Skullcandy’s March Quarter: Great Sales Growth. Where’s the Income?

The gross profit margin fell from 50.8% to 48.8%. Selling, general and administrative expenses rose 70% from $14.4 million to $24.5 million. There was no related party interest expense this quarter compared to $1.72 million of such expense in the same quarter last year.

 

Okay, so those are the big numbers from the income statement. Let’s see what’s behind them.

 

International sales (meaning mostly Canada and Europe) increased 44.1% or $3.3 million to $10.9 million and represented 20.5% of sales. It was $7.6 million or 21.1% of sales in the quarter last year. Of that increase, $2.2 million was the result of the acquisition of their European distributor. 

 

Online sales were 9.7% of sales or $5.2 million, an increase of 69.4%. Management notes that the increase was mostly the result of the acquisition of Astro Gaming.

 

Domestic sales were up 46.5% to $37.2 million and were 69.8% of total sales. Management comments, “This increase primarily reflects increased volume to existing retailers.” That comment takes me to the 10Q footnote on concentration of credit risk note.

 

Skull mentioned unidentified customers A, B, and C. Customer A was 15% of the quarter’s sale. In the same quarter the previous year, A was less than 10%. Customer B fell from 14% of sales in the quarter last year to less than 10% in this year’s quarter. We don’t know how much less than 10%. Customer C was 14% in last year’s quarter and 13% in this year’s.  Sales to their top ten domestic customers accounted for 51% of sales during the quarter compared to 48% in last year’s quarter.

 

Accounts receivable owed by A, B, and C combined accounted for 36% of total receivables of $39 million, or $14 million at the end of the quarter. 

 

To me, this is a pretty significant concentration. Either customer A or C is Best Buy and the other one is Target. Best Buy has been having some problems and announced in April they were closing 50 stores this year. It had 1,103 U.S. Best Buy stores at the end of fiscal 2012.

 

Currently, Skullcandy sells in Best Buy, Target, Dick’s, Fred Meyer, Sports Authority, and Walgreens, as well as the usual specialty channels and no doubt in some others I don’t know about. I’ll get back to this when we discuss strategy.

 

The organic sales increase then (the increase ignoring acquisitions) came mostly from the U.S. but didn’t generate any profits.

 

Okay, the gross margin. Skull says “The decrease in gross margin was due primarily to lower margin sales to the closeout channel in connection with our transition to an updated product and packaging collection…” They also note that they “…are experiencing higher product costs due to increasing labor and other costs in China. If we are unable to pass along these costs to our retailers and distributors or shift our sales mix to higher margin products, our gross profit as a percentage of net sales, or gross margin, may decrease.”

 

In their prepared remarks, management noted that both unit volume and the average selling price increased double digits in the first quarter. The price increase was driven by a move towards higher priced, over the ear headphones. But the over the ear headphones have lower gross margins than the in the ear product, so that’s another reason for downward pressure on the gross margin. 

 

There was also an interesting disclosure and discussion related to gross margin in the conference call that said the following:

 

“Late in the quarter we made the decision to clear out a sizable amount of miscellaneous older products in our warehouse. This was an assortment of older odd lot products that had accumulated over the past several years. This revenue transact (sic) at margins lower than is typical for the close out channel which impacted overall gross margins by 150 basis points. While this resulted in downward pressure to our gross margins that we had not planned for in the quarter, it improved the quality of our remaining inventory on hand.”

 

This closed out inventory represented “a couple of million dollars” in incremental revenue.

 

I understand managing quarterly earnings as a public company and that inventory is part of that. But anybody in this industry who has any inventory that has “…accumulated over the past several years” and has increased in value should let me know so I can tell everybody your secret. I’ve never seen a good reason not to get rid of old inventory sooner rather than later. Well, aside from a systems issue that made it hard to identify the obsolete inventory or not wanting to take the earnings hit I mean. Still, it doesn’t sound like it’s enough to be concerned with, though it did lead to a couple of questions from the analysts.

 

Three quarters of the gross margin percentage decline, then, was the result of the closeout sale of old inventory and more current inventory in old packaging. All else being equal, we can expect margin to recover by that 1.5% in the next quarter though, as I’ve mentioned, they do point to some other potential margin pressures.

 

The increase in selling, general and administrative expense (sg&a) was “…primarily the result of $4.1 million in additional payroll related expenses, $1.8 million in additional marketing and advertising expenses and $1.0 million in additional depreciation and amortization based on increased investments in property and equipment and the acquisition of certain intangible assets in August 2011.”

 

As a percentage of revenue, sg&a increased from 40% to 46%. They refer to the growth as “critical” spending to support long-term growth, and I can see why they need to do it given the stage of the company’s development and its revenue growth. In response to a question during the conference call, they tell us that sg&a spending will be lower during the rest of the year’s quarters, and use trade show spending as an example of why the first quarter was higher. That makes sense to me, but obviously this spending can’t continue to increase as a percentage of sales. Getting that percentage to decline is a way to pull some bucks to the bottom line.

 

I don’t have much to say about the balance sheet. A year ago it kind of sucked (negative equity) because of $63 million in related party long term debt. That went away with the public offering. The March 31 balance sheet shows $11 million in cash, $110 million in equity, no long term debt and a solid current ratio. Acquisitions also make balance sheet comparisons a bit difficult.

 

Due to online price competition, Skullcandy revamped their web site and, more importantly I think, reduced by more than 60% the number of retailers approved to resell product online. The remaining retailers have agreed to follow minimum advertised pricing policies, and Skull has implemented online product tracking to enforce their policies.

 

Another thing that’s going on is the rollout of their new packaging. This of course leads to questions about what happens to the product in the old packaging. Do retailers transition gradually or all at once? How do they price and sell the old product? Skull says they “… worked with all of our retailers to map out a transition strategy that varies from linking old and new skews for a period of time to a complete reset on a certain day. In this transition we’ve anticipated the certain level of returns of the old package items and will look to steadily sell through most of this over the next several quarters.”

 

 Fair enough. It’s kind of an inevitable pain in the ass that is going to happen when you make this kind of change. It has some costs but comes under the heading of ordinary course of business.

 

If you follow Skull’s stock, you know that the market wasn’t happy with these results and management’s explanation even though Skull characterized the net income as in line with expectations. I’ve discussed above some of the things that might have given some holders of the stock pause.

 

In the past, I’ve characterized Skull’s strategy as trying to be cool in the very broad market. I’d add that it’s trying to bring coolness to some of its non-core retailers and convince those retailers that can be an asset. That’s kind of an oversimplification, but I like oversimplification when discussing broad strategies. Other industry brands, of course, are broadening their distribution, but I don’t expect to see most of them in Fred Meyer.   

 

Whether or not Skull can do that is really the bet you place when you buy Skull’s stock (I don’t own stock in any company I write about). Skullcandy management knows that keeping a first mover advantage in any market is a hard thing to do. Not only are they growing sales quickly, but they are investing in people and infrastructure, bringing product development in house, making changes in packaging, trying to merchandise differently in mass market retailers, and generally spending a whole bunch of money trying to secure and strengthen their position. They hope/believe that there is some combination of branding and technology that minimizes the extent to which headphones become commoditized. 

 

Even if they are making all the right decisions, that kind of change and growth (positive chaos maybe is a good term) has some costs and consequences, and we saw them in this review of their quarterly results. I had to spend way longer than usual trying to interpret what Skullcandy was saying in their quarterly report and conference call and it makes my Spidey senses tingle. Hopefully, for no good reason.