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, 2007, 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, the outcome of lawsuits filed against us could have a material adverse effect on us 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 months ended March 31, 2007, approximately 98% of our net sales were derived from the sale of our HEELYS-wheeled footwear.  For the three months ended March 31, 2008, approximately 97% 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. As a result, the sources of our domestic net sales were largely concentrated and we were susceptible to customer-specific and region-specific factors. This concentration caused variability in our results of operations. Since that time, we have diversified our retail customer base in the United States by widening our distribution to include full-line sporting goods retailers, specialty apparel and footwear retailers, select department stores, family footwear stores, and select online retailers. We will continue to selectively add new accounts and increase our penetration in the domestic market.

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 international net sales were also largely concentrated and we were susceptible to 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 expanded our international distribution channels to mitigate this concentration.  Historically, our products have been sold to independent distributors with exclusive rights to specified international territories. During the first quarter of 2008, we opened a new sales and marketing office in Belgium to focus on expanding our international opportunities by working more closely with our distributors, establishing relationships with distributors in new international markets and, in selective markets, selling our products direct to retail customers.  We recently entered into agreements with two of our international distributors whereby we terminated their rights to distribute our products in their specified territories.  The agreement with our distributor for Germany and Austria was effective March 31, 2008, for distribution rights in Germany and Austria.  The agreement with our distributor for France, Monaco and Andorra was effective April 30, 2008, for distribution rights in France, Monaco and Andorra.  Our Belgium office took over the distribution of our products in Germany and Austria effective April 1, 2008 and in France, Monaco and Andorra effective May 1, 2008.

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;

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·        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 recognition of our HEELYS brand and the 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 may 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

During the second half of  2007, we experienced challenges related primarily to higher than expected inventory positions of product at many of our domestic accounts as weekly unit sales were lower than internal projections of many of our domestic retail customers, which had a significant adverse effect on our results for the second half of 2007. We believe that this was 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. Certain of our major retailers were reluctant to place significant fourth quarter 2007 orders until their current inventory was reduced to their targeted levels. We also saw decreased prices on our products at certain of our retailers in the fourth quarter of 2007. These factors led us to work closely with each of our key retail customers to assist them in managing their inventory and sell-through. This included providing marketing discretionary funds, rescheduling orders to later dates, accepting cancellations, increasing marketing, promotion and advertising support, and accepting returns.  As a result of the decrease in net sales during the second half of 2007 and cancelled orders, our inventory position at year end was greater than we have historically seen.

While inventory levels decreased to more appropriate levels during the first quarter of 2008 at many of our domestic retailers,  we continued to see decreased retail prices on many of our products during a difficult footwear and apparel environment.  Many retailers were reluctant to place significant orders during the first quarter of 2008 which resulted in decreased sales.  As a result of the market conditions and our higher than normal inventory level at the end of 2007, we sold product at discounted wholesale prices resulting in lower gross margins.  We continued to work with our key retail customers to assist them in managing their inventory, sell-through, and margin expectations during the quarter.

For the remainder of 2008, we expect to continue to see retail customers being more cautious when placing future orders and shifting toward shorter lead times. This trend will require us to take a more aggressive inventory position to be able to meet at-once orders. While we will continue to experience some rescheduled orders, cancellations and returns in the normal course of business, we do not anticipate, at this time, for those to be as significant as those we encountered during the second half of 2007. Additionally, we will continue to provide marketing, promotional and advertising support to our retail customers to promote the sell-through of our products. We will actively monitor inventory levels at our retail customers in an effort to manage the balance between supply and demand in the retail channel.

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, select department stores, family footwear stores and select online retailers.   For the three months ended March 31, 2008, 41.9% of our total net sales were derived from domestic retail customers.

Internationally, our products are sold to independent distributors with exclusive rights to specified territories, but we recently started distributing our products directly in Germany, Austria, France, Monaco and Andorra.  Historically, sales to our independent distributors are denominated in U.S. dollars.  During the first quarter of 2008, we opened a new sales and marketing office in Belgium to focus on expanding our international opportunities by working more closely with our distributors, establishing relationships with distributors in new international markets and, in selective markets, selling our products direct to retail customers. We recently entered into agreements with two of our international distributors whereby we terminated their rights to distribute our products in their specified territories.  The agreement with our distributor for Germany and Austria was effective March 31, 2008, for distribution rights in Germany and Austria.  The agreement with our

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distributor for France, Monaco and Andorra was effective April 30, 2008, for distribution rights in France, Monaco and Andorra.  Our Belgium office took over the distribution of our products in Germany and Austria effective April 1, 2008 and in France, Monaco and Andorra effective May 1, 2008.  Additionally, effective April 1, 2008, our subsidiary Heeling Sports EMEA will be responsible for sales to our independent distributors in EMEA (Europe, Middle East and Africa).  Sales to our customers in Germany, Austria, France, Monaco and Andorra will be denominated in Euros.  Sales to our independent distributors in the other EMEA countries will be denominated in U.S. dollars.  Sales to our independent distributors in non-EMEA territories will continue to be processed at our office in Carrollton, Texas and denominated in U.S. dollars.  Payments are required to be made in the same currency as invoiced.  For the three months ended March 31, 2008, 44.8% of our total net sales were derived from sales to our European distributors. No country, other than the United States, accounted for 10% or more of our net sales for the three months ended March 31, 2008.

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 inbound and outbound freight, warehousing expenses, tooling depreciation, royalty expenses related to licensed intellectual property, an inventory reserve for shrinkage and write-downs, costs associated with operating our representative office in China and, until 2008, commissions paid to our independent sourcing agent.

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 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.

Through December 31, 2007, we paid 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. In January 2008, we opened a representative office in Qingdao, China and terminated our consulting agreement with our independent sourcing agent. This new office will serve multiple sourcing functions including quality control, price negotiation, logistics and product development. We believe our Qingdao office will help us improve our research and development efforts, enhance communication between us and our distribution and manufacturing partners and give us more direct control over the manufacturing and sourcing process. This new office is managed by our Vice President—Sourcing. Costs related to operating this office are included in cost of sales.

We generally avoid selling our products at close-out prices. When demand for our products slows, we discount our products to reduce our inventory, which causes 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.

Our inventories are stated at the lower of cost or market. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the forecast of future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we record a reserve for write-down equal to the difference between the cost of the inventory and the estimated net realizable value. This write-down reserve is recorded to cost of sales. If changes in market conditions result in reductions in the estimated net realizable value of our inventory below our previous estimate, we would increase our reserve for write-down in the period in which we made such a determination and record it to cost of 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.

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 which 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.

Our selling, general and administrative expenses may 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 expenses associated with operating as a public company.

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Income Taxes

We operate through Heeling Sports Limited, a Texas limited partnership, and as such are subject to Texas franchise taxes on gross margin sourced to the State of Texas. In addition, because the Company holds inventory in a third-party distribution facility in San Pedro, California, the Company has tax filing responsibilities in that state. In February 2008, the Company formed a subsidiary in Belgium to function as the headquarters for European sales operations. The Company will be subject to tax in Belgium in future periods.  The Company is currently evaluating the structure of international business operations and considering the formation of subsidiaries in other European countries. Increased activities in foreign jurisdictions or the formation of foreign subsidiaries could cause the Company to be liable for income taxes in additional foreign jurisdictions.

Comparison of the Three Months Ended March 31, 2008 and Three Months Ended March 31, 2007

Net sales.    Net sales decreased $36.3 million, or 73.5% to $13.1 million for the three months ended March 31, 2008, from $49.4 million for the three months ended March 31, 2007. This decrease was primarily the result of lower unit sales of our HEELYS-wheeled footwear, which decreased by 1.2 million pairs, or 70.5%, to 500,000 pairs for the three months ended March 31, 2008, from 1.7 million pairs for the three months ended March 31, 2007. For the three months ended March 31, 2008, 41.9% of our net sales were derived from domestic retail customers, compared to 80.8% for the three months ended March 31, 2007.

Domestically, our net sales decreased $34.4 million, or 86.3%, to $5.5 million for the three months ended March 31, 2008, from $39.9 million for the three months ended March 31, 2007. This decrease was the result of lower unit sales of our HEELYS-wheeled footwear and decreased average sales price per unit sold.  Domestic unit sales decreased by 1.1 million pairs, or 83.1%, to 225,000 pairs for the three months ended March 31, 2008 from 1.3 million pairs for the three months ended March 31, 2007. We believe that the decrease in unit sales may be primarily attributable to the high inventory positions at many of our domestic accounts which resulted in lower orders for product during the quarter and certain of our retail customers have been reluctant to place significant orders until their current inventory levels are reduced to targeted levels. The decrease in our average sales price per unit during the quarter is a result of the decreased prices on our products at certain of our retailers and our increased inventory position at year-end.  During the fourth quarter of 2007 and the first quarter of 2008, certain of our retailers reduced retail selling price of our product to drive sales which has resulted in an overall decrease in our average sale price on units sold.  Additionally, we have adjusted the selling price on certain of our products as we continue to manage our inventory levels.

Internationally, our net sales decreased $1.9 million, or 19.6%, to $7.6 million for the three months ended March 31, 2008, compared to $9.5 million for the three months ended March 31, 2007.  This decrease was primarily the result of lower unit sales of our HEELYS-wheeled footwear, which decreased 94,000, or 25.4%, to 275,000 pairs for the three months ended March 31, 2008, from 369,000 pairs for the three months ended March 31, 2007.   This decrease in units sold is attributable to lower sales to our distributor in the United Kingdom, which was due to a high inventory position at December 31, 2007 at this distributor; offset by increase in sales to other distributors in Europe and Japan.

Gross profit.    Gross profit decreased $14.7 million to $2.8 million for the three months ended March 31, 2008, from $17.5 million for the three months ended March 31, 2007. Our gross margin was 21.5% for the three months ended March 31, 2008 compared to 35.4% for the three months ended March 31, 2007. This decrease in gross margin is attributable to a reduction in average selling price on certain of our products to manage our inventory levels as well as to assist retailers in obtaining acceptable profit margins; an increase in costs related to the opening of our representative office in China in January 2008 to give us more direct control over the manufacturing sourcing process; an increase in our inventory reserve; and an increase in third-party distribution facility costs.

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On domestic sales, our gross profit decreased $13.6 million to $540,000 for the three months ended March 31, 2008, from $14.2 million for the three months ended March 31, 2007. Our gross margin decreased 25.6% to 9.8% for the three month ended March 31, 2008, from 35.5% for the three months ended March 31, 2007.  This decrease in gross margin was mainly the result of a change in product mix sold (7.3% increase in costs as a percentage of domestic net sales), costs associated with the opening of the representative office in China (2.2% increase in costs as a percentage of domestic net sales), costs associated with the third-party distribution facility in San Pedro, California (4.4% increase in costs as a percentage of domestic net sales) and an increase in inventory reserves (8.9% increase as a percentage of domestic net sales).

On international sales, our gross profit decreased $1.0 million to $2.3 million for the three months ended March 31, 2008, from $3.3 million for the three months ended March 31, 2007.  Our gross margin decreased 4.8% to 30.0% for the three months ended March 31, 2008, from 34.8% for the three months ended March 31, 2007.  This decrease in gross margin was attributable to an increase in sourcing office costs (2.3% increase in costs as a percentage of international net sales) and costs associated with the third-party distribution facility in Belgium (2.2% increase in costs as a percentage of international net sales).

Sales and marketing expense.    Sales and marketing expense, excluding commissions, payroll and payroll related expenses, and stock-based compensation expense, increased $878,000 to $1.9 million for the three months ended March 31, 2008, from $1.0 million for the three months ended March 31, 2007, as a result of the overall increase in our marketing efforts to promote our HEELYS-wheeled footwear and brand image; offset by a decrease in our co-op marketing costs. Because the spring/summer season is traditionally a slow selling season historically we have limited our consumer advertising during the first quarter.  However, during the first quarter of 2008, we ran several television advertising campaigns which included one new commercial resulting in the recognition of production costs.  In total there was an increase of approximately $889,000 of consumer advertising related expenses in the first quarter of 2008, when compared to the first quarter of 2007.  Through cooperative advertising programs, we reimburse our domestic retail customers for certain of their costs of advertising our products.  We record these costs in selling and marketing expense at the point in time when we are obligated to our customers for the costs, which is when the related revenues are recognized. Cooperative marketing related costs decreased $233,000 from $381,000 for the three months ended March 31, 2007, to $148,000 for the three months ended March 31, 2008, mainly as a result of the decrease in our domestic sales. Sales commissions decreased $1.0 million from $1.2 million to $200,000 as a result of the decrease in domestic net sales.  Payroll and payroll related expense increased $48,000 as a result in changes in the composition of our selling and marketing related staff. Stock-based compensation expense decreased $118,000, mainly as a result of forfeiture of stock option awards by employees that are no longer employed by us.

General and administrative expense.    General and administrative expense increased $391,000 to $2.8 million for the three months ended March 31, 2008, from $2.4 million for the three months ended March 31, 2007.  Legal and professional fees incurred to enforce and protect our intellectual property increased $213,000 to $453,000 for the three months ended March 31, 2008, from $240,000 for the three months ended March 31, 2007.  Professional fees for accounting related services increased $114,000 to $375,000 for the three months ended March 31, 2008, from $261,000 for the three months ended March 31, 2007.  The increase in professional fees for accounting related services was directly related to the completion of the audit of our consolidated financial statements for the fiscal year ended December 31, 2007 and the increased reporting and compliance requirements as a result of the Sarbanes-Oxley Act.  We were first required to comply with the Sarbanes-Oxley Act for the fiscal year ended December 31, 2007.  Legal fees for general corporate matters increased $126,000 to $197,000 for the three months ended March 31, 2008, from $71,000 for the three months ended March 31, 2007.  The increase in legal fees was the result of fees incurred as a result of the lawsuits filed in the second half of 2007 in connection with our initial public offering as well as an increase in fees incurred related to general corporate matters.  Effective February 1, 2008, our then Chief Executive Officer resigned and we engaged the services of an executive search firm to identify a replacement.  During the first quarter of 2008, we incurred $129,000 directly related to this search.  Additionally, we entered into an agreement with one of our directors to act as our interim Chief Executive Officer. We pay this individual a monthly fee for his services and during the first quarter of 2008, we recognized $82,000 of related fees.  During the first quarter of 2008, we opened a new sales and marketing office in Belgium to focus on expanding our international opportunities by working more closely with our distributors, establishing relationships with distributors in new international markets and, in selective markets, selling our products direct to retail customers. In connection with the opening of this office we incurred $62,000 of professional fees for legal and accounting services.  These increases in general and administrative expenses were offset by a $294,000 decrease in general liability related insurance expense which decreased from $453,000 for the three months ended March 31, 2007, to $159,000 for the three months ended March 31, 2008.  Our liability insurance costs are based upon the value of inventory shipped as well as gross sales for the period and therefore decreased in relation to the decrease in sales.

Severance.   Effective February 1, 2008, our then Chief Executive Officer (“CEO”) resigned.  In connection with his resignation, we entered into a severance agreement with our former CEO pursuant to which he is entitled to receive approximately $470,000, payable in ten semi-monthly installments of approximately $17,000 beginning six months after the effective date of the severance agreement, followed by one lump sum payment of $300,000 payable in January 2009 and up to 14 months of reimbursements for health and life insurance (estimated cost at February 1, 2008 of $16,000). We recognized 100% of this liability and the related severance cost on February 1, 2008.  If an event or circumstances occurs that discharges or removes our responsibility to settle this liability with our former CEO, the liability and related costs will be reversed.  In addition, our former CEO agreed to perform certain consulting services for us for one year with no additional monetary compensation.  During the term of this consulting relationship, options granted to the former CEO will continue to vest in accordance with the Heelys, Inc. 2006 Stock Incentive Plan.  On February 1, 2008, the Company recognized $207,000 in stock-based compensation expense, which is 100% of the related stock-based compensation for those stock options expected to vest during the term of the consulting arrangement.

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Operating income (loss) .    As a result of the above factors, operating income decreased $15.5 million to a loss from operations of $3.3 million for the three months ended March 31, 2008, from income from operations of $12.2 million for the three months ended March 31, 2007.

Other income .   Other income was $755,000 for the three months ended March 31, 2008, which was mainly attributable to $750,000 of other income recognized in connection with an agreement we reached during the quarter to settle a pending patent and trademark lawsuit.

Income taxes.    We recognized an income tax benefit of $642,000  for the three months ended March 31, 2008, representing an effective income tax rate of 38.0%, compared to income tax expense of $4.6 million for the three months ended March 31, 2007, representing an effective income tax rate of 35.4%.  We currently expect our effective tax rate to be approximately 38.0% for the fiscal year ending December 31, 2008. The effective tax rate differs from the federal statutory rate of 35% primarily because of state income tax expense.

Net income (loss).    As a result of the above factors, we had a net loss of $1.0 million for the three months ended March 31, 2008, compared to net income of $8.5 million for the three months ended March 31, 2007.

Liquidity and Capital Resources

Our primary cash need is for working capital, which we generally finance with cash flow from operating activities. In December 2006, we completed an initial public offering of our common stock. The net proceeds to us were approximately $58.8 million, after deducting an aggregate of $4.6 million in underwriting discounts and commissions and $2.2 million in other expenses incurred in connection with the offering. We used $8.5 million of these proceeds to repay amounts outstanding under our revolving credit facility in 2006, and $28.5 million for the payment of income taxes. We intend to use the remaining proceeds to fund infrastructure improvements, including expanding and upgrading our information technology systems; acquire complementary companies or products; hire new employees; fund marketing and advertising programs and product development; expand our international operations; and for other general corporate and working capital needs.

These sources of liquidity may be impacted by fluctuations in demand for our products, investments in our infrastructure and expenditures on marketing and advertising.

        The table below sets forth, for the periods indicated, our beginning balance of cash and cash equivalents, net cash flows from operating, investing and financing activities and our ending balance of cash and cash equivalents:

Cash flow from operating activities consists primarily of net income (loss) adjusted for certain non-cash items including depreciation and amortization, deferred income taxes, stock-based compensation expense, tax impact of stock-based compensation awards and the effect of changes in operating assets and liabilities, principally accounts receivable, inventory, accounts payable and accrued expenses.

For the three months ended March 31, 2008, cash provided by operating activities was $2.2 million compared to $16.5 million for the three months ended March 31, 2007.  Cash provided by operating activities for the three months ended March 31, 2008, was primarily related to net loss of $1.0 million adjusted for non-cash items including deprecation and amortization expense of $150,000, stock-based compensation expense of $457,000 (including $207,000 recognized in connection with the resignation of our former CEO effective February 1, 2008), a $238,000 increase in net deferred income tax benefits, and a $2.9 million decrease in net working capital.  The decrease in net working capital was primarily due to:

$4.5 million decrease in operating assets:

·       $2.9 million decrease in accounts receivable; offset by a $814,000 decrease in allowances for a net decrease of $2.1 million. The decrease in accounts receivable and allowances was mainly due to the decrease in sales during the quarter.

·       $2.8 million decrease in inventory, net of increase in reserves of $507,000.  The decrease in inventory is in response to decreased sales and decreased purchases during the slower spring/summer selling season.

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·       $382,000 increase in income tax receivable due to recorded income tax benefit, net of deferred benefit, for the three months ended March 31, 2008.

·       $111,000 decrease in prepaid assets and other current assets which is the result of a $366,000 increase in prepaid assets which is mainly attributable to the $477,000 payment made on March 31, 2008 in connection with the agreements entered into with German distributor to terminated distribution rights; offset by a $255,000 decrease in prepaid insurance.

$1.6 million decrease in operating liabilities:

·       $1.2 million decrease in accrued expenses (excluding accrued severance) mainly due to timing.

·       $865,000 decrease in income taxes payable primarily the result of the payment of taxes due to the State of California.

·       $483,000 increase in accrued severance resulting from the resignation of former Chief Executive Officer effective February 1, 2008.

·       $22,000 net increase in accounts payable, commissions payable and accrued bonuses mainly due to timing.

Investing activities relate primarily to investments in intangible assets and capital expenditures. Investments in intangible assets are amounts we capitalize related to our patents and trademarks. Capital expenditures are primarily related to leasehold improvements, furniture and fixtures, computer equipment, warehouse equipment and product molds and designs.  Cash used in investing activities decreased $284,000 to $172,000 for the three months ended March 31, 2008, from $456,000 for the three months ended March 31, 2007.  Cash used during the three months ended March 31, 2007 was mainly due to the leasehold improvements to our offices in Carrollton, Texas to expand our office space and for purchases of office equipment and furniture and fixtures to accommodate increased headcount.  Cash used during the three months ended March 31, 2008 was mainly attributable to the opening of our offices in China and Belgium.

For the three months ended March 31, 2008, net cash provided by financing activities was $6,000 compared to cash used in financing activities of $1.2 million for the three months ended March 31, 2007.  The $6,000 cash provided by financing activities for the three months ended March 31, 2008 was due to stock option exercises.  For the three months ended March 31, 2007, net cash used in financing activities was primarily the result of the payment of $1.1 million of liabilities incurred in connection with our initial public offering, which we closed in December 2006, and principal payments on our promissory notes of $211,000; offset by $22,000 in cash provided by the exercise of stock options.

We believe that our cash flow from operating activities, together with the remaining net proceeds from the initial public offering of our common stock, will be sufficient to meet our liquidity needs and capital expenditure requirements for at least the next 12 months.

Revolving Credit Facility — In August 2004, the Company entered into a $3,000,000 revolving credit facility with a predecessor of JPMorgan Chase Bank, N.A. In August 2006, the Company amended this revolving credit facility, increasing the maximum amount available to $25.0 million. In December 2006, all amounts outstanding under this revolving credit facility were repaid with a portion of the proceeds from the Company’s initial public offering. The maximum amount available under this revolving credit facility decreased to $10.0 million on January 1, 2007. On February 7, 2007, the Company amended the revolving credit facility to (a) decrease the maximum amount available to $2.0 million, (b) eliminate the 0.25% non-usage fee and (c) eliminate other terms, including terms requiring the Company to provide monthly reports regarding the Company’s inventory and accounts receivable. The revolving credit facility expired on June 30, 2007. Borrowings were subject to certain limitations, primarily based upon 85% of eligible accounts receivable and 50% of eligible inventory not to exceed the amount advanced on eligible accounts receivable. Indebtedness under the revolving credit facility bore interest at a floating rate of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. Accounts receivable and inventory were pledged as collateral and the Company was subject to compliance with certain covenants, including minimum levels of net worth and minimum interest coverage ratios. The Company was not permitted to pay dividends or make distributions.

In September 2007, the Company entered into a $2,000,000 revolving credit facility with JPMorgan Chase Bank, N.A. which expires June 30, 2009. Indebtedness under this revolving credit facility bears interest at a floating rate of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. This revolving credit facility contains various restrictive covenants including (i) an obligation for the Company to maintain a tangible net worth of at least $75 million and (ii) a prohibition on the Company incurring any other indebtedness for borrowed money. The Company is also prohibited from creating or permitting any lien, encumbrances or other security interest on the Company’s accounts receivable or inventory. There were no borrowings under this revolving credit facility during the three months ended March 31, 2008.

An irrevocable standby letter of credit in the amount of $50,000 was outstanding in favor of the landlord for the Company’s corporate headquarters. The landlord could draw upon this letter of credit if the Company was in default under the lease. The letter of credit expired on March 1, 2008.

Promissory Note — During 2006, the Company signed an agreement with a commercial finance company to finance the payment of its commercial general liability and umbrella premiums. The agreement provided for an initial payment of a portion of the premium, with the

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remaining principal balance plus interest to be paid in monthly installments. Prepaid premiums from the insurance policies financed were pledged as collateral under the promissory notes. This promissory note was paid-in-full during the first quarter of 2007.

Contractual Obligations and Commercial Commitments

As of March 31, 2008, there were no material changes in our contractual obligations as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007.

Seasonality

Similar to other vendors of footwear products, sales of our products are subject to seasonality. There are three major buying seasons in footwear: spring/summer, back-to-school and holiday. Shipments for spring/summer take place during the first quarter and early weeks of the second quarter, shipments for back-to-school generally begin in May and finish in late August and shipments for the holiday season begin in October and finish in early December. Historically, we have experienced greater revenues in the second half of the year than those in the first half due to a concentration of shopping around the back-to-school and holiday seasons. In 2006, due to the growth of our business and the delays we experienced from our independent manufacturers, we experienced a higher percentage of net sales in the third quarter in comparison to the total year than we experienced in the past, as many orders were delayed from the second quarter to the third quarter, thereby causing the second quarter to be lower than normal and the third quarter to be higher than normal. In 2006, we estimate that approximately $20 million of net sales shifted from the second quarter to the third quarter due to late shipments. During 2007 we did not experience the same production delays, but instead experienced challenges related primarily to higher than expected inventory positions of product at many of our domestic accounts as weekly unit sales were lower than internal projections of many of our domestic retail customers, which had a significant adverse effect on our results for the second half of 2007. We believe that this was 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. Certain of our major retailers are reluctant to place significant orders until their current inventory is reduced to their targeted levels. We also saw decreased prices on our products at certain of our retailers in the fourth quarter of 2007 and in the first quarter of 2008. These factors have led us to work closely with each of our key retail customers to assist them in managing their inventory and sell-through. This process typically includes providing marketing discretionary funds, rescheduling orders to later dates, accepting cancellations, increasing marketing, promotion and advertising support, and accepting returns. Although weather is a factor in our seasonality, it is difficult to measure its impact. Results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year.

Vulnerability Due to Customer Concentration

For the three months ended March 31, 2008, Academy accounted for 14.0% of our total net sales.  For the three months ended March 31, 2007, Shiner Ltd. (our distributor in the United Kingdom), The Sports Authority and Finish Line represented 14.8%, 13.4% and 10.7% of our total net sales, respectively.  No other retail customer or independent distributor accounted for 10% or more of our net sales in any of these periods. We anticipate that our net sales may remain concentrated for the foreseeable future. If any of our significant retail customers or independent distributors decreases its purchases of our products or stops purchasing our products our net sales and results of operations could be adversely affected.

Critical Accounting Policies

Our management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosure at the date of our financial statements. We continually evaluate our estimates and judgments, including those related to net sales, collectability of accounts receivable, inventory reserve allowances, long-lived assets, income taxes and stock-based compensation. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis of our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results or changes in the estimates or other judgments of matters inherently uncertain that are included within these accounting policies could result in a significant change to the information presented in the consolidated financial statements. We believe that the following discussion addresses the critical accounting policies that are necessary to understand and evaluate our reported consolidated financial results.

Revenue Recognition.    Revenues are recognized when merchandise is shipped and the customer takes title and assumes risk of loss, collection of relevant receivables are probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Title passes upon shipment or upon receipt by the customer depending on the agreement with the customer. Revenues are stated net of estimated returns and other allowances, including permitted returns of damaged or defective merchandise and marketing discretionary funds. Other allowances include funds for promotional and marketing activities and a volume-based incentive program. We base our estimates and judgments on historical experience and other various factors including customer communications, and analysis of relevant market information.

Reserve for Uncollectible Accounts Receivable.    We continually make estimates relating to the collectability of our accounts receivable and maintain a reserve for estimated losses resulting from the failure of our customers to make required payments. In determining the amount of the reserve, we consider our historical level of credit losses and make judgments about the creditworthiness of significant customers.

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Because we cannot predict future changes in the financial stability of our customers, actual future losses from uncollectible accounts may differ from our estimates. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, a larger reserve might be required. If we determined that a smaller or larger reserve was appropriate, we would record a benefit or charge to general and administrative expense in the period in which we made such a determination.

Inventory Write-Downs.    Our inventories are stated at the lower of cost or market. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the forecast of future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we record a reserve against our inventory equal to the difference between the cost of the inventory and the estimated net realizable value. This reserve is recorded to cost of sales. If changes in market conditions result in reductions in the estimated net realizable value of our inventory below our previous estimate, we would increase our reserve in the period in which we made such a determination and record it to cost of sales.

Long-Lived Assets.    Long-lived assets, including furniture and fixtures, office equipment, plant equipment, leasehold improvements, computer hardware and software and certain intangible assets, are recorded at cost and this cost is depreciated over the asset’s estimated useful life. We continually evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets and certain intangible assets may warrant revision or that the remaining balance may not be recoverable. These factors may include a significant deterioration of operating results, changes in business plans or changes in anticipated cash flow. When factors indicate that a long-lived asset or certain intangible property should be evaluated for possible impairment, we review the asset or property to assess recoverability from future operations using the undiscounted pre-tax future net cash flows expected to be generated by that asset or property. Impairments are recognized in earnings to the extent that the carrying value exceeds fair value.

Income Tax.    We estimate what our effective tax rate will be for the full year and record a quarterly income tax expense in accordance with the anticipated effective annual tax rate. As the year progresses, we continually refine our estimate based upon actual events and income before income taxes by jurisdiction during the year. This process may result in a change to our expected effective tax rate for the year. When this occurs, we adjust the income tax expense during the quarter in which the change in estimate occurs so that the year-to-date expense equals the expected annual rate. Tax laws require items to be included in our tax returns at different times than when these items are reflected in the consolidated financial statements. Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These timing differences create deferred tax assets and liabilities. We assess the realizability of our deferred tax assets to determine whether a valuation allowance is required. Based on all available evidence, both positive and negative, and the weight of that evidence to the extent such evidence can be objectively verified, if we determine if it is more likely than not the deferred tax asset will not be realized a valuation allowance is established.

Uncertain Tax Positions.     In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes . FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Significant judgment is required in determining whether the recognition threshold has been met for recording an uncertain tax benefit and in determining the appropriate measurement of the uncertain benefit under FIN 48.

Stock-Based Compensation.    We account for stock-based compensation in accordance with SFAS No. 123(R), which requires the measurement of compensation cost based on the estimated fair value of the award on the date of grant. We recognize that cost using the straight-line method over the period during which an employee is required to provide service in exchange for the award—the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. We determine the grant-date fair value of employee stock options using the Black-Scholes option-pricing model. The amount of compensation expense recognized will depend upon numerous factors and estimates, including the number and vesting period of option grants, the publicly traded price of our common stock, the estimated volatility of our common stock price, estimates of the timing and volume of exercises and forfeitures of the options and fluctuations in future interest and income tax rates.

Recent Accounting Pronouncements

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements , (“SFAS 157”).  Effective January 1, 2008, the Company adopted SFAS 157.  In February 2008, the FASB issued Staff Position No. 157-2, Effective Date of FASB Statement No. 157 (“FSP 157-2”), which delayed the effective date of SFAS 157 for certain nonfinancial assets and liabilities, including fair value measurements under SFAS 141 and SFAS 142 of goodwill and other intangible assets, to fiscal years beginning after November 15, 2008.  Therefore, the Company has adopted the provisions of SFAS 157 with respect to its financial assets and liabilities only.  SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements.  Fair value is defined under SFAS 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  Valuation techniques used to measure fair value under SFAS 157 must maximize the use of observable inputs and minimize the use of unobservable inputs.  The standard describes a fair value hierarchy based on the following three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value: Level 1 – Quoted prices in active markets for identical assets or liabilities; Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data

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for substantially the full term of the assets or liabilities; and Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. As of March 31, 2008, the Company did not hold any assets or liabilities that are required to be measured at fair value on a recurring basis, and therefore the adoption of the respective provisions of SFAS 157 did not have a material impact on the Company’s condensed consolidated financial statements.

In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115 , (“SFAS 159”). SFAS 159 permits companies to measure many financial instruments and certain other items at fair value at specified election dates. Unrealized gains and losses on these items will be reported in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument (with a few exceptions), is irrevocable and is applied only to entire instruments and not to portions of instruments. The Company adopted SFAS 159 effective January 1, 2008. Upon adoption, the Company did not elect the fair value option for any items within the scope of SFAS 159 and, therefore, the adoption of SFAS 159 did not have an impact on the Company’s condensed consolidated financial statements.

In December 2007, the FASB issued Statement No. 141(R), Business Combinations , (“SFAS 141(R)”). SFAS 141(R) revises the current accounting practices for business combinations. Significant changes as a result of issuance of SFAS 141(R) include a revised definition of a business, expensing of acquisition-related transaction costs, and a change in how acquirers measure consideration, identifiable assets, liabilities assumed and goodwill acquired in a business combination. SFAS 141(R) is effective for the Company on January 1, 2009, and will be applied prospectively to all business combinations subsequent to the effective date.

In December 2007, the FASB issued Statement No. 160, Noncontrolling interests in Consolidated Financial Statements–an amendment of ARB No. 51 , (“SFAS 160”). SFAS 160 requires expanded disclosures in the consolidated financial statements that clearly identify and distinguish between the interests of the parent’s owners and the interests of noncontrolling owners of a subsidiary. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. The Company does not expect SFAS 160 to have a material impact on its financial position, cash flows or results of operations.

In March 2008, the FASB issued Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133, (“SFAS 161”). SFAS 161 requires enhanced disclosures for derivative instruments and hedging activities that include how and why an entity uses derivatives, how instruments and the related hedged items are accounted for under SFAS 133 and related interpretations, and how derivative instruments and related hedged items affect the entity’s financial position, results of operations and cash flows.  SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  The Company does not expect SFAS 161 to have a material impact on its financial position, cash flows or results of operations.

Company must defend. The Company believes that none of the pending personal injury, product liability or intellectual property legal matters will have a material adverse effect upon the Company’s financial position, cash flows or results of operations.