of employees to support the growth of our company, a $184,000 increase in point-of-sale marketing efforts, $89,000 in stock-based compensation costs, and a $82,000 increase in consumer advertising mainly as a result of a longer advertising campaign during the quarter.  Although the dollar amount of sales and marketing expense increased, sales and marketing expense as a percentage of net sales decreased to 5.2% for the three months ended June 30, 2007 from 9.6% for the three months ended June 30, 2006.

General and administrative expense.    General and administrative expense increased $2.1 million to $3.3 million for the three months ended June 30, 2007 from $1.2 million for the three months ended June 30, 2006. This increase was the result of $517,000 in costs directly attributable to our status as a public company after the completion of our initial public offering in December 2006, $400,000 of costs incurred in connection with the proposed (and subsequently withdrawn) secondary offering by certain of our stockholders during the quarter, a $342,000 increase in payroll and related employee costs resulting from an increase in headcount, $324,000 increase in our provision for doubtful accounts from March 31, 2007 to June 30, 2007 offset by $78,000 of recoveries, $267,000 in stock-based compensation costs, $234,000 in legal fees to

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enforce our intellectual property and $122,000 in consulting fees.  As a percentage of net sales, general and administrative expense increased to 4.5% for the three months ended June 30, 2007 from 3.9% for the three months ended June 30, 2006.

Operating income.    As a result of the above factors, operating income increased $12.6 million to $19.1 million for the three months ended June 30, 2007 from $6.5 million for the three months ended June 30, 2006. As a percentage of net sales, operating income increased to 25.7% for the three months ended June 30, 2007 from 21.1% for the three months ended June 30, 2006.

Income taxes.    Income taxes were $7.1 million for the three months ended June 30, 2007, representing an effective income tax rate of 35.6%, compared to $2.3 million for the three months ended June 30, 2006, representing an effective income tax rate of 35.0%.  We currently expect our effective tax rate to be approximately 35.4% for the fiscal year ended December 31, 2007.

Net income.    As a result of the above factors, net income was $12.8 million for the three months ended June 30, 2007 compared to $4.2 million for the three months ended June 30, 2006. As a percentage of net sales, net income increased to 17.2% for the three months ended June 30, 2007 from 13.5% for the three months ended June 30, 2006.

Comparison of the Six Months Ended June 30, 2007 and Six Months Ended June 30, 2006

Net sales.    Net sales increased $79.1 million, or 177.5%, to $123.7 million for the six months ended June 30, 2007 from $44.6 million for the six months ended June 30, 2006. This increase was primarily the result of higher unit sales of our HEELYS-wheeled footwear, which increased by 2.7 million pairs, or 190.3%, to 4.2 million pairs for the six months ended June 30, 2007 from 1.4 million pairs for the six months ended June 30, 2006, partially offset by a lower average selling price due to product mix. For the six months ended June 30, 2007, 87.3% of our net sales were derived from domestic retail customers, compared to 88.0% for the six months ended June 30, 2006. Domestically, our net sales increased $68.8 million, or 175.5%, to $108.1 million for the six months ended June 30, 2007 from $39.2 million for the six months ended June 30, 2006. This increase was primarily the result of higher unit sales of our HEELYS-wheeled footwear to existing and new retail customers, which increased by 2.4 million pairs, or 187.6%, to 3.6 million pairs for the six months ended June 30, 2007 from 1.3 million pairs for the six months ended June 30, 2006. Internationally, our net sales increased $10.3 million, or 192.0%, to $15.7 million for the six months ended June 30, 2007, compared to $5.4 million for the six months ended June 30, 2006.

Gross profit.    Gross profit increased $28.2 million to $43.8 million for the six months ended June 30, 2007 from $15.6 million for the six months ended June 30, 2006. Our gross margin was 35.4% for the six months ended June 30, 2007 compared to 35.0% for the six months ended June 30, 2006.   The increase in gross margin was attributed to reduced freight costs and product mix, partially offset by an increase in our estimated reserves for returns, co-op advertising and marketing discretionary fund allowances as well as the markdown assistance we recorded during the second quarter of 2007.  This markdown assistance resulted in a decrease in our gross margin of 0.7%.

Sales and marketing expense.    Sales and marketing expense increased $2.4 million to $6.7 million for the six months ended June 30, 2007 from $4.3 million for the six months ended June 30, 2006. This increase was primarily the result of a $875,000 increase in sales commissions related to our increased domestic net sales partially offset by a decrease in commission rates, a $388,000 increase in payroll and payroll related expenses resulting from an increase in the number of employees to support the growth of our company, a $326,000 increase in point-of-sale marketing efforts, a $282,000 increase in co-op advertising resulting from increased sales, $193,000 in stock-based compensation costs and a $82,000 increase in consumer advertising mainly as a result of a longer advertising campaign during the three months ended June 30, 2007.  Although the dollar amount of sales and marketing expense increased, sales and marketing expense as a percentage of net sales decreased to 5.4% for the six months ended June 30, 2007 from 9.7% for the six months ended June 30, 2006.

General and administrative expense.    General and administrative expense increased $3.6 million to $5.8 million for the six months ended June 30, 2007 from $2.2 million for the six months ended June 30, 2006. This increase was the result of $1.1 million in costs directly attributable to our status as a public company after the completion of our initial public offering in December 2006, a $662,000 increase in payroll and related employee costs resulting from an increase in headcount, $562,000 in stock-based compensation costs, $454,000 in legal fees to enforce our intellectual property, $400,000 of costs incurred in connection with the proposed (and subsequently withdrawn) secondary offering by certain of our stockholders in the second quarter of 2007, and $177,000 increase in our provision for doubtful accounts from December 31, 2006 to June 30, 2007 offset by recoveries of $102,000, and $158,000 in consulting fees.  As a percentage of net sales, general and administrative expense decreased to 4.7% for the six months ended June 30, 2007 from 4.8% for the six months ended June 30, 2006.

Operating income.    As a result of the above factors, operating income increased $22.2 million to $31.3 million for the six months ended June 30, 2007 from $9.1 million for the six months ended June 30, 2006. As a percentage of net sales, operating income increased to 25.3% for the six months ended June 30, 2007 from 20.5% for the six months ended June 30, 2006.

Income taxes.    Income taxes were $11.6 million for the six months ended June 30, 2007, representing an effective income tax rate of 35.4%, compared to $3.2 million for the six months ended June 30, 2006, representing an effective income tax rate of 35.0%.  We currently expect our effective tax rate to be approximately 35.4% for the fiscal year ended December 31, 2007.

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