Hints of a New Business Model; Skullcandy’s Quarter

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I love it when a plan starts to come together. Especially when it’s a plan I’ve endorsed and follows an approach I’ve been recommending for many companies since about 2008. As you know, I’ve been concerned that public companies have pressures on them to grow that make it hard to be brand builders because getting that growth can require you to distribute your product in ways that are bad for the brand. But often, the brand is all you’ve got, and you damage it at your peril.

The larger a public company is the more of an issue it becomes. Skull has the advantage of not being that large. It further benefitted, if you want to call it that, from being an acknowledged turnaround from which nobody had much in the way of immediate expectations. This left new CEO Hoby Darling, when he joined the company in March of 2013, free to clean up the distribution, reduce off price channel sales and focus on building the brand even though the immediate result was a big reduction in revenues.

I’m not claiming “Problem solved!”, but the results for the September 30 quarter are very positive.

Sales grew 16% from $50 million in last year’s quarter to $58.1 million. The gross margin rose from 44.9% to 45.3%. SG&A expenses were up about 3.7%, but operating income still rose from $514,000 to $3.58 million. Pretax income was up from $236,000 to $2.66 million in spite of $780,000 in additional other expenses that were foreign currency related.

Net income doubled from $1.08 to $2.15 million in spite of a tax bill that went from a benefit of $842,000 to an expense of $507,000 representing a total increase of $1.35 million.

So what’s the secret sauce? There isn’t one! I will remind you, as Hoby does every chance he gets, what Skullcandy’s five pillar strategy consists of. “…the pillars are: One, marketplace transform; two, create the innovation future; three, grow international to 50% of the business; four, expand and amplify known-for categories and partnerships; and five, team and operational excellence. “

Make good product, compete where you can identify an advantage, support your retailers, get the right people in the right jobs, run the business well, cherish the brand. Gee, it sounds way cooler when you call it five pillars and use lofty phrases like “marketplace transform.”

I’ll bet you that it isn’t just the analysts that hear this. Every employee probably hears it all the time and has been hearing it since he rolled it out shortly after taking the job. It’s Skullcandy’s mantra. It brings focus, direction, and efficiency to the company. Once you internalize it, you know what’s important and what’s not, and what to do and not do. Okay, I admit it’s not that simple, but I hope you see the advantage to any company.

I’m having a lot of fun talking about issues of strategy, but I need to give you a few more pieces of financial information. I’ll get back to strategy.

Skull’s domestic sales (just the U.S.) were $38.5 million, up 18.9% from $32.4 million in last year’s quarter. International sales rose 11.1% from $17.6 to $$19.5 million. International, then, represented 33.6% of total revenue for the quarter.

The table below from the 10Q shows gross profit and gross profit margin broken down by domestic and international and the change in each.

Skull

 

 

 

 

 

 

 

 

“Domestic net sales increased primarily due to sales of earbuds, wireless speakers and opening a new account.” I assume that new account in Walmart, which I’ll discuss below. “International net sales increased primarily due to increased sales in Canada, and to a lesser extent Mexico and China.” Europe is conspicuous by the absence of its mention.

Domestic operating profit improved from a loss of $2.47 million to a profit of $397,000. In international, it grew from $2.98 to $3.19 million. That’s about a 1% return domestically and 16.3% internationally. No wonder they want to increase international sales to 50% of the total. I should note, however, that I expect some further improvement in domestic operating profit as/if they make progress on their strategy. Hoby Darling notes in the conference call that they continue to “…edit accounts that don’t support Skullcandy’s premium yet accessible brand position.”

In addition, note that “The Domestic segment also includes the majority of general corporate overhead and related costs which are not allocated to the International segment. “ As a result, it’s not quite fair to compare domestic and international operating income percentages straight up.

The gross margin increased partly because of a shift to sales of higher margin products and also because of “…decreases in warranty expenses as a result of enhanced product quality.” The second is particularly good to see. It’s no secret that Skull had quality issues.

SG&A expense fell as a percentage of net sales from 43.8% to 39.2%, though in total dollars they increased by $824,000 with the first reason for the increase given as “…increase in marketing and demand creation efforts…” and the other being higher research and development expense. Both are consistent with the strategy.

Two other things for you to note:

“In the third quarter of 2014, the Company sold products to certain customers through consignment arrangements. The Company had approximately $1.0 million of inventory consigned to others included in inventories at September 30, 2014.” I generally hate consignment, because it implies some brand weakness if that’s the only way a company can get a retailer to take its product. But perhaps in the day of selling to huge retailers, it’s inevitable when you start up with one of those retailers, and I’m wondering if this isn’t part of the deal with Walmart.

There’s one customer that accounted for 17.4% of revenue and 17% of Skull’s receivables during and at the end of the quarter. I’m guessing Best Buy.

Okay, Walmart. I’ve been arguing that the days of easy distribution decisions were long over, and that each new retail channel had to be evaluated individually. I’ve also suggested that in the day of the omnichannel and mobile devices, where you sell may not matter as much; how you merchandise in the channels you choose and how you connect with your consumers is what counts. That seems to be how Skullcandy is thinking about Walmart. In the conference call, CEO Darling lists five questions they asked as they considered a relationship with Walmart. The questions are:

  • “…does our consumer shop there?”
  • “…does out competition sell there?”
  • “…can we segment our product line so that by adding Walmart, we aren’t cannibalizing sales of our existing retail partners?”
  • ”…can we reach a new consumer in a geography that has been underserved by Skullcandy?”
  • “…can we deliver good in-store experience and tell our brand story?”

They believe the answers to one, two, and four are yes. Three is so far so good. Five is something they are working on into next year.

My suggestion is that every company shamelessly steal these questions and use them in evaluating your own distribution decisions. One catch- you have to figure out with some rigor who your consumers are first.

Obviously, I’m pretty impressed with what Skullcandy is doing. But hey, it’s me and I have some longer term strategic issues which I’ve raised before.

First, consumer technology products have always, eventually, become a commodity. Skull thinks they can prevent that for their brand at least. They have to.

Second, the competitors are many and larger and better resourced than Skullcandy. Part of Skull’s plan is to compete with new and improved products and technology. We’ll see. Maybe it’s becoming about the smarts of the people you have and the connections with consumers as a source of new ideas rather than just the size of your budget.

Finally, if Skullcandy continues to improve, they may find themselves in the position where they have that age old conflict between curating the brand and growing revenues to the satisfaction of Wall Street. I suppose that’s a problem they’d like to have.

As you know, there’s a lot we don’t get told in 10Qs and conference calls. But I’m intrigued by Skullcandy because what I’m hearing, or think I’m hearing at least, is that they have wiped the slate clean and are building a brand for the online/internet/mobile/omnichannel/empowered consumer era. I don’t yet know the extent to which all these changes obviates some of the common business knowledge around distribution, marketing , merchandising, niche building and product development. I don’t think extrapolating the past into the future works as a predictive mechanism. What I think is that the reason Skullcandy may succeed is because they are embracing some of these changes. It can change the competitive equation.

Maybe a Public Company Can Actually Pull This Off! Skullcandy’s June 30 Quarter

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I’ve written probably way more times than you want to hear about how it’s been a good time to focus on brand building, distribution, and gross margin dollars rather than generating big sales increases that can only be realized in the short term with resulting long term damage to a business.   And I’ve sympathized with public companies who’d like to take this approach, but have a hard time doing it because of Wall Street growth expectations.

Well guess what? It looks like Skullcandy might just have a chance to do it. For the quarter, they reported a 6% sales increase to $53.9 million from $50.8 million in the same quarter last year. They had net income of $1.58 million compared to a loss of $689 thousand last year.
That’s nice, and it’s necessary. But from my point of view, what it does is buy Skull some time, and acquiescence from Wall Street, to continue doing what they’re doing.

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Skullcandy’s First Quarter: Signs That the Strategy is Taking Hold

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The improvement in Skull’s financials for the quarter ended March 31 is clear on both the income statement and balance sheet, though the company still reported a loss. You can see the 10Q here.

Skull, as you may recall, is focused on building the brand by aggressively reducing off price sales, being cautious with distribution, taking product development in house, and focusing on some specific niches. They’ve also, of course, managed their expenses down.
We’ll see the results in their numbers, but what I think will be the barometer of their success was stated early in the conference call by CEO Hoby Darling.
“We need to be a brand that works within our exiting retailers to organically grow versus just increasing revenue through new doors. This is somewhat new, as much of our historical growth came from continually adding new doors versus doing a great job in doors where we already sold.”

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Skullcandy’s Year and Quarter: Still Comes Down to Whether They Can Be Cool at Fred Meyer

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My dilemma is that I like almost all of what Skull is doing. But it’s hard to pull it off as a public company. Either they are pursuing a niche strategy where it will be hard to get acceptable public market kind of growth, or they are competing in a much larger market against players that have them outgunned. My take on the conference call and 10K (which you can see here), is that they are trying to straddle the two. Here’s how they put it. 

“We have a sales and distribution strategy that allows us to build relevant and exclusive products for our specialty retailers while giving us a runway to build demand creation and scale production before launching into large format retailers. This builds our brand authenticity with our specialty retailers while creating a robust product pipeline for the future.”
 
I have written way too many times that the further you get beyond the “core” market, the more likely it is that the consumer may know your name but not your story. I think they need to not just know, but embrace your story if your competitors are way bigger than you are and have you out resourced. That’s Skullcandy’s challenge.
 
Financial Results
 
Let’s start with the December 31 balance sheet. Over all, it’s not dramatically different from a year ago. The current ratio is strong and hasn’t changed much. Neither have total liabilities to equity. Cash has increased from $19 to $39 million as cash generated by operations rose from $13.5 to $23.5 million. I like cash. There’s still no bank or long term debt. Receivables have fallen from $76 to $58 million, consistent with the decline in sales of 29.5%, from $298 to $210 million.
 
North American sales fell 30.4% from $222.6 to $155 million due to “Increased competition in the audio and gaming headphone markets and…our continued scaling back of sales to the off-price channel, which were down approximately 48.9% compared with 2012, contributed to the decrease in North America net sales. In addition, and to a lesser extent, the decrease in net sales was the result of the transition to a direct distribution model in Canada, our decision to stop selling products to certain retailers and distributors that were violating our policies on minimum advertised prices and our significant decrease of discounted online sales at www.skullcandy.com.”
 
International sales, including those sold in the United States with “ship to” locations outside of North America, decreased from $75.1 to $55.1 million. Non-U.S. sales decreased 27%, falling from $28.5 to $20.8 million. “The decline was primarily attributable to lower sales in Europe, which continued to be a challenging retail environment and our desire to carefully control inventory with retail customers in our international set of distributor partners. The softness, though, in Europe was offset to a lesser extent by gains in Japan, Mexico and Canada…”
 
In explaining the sales decline above, you’ll notice they start with “increased competition” and then mention the reduced off-price channel sales. I wonder what percentage of the total decline resulted from increased competition. It would be useful if they explained exactly what sales channels “off-price” referred to and how many dollars the cut backs represented.
 
Back on the balance sheet again, we see that inventories have decreased only very slightly, from $41.6 to $40.3 million. I would have expected a much large decline given the fall in revenue. The 10K doesn’t tell us anything about the quality of inventory. We learn in the conference call that they have $3.1 million in additional inventory in a warehouse in Canada that didn’t exist a year ago. One of the analysts asked how comfortable there are with their inventory and got told by CEO Hoby Darling that “…overall, we have really clean inventory.” Nothing they said really explained to me why it wasn’t down more given the revenue decline.
 
Switching back to the income statement, we find a gross profit margin that declined from 46.8% in 2012 to 44.3% in 2013. The 10Q says, “The decrease in gross margin was primarily attributable to increased sales returns and allowance expense due to increased returns rates to the Company’s retail customers and a shift to a lower margin product mix.”
 
Like with the inventory, I’d like a lot more information about that. With the sales decline, they lead by talking about increased compensation. Then they tell us in the conference call that sales returns and allowance expense was 11% of revenue in 2013, up from 6.4% in 2012. And remember they are reducing their off-price sales. I don’t quite know what that term means or how many dollars of sales we’re talking about, but I guess I might have expected that reducing those off-price sales would have tended to improve the gross margin if the number is significant.
 
Selling, general and administrative expenses were approximately level at $98 million. As a percentage of sales they rose from 32.9% to 46.7%. There are $8.2 million in “nonrecurring expenses,” as they like to refer to them, included in that number. These include a big customer bankruptcy filing, moving their offices, severance for the former CEO, and a write down for some “end-of-life” products. 
 
It isn’t just with Skullcandy that I get a smile on my face when I see the list of what they call nonrecurring. There always seems to be something next year that’s nonrecurring. I think companies should establish a reserve for nonrecurring expenses like they do with bad debt. Course, if you reserve for them it means you expect them, and then I suppose they can’t be classified as nonrecurring. But, damn it, something nonrecurring seems to occur every year.
 
Demand creation expense increased by $1.1 million to $27.1 million. Given their strategy, I think that’s appropriate, and I’d even like to see more. I like their 4-city takeover concept, “…based around Crusher and our NBA All-Star in Chicago with Derrick Rose, Oklahoma City with Kevin Durant, Houston with James Harden, and Minneapolis, where we featured the product and athletes on billboards, buses wrap with Crusher and exploding windows, athlete product and brand images projected onto buildings and other out-of-home media during the holidays and into the beginning of this year.” It’s coordinated with a big social media component.
 
Their operating income for the year declined from a positive $41.5 million to a loss of $5 million. The net loss was $3 million compared to a profit of $25.8 million last year. That includes an income tax expense of $14.6 million last year compared to a tax credit of $2.9 million in 2013.
 
Sales for the last quarter of the year fell from $101 to $72.2 million. Gross margin was down from 44.5% to 43.5%. They had net income during the quarter of $3.7 million compared to $11.4 million in the same quarter last year.
 
Walmart, Other Customers and Strategy
 
Skul’s two biggest customers during the year were Target and Best Buy. One of them was 10% of sales and one 14%. Don’t know which was which. They accounted for 28% and 25% of the company’s accounts receivable at the end of the year.
 
In the conference call, we learn from CEO Darling that Skullcandy will “…test the segmented product line that focuses on our entry level price points with Walmart in mid-Q2. Some people will ask whether Walmart is right for the brand.” Indeed. 
 
Here’s how he says they think about distribution in general:
 
“When we think about adding distribution, we think about 5 key questions: First, does our consumer shop at the location? Second, does our consumer expect to find us there because our competitors are there? Third, can we position the brand at retail point-of-sale in a way that is fun, young and irreverent and does not dilute the brand? Fourth, can we serve a customer that otherwise has limited access to our products at brick-and-mortar from a geographic perspective? And fifth, whether we can create segmentation throughout our distribution pyramid from pinnacle on down?”
 
Here’s how he answers those questions with regards to Walmart:
 
“First, we know our consumer shops at Walmart. Second, each of our competitors, including Beats, Apple, Sony, Bose, Yurbuds and Monster are all already sold at Walmart and have been there for multiple seasons. Third, we have negotiated POS that we believe will look and feel right so that our consumer has a good experience with our brand. Fourth, Walmart is the store in many towns, where there’s no other or very limited Skullcandy distribution, especially throughout the South and Midwest. Lastly, we’ll segment Walmart during this test to only the price points and designs that we believe are most attractive to the Walmart customer and are different than most of our other accounts.”
 
At Walmart, they are going to be focusing on buds under $20 and headphones under $35. They indicate this is a “…different assortment than almost all of our other retailers have.” 
 
I started this analysis talking about the difficulty of being a niche brand while meeting the expectations of Wall Street. You can almost feel the dilemma this causes when Hoby says, “As part of opening Walmart, we are also doubling down our core and influencer retail partners…We have to keep specialty special.” When he notes above that their competitors are already at Walmart I can’t quite figure out if, as he says, that’s a reason to be there or a reason not to be there. They talk about how they are going to manage the brand at Walmart and insure sell through (though they aren’t specific as to how). But if the Walmart order gets significant (remember something like 6,000 stores in the U.S. and 10,000 worldwide) and Walmart wants a different mix or better pricing, how easy will it be to say no?
 
When Skull went public, I characterized their challenge as “being cool at Fred Meyer.” They are certainly more focused, thoughtful and cautious about how they go about doing that, but the challenge hasn’t really changed and the competitive landscape has gotten tougher.

 

 

Skullcandy’s Quarter; Consolidating to Grow

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Skullcandy’s 10Q for its September 30 quarter came out yesterday. I’ve been through it and the conference call. They are continuing to apply the tactics they’ve adopted as part of their turnaround strategy. That means, in the words of CEO Hoby Darling, “…as we go into Q4, we’re going to do the exact same things that we did in Q3 that are working. And that is we’re going to continue to edit off-price, we’re going to continue to cut accounts that are brand-dilutive. We’re going to continue to cut accounts that break map pricing and don’t allow us to control our brand online.” 

As you know, I like these things. Well, let’s not say I like them so much as I don’t think brands like Skull have much choice. Given their competitors and the nature of the product, what else can they do but start by trying to stake out a market niche they can be a leader in and, hopefully, grow from? If they watch their distribution, and are the leading brand in the youth culture “cool” niche, I suspect they can improve their margins, reduce operating expenses, and bring more money to the bottom line. I’ve described in various articles how I think that works in general.
 
And that would be a fine result if they weren’t a public company. But they are, and the markets want to see regular revenue growth. Skull management thinks they can resume their growth (though they aren’t specific about how much growth) in the second half of 2014. But they are preparing for that growth by hunkering down in a niche where they see the brand as having a competitive advantage.  Ask Burton or Volcom, just to name a couple of brands, how easy it is to grow out of a niche you are strong in when the competitors are big and well resourced.
 
Okay, hold that thought while we take a look at the numbers.
 
I’m going to start with the balance sheet just to get it out of the way. There’s not much to say. It’s pretty strong. Cash has risen to $34.7 million from $1.9 million a year ago. Receivables are down from $60 to $41 million, consistent with the decline in revenue. Inventory has fallen from $55.4 to $48.7 million.
 
Given the sales decline, I might have expected more of a year over year inventory decline. Part of the reason it isn’t down more is that they’ve got $2.5 million of inventory newly tied up in direct distribution in Canada that they started in the September 30 quarter. But they acknowledge that they’ve got some current inventory of high end product that isn’t selling well, and they are working to get rid of it.
 
Notice that the lawyers made them add “Our business could be harmed if we fail to maintain proper inventory levels” as a risk factor in the 10Q. Now, lawyers take an abundance of caution approach to risk factors, but it wasn’t included before and now it is. I conclude that whatever the level of excess inventory is, it’s not completely insignificant. An analyst might have asked about this in the conference call, but the call is before the 10Q is released so they didn’t know about it.
 
Aside from a few bucks in deferred taxes, there’s no long term debt, and equity has risen from $129 to $136 million. The current ratio and total debt to equity are solid.
 
Revenue fell from $71 million in last year’s quarter to $50 million this year. They’ve got two customers who represented $21.4 million of total revenues for the quarter, or 43%. They don’t say this, but I suspect they are Target and Best Buy. That’s kind of a serious concentration.
 
North American sales, which include Canada and Mexico, were $34.8 million down from $57.4 million in last year’s quarter. That’s a decline of 39.4%. International sales rose from $13.6 to $15.2 million, or by 11.8%. They point out that, “Included in the North American segment for the three months ended September 30, 2013 and 2012 are international net sales of $932,000 and $2,976,000, respectively, that were sold from the United States to customers with a “ship to” location outside of North America.”
 
They talk a lot about the tactics I highlighted at the beginning of this article. Get out of off price, enforcing pricing, etc. Good stuff. But when we get to the 10Q and they talk about the reasons for the sales decline, here’s what they say:
 
“Contributing to the decrease in net sales is increased competition in the audio and gaming headphone markets. Additionally contributing to the decrease, and consistent with the strategy stated in previous quarters, we continued to scale back our sales to the off-price channel, which were down approximately $4.4 million, or 74.6%, compared with the three months ended September 30, 2012. We expect sales to the off-price channel to continue to be down more than 50% in the fourth quarter of 2013. There was also a decrease in net sales of $2.2 million as a result of the transition to a direct distribution model in Canada. We also actively stopped selling products to certain retailers and distributors that were violating our policies on minimum advertised prices which further contributed to the decrease in net sales.”
 
Long quote. But what I noticed was that they started the explanation by talking about increased competition, not their distribution and pricing tactics. Does that imply that increased competition is more of a factor than intentionally reduced tactics? I don’t know and no analyst had an opportunity to asking in the conference call. 
 
Gross margin fell from 47.4% to 44.9%. As reported, it was 43.4% in North America, down from 46.6% in last year’s quarter. For the international segment, it was 48.1%, down from 51%. Eventually, they’d like to grow the international business to 50% of their total from 25% right now. I am sure the better margin has something to do with that.
 
The theory is that if you tighten up distribution and enforce pricing agreements, your gross margin is supposed to improve as you cut off price sales. Interesting that we’re not seeing that. Maybe it’s too soon. “The decrease in gross margin was primarily attributable to increased allowances to the Company’s retail customers and a shift to a lower margin product mix,” they tell us.
 
The “allowances” are from 1% to 1.5% that they are giving certain retailers who have inventory of the high end product I mention above. The “shift to lower margin product mix” I’m a bit confused about. Some of you may recall that under Hoby Darling’s predecessor, they were pursuing higher priced, over the ear product that had lower margin, but generated more gross margin dollars. Now, we’re told, they are going to focus on the $100 and under market where they have a strong market position but which apparently has a lower margin than the higher price products, which I thought had lower margins and they are moving away from. That’s another clarification I’d be asking for if I were an analyst and had the 10Q before the conference call. Yes, I’m kind of on a “Conference calls are useless unless you have the actual filing and time to look at it,” rant. Just ignore me.
 
In the conference call they refer to difficult conditions in Europe, an expectation of a highly promotional holiday season, and the ongoing industry consolidation. Those things are not usually good for margins.
 
Selling, general and administrative expenses (SG&A) fell from $23.1 to $22.4 million, or by 3%. There was $1 million in expense associated with closing the San Clemente office. Without that, the decline would have been 7.4%. As a percentage of net sales SG&A rose from 11.3% to 43.8%.
 
In discussing these expenses, they note they invested an additional $300,000 in “marketing and demand creation efforts” and there is discussion about how Skull is continuing to “…leverage our powerful portfolio of brand ambassadors and roster of athletes in fun and compelling ways that generated consumer excitement and demand.” In case anybody hasn’t figured it out, this is a youth culture and fashion brand- not an action sports brand in spite of its roots there.
 
Operating income fell from $10.6 million to $514,000. It went from $7.4 million in North America to a loss of $2.2 million. In international, operating income fell from $3.2 million to $2.7 million. Net income declined from $6.5 million to $1.1 million. Net income was higher than operating income during the quarter due to an $842,000 tax credit.
 
Over on the cash flow, we see that they’ve generated $18.8 million in cash from operating activities during the nine months ended September 30. During the same period last year they used $11.3 million. That’s quite an improvement. You’d expect it given the balance sheet.
 
In 2014, Skullcandy “…plans to selectively add new distribution in the U.S. in underserved geographic areas and where our consumer expects to find us based on where our competition sells.” They are also going to open their first outlet store in Park City before the end of this year. They will be looking to open some additional ones during next year. As you’re all aware, outlet stores have evolved way past where they are just a place to get rid of slow moving merchandise.
 
They are also launching this quarter a blue tooth speaker called Air Raid that will retail for $149. This is their first non-headphone technology product and it’s probably a place they need to go to get the revenue growth they require. As CEO Darling puts it, “…expanding into new adjacent audio categories is an important part of our growth strategy.”
 
Skullcandy is tightening its distribution and pricing with the goal of solidifying its brand positioning. They are trying to lead in the youth culture “cool” headphone space in the $100 and under price range and also offer distinctive product, both in terms of performance and branding, to their customers. If they can do that in what they characterize as a highly competitive, consolidating market, then they have to figure out how to grow out of that niche while maintaining the positioning they are working so hard to achieve.
 
In the action sports business, that’s been damned difficult. We’ll watch to see if their different positioning, even though they are action sports based, makes it any easier.

 

 

Selling Less In a Good Cause; Skullcandy’s Strategy and Quarter

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In the quarter ended June 30, Skull’s sales fell by 30% to $50.8 million from $72.4 million in the same quarter the previous year. Their gross margin fell from 48.6% to 44.9%. Selling, general and administrative expenses actually rose slightly from $23.5 to $24 million, but if you exclude the almost $1 million that’s included for the move from San Clemente to Park City, it fell a bit. Net income, not surprisingly, declined from a profit of $6.8 million to a loss of $689,000. 

It’s not that I’m thrilled to see these results, but I think they are indicative of Skull pursuing the only strategy they can reasonably pursue. Here’s how CEO Hoby Darling puts it:
 
“While I do not believe we will turn our sales trajectory positive this year, we’re decisively taking action based on learnings from some historical missteps and being more disciplined around distribution, retailer and product segmentation, discounting and importantly, the alignment of product, marketing and sales. These are necessary first steps to protect the brand and set us up for long-term healthy growth.”
 
You remember that last quarter Skull was cutting back on the sales through off price channels (year to date those sales are down 50%). Now we find out they’ve actually held back some product from some retailers to protect their brand position. As CEO Darling puts it, “We need a clear distribution channel and to have retailers and consumers seeking out our products.”
 
One more quote:
 
“We will continue to aggressively rebalance our distribution pyramid so that demand and supply are more closely matched. This includes minimizing the end-season product sales in the off-price channel, protecting our map pricing policy and supplying our retailers with the right amount of product to match healthy demand. We will continue to protect profitability, while investing in our most important growth initiatives in demand creation.”
 
Oh hell, just one more:
 
“As we think about our future, the main tenets of our strategy are based on the following: first, transforming the marketplace. This includes rebalancing and segmenting our distribution pyramid to amplify with winning retailers and match supply to market demand and clarifying our brand message, with a strong focus around digital and planned sale.”
 
Regular readers will know why I’m all a dither about this strategy. I’ve been pushing for some years the idea that with sales growth harder to come by, gross margin dollars and control of operating expenses was where you needed to focus to improve profitability. I’ve said that distribution and deciding who to sell to is way harder than it used to be. But I’ve also said that if you recognize the relationships between operations (especially inventory management) on the one hand and sales and marketing on the other, you can achieve better results while spending a lot less.
 
Like Quiksilver and Billabong have done and are doing, Skullcandy is also working to “…create a cohesive organization by removing the operating silos that were hampering communications, alignment and culture between different areas of the business." CEO Darling, by the way, thinks they can probably spend less on demand creation. He makes that comment in kind of an offhand way, but if the company approaches their customer segmentation, pricing, and distribution in the way he describes, it might be a lot less. Overall, what Skull is doing kind of reminds me of Spy’s strategy. And the bottom line is that Skull is going to have to reduce its SG & A spending as a percentage of sales unless sales grow way faster than they seem to expect.
 
There’s just one fly in the ointment. Like Billabong, Quiksilver and Spy, Skullcandy is public. These are four companies that would be better off if they were private and free to pursue brand strategies unconstrained by the need for regular, quarterly growth. Skull is purposefully restricting sales to defend and strengthen their brand and market position and, I’m expecting, greatly improving their overall profitability. Great decision.
 
But there’s that pesky Wall Street revenue growth bias out there. What to do? Skull expects that their current actions will increase their sales in their core market, though not until 2014. CEO Darling describes the brand as “…fun, young and irreverent, woven in with creative and active.” Good definition. “As small and creative company, we have the opportunity to be special and more unique than our larger competitors.” I agree. But that focus also limits growth because it limits your available customers.
 
What to do? Product extensions, which the analysts ask about every quarter, are one answer. Sell more to the same customer. The Air Raid Bluetooth speaker will be in retail in the fourth quarter. And you also look for growth by “…expanding beyond our core audio headphone market and partnering with other brand leaders and their respective consumer categories will assist in broadening our region appeal to give Skullcandy added legitimacy outside of our core market position.” They use a deal they are making with Lululemon as an example. Sell more to a new customer.
 
Let’s assume that as a result of implementing these strategies I like that Skullcandy solidifies its position in its core market, grows sales slowly (slower growth initially is implicit in its strategy), and improves its profitability on those sales significantly. As a private company, that might arguably be a great result. As a public one, not so much. So along come the brand extensions and the partner deals “to give Skullcandy added legitimacy outside of our core market position.”
 
How’s that worked out in this industry in the past for public companies? As I’ve pointed out, Zumiez is the only action sports based company that’s public and doing well. Others are all having difficulty or have been acquired.
 
Skull has the balance sheet to pursue its strategy. They’ve got no long term debt, $30 million in cash (up from $7 million a year ago) and a strong current ratio. Operations provided $12 million in cash flow during the first six months of the year compared to using $8 million in the first six months of last year. Inventory over the year fell 17% from $50.5 to $42 million. I might have expected a larger drop given the sales decline. They tell us the decline wasn’t greater “…due to higher gaming inventories support retail and the building of inventory in China to support our direct sales model there.” I’d be interested to know how much of their existing inventory is price point product they still need to move.
 
Much of the sales decline was due to a reduction in the off price sales, but they also mention “…lower sell-in at a key customer and a decline in sales to several of our specialty retailers.” They have one customer that represented 18.3% of sales during the quarter compared to 11.4% in last year’s quarter. While I imagine that increase is explained by their decision to reduce price point sales, it’s still quite a concentration.
 
They make the interesting comment that they see some market movement from over the ear product to in ear. They don’t tell us the extent of the change. That’s interesting because in their last call they talked about moving towards higher priced but lower margin (generating more margin dollars) product that was largely over the ear. I was surprised no analyst asked about that.
 
Skullcandy has a strategy I fully support, but wonder how it will be received in the public markets. They have some personnel, relocation, and operational changes going on that it’s just going to take a little time to work through. I will wait to see how their product extensions work out. I hope they aren’t too aggressive in that area.

 

 

Skullcandy’s Quarter: I Think I Recognize This Strategy

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New President and CEO Hoby Darling has been at Skull north of two months now, and the company has released its first 10Q and had its first conference call with him at the helm. The outlines of his strategy are starting to become clear. Interestingly, you’ll note some similarities with the strategy of certain VF brands as I described it yesterday and with what I’ve been generally recommending for a while now. Let’s start with the numbers and then move on to that strategy. 

Financial Results
 
Net sales were down 30.4% to $37.1 million for the March 31 quarter. They were $53.3 million for the same quarter in the prior year. North American sales fell 37.9% from $46.1 million to $28.7 million. Part of the reason for the decline was a 67% reduction in “…the highly discounted off-price channel….” They had said they were going to do that and I think it’s a great move, consistent with the strategy they outline. Gaming headphone sales (Astro) rose 43.8%, but CFO Westcoat also notes in the conference call that “All of our full price audio channels were down.” He also notes gains in their 2XL brand business.
 
He made another interesting comment, saying that, “With respect to pricing bands, sales of under $100 declined due primarily to promotion and mix while sales in the over $100 band increased 29.1%, primarily from the sales of our premium gaming headphones.” I know they’ve been pushing the higher priced products, but he makes it sound here like traction at the higher price points was only with gaming. 
 
International sales were up 17.5% to $8.4 million but “Included in the North America segment in Q1
2013 and Q1 2012 are net sales of $2.1 million and $3.4 million, respectively, that were sold from North America to customers with a “ship to” location outside of North America. Adjusting these sales into the international segment, international net sales decreased 0.6%.”
 
The overall gross profit margin fell from 48.1% to 44.5%. In North America it was down from 47.1% to 43.5%. They tell us this was due to “…an increase in tooling depreciation and a write off of $0.8 million of inventory related to end of life products (“EOL”).” I assume the tooling depreciation is an ongoing expense. Assuming the inventory write downs are done, gross margin should begin to improve based just on its absence. We’re told in the conference that 2.2% of the decline was a result of the inventory write-off. We couldn’t, in the conference call, get a definitive answer that there was no more inventory to be written down.
 
If they’ve got overvalued inventory, I’m thrilled to see them recognizing that it sucks and writing it off. I recommend this to everybody. Inventory delusion disease is a terrible condition, but treatable with a dose of reality. I also see the write down as consistent with Skull’s strategy as I’ll explain.
 
The international gross margin fell from 54.4% to 48.1%. This was due to the bankruptcy of retailer HMV in the UK and higher levels of discounting.
 
Skull is and has been in the process of moving to some higher priced but lower margin products. As you know, I’m all about how many gross margin dollars you can generate as opposed to just the gross margin percentage. I like that approach and, once again, think it’s consistent with the strategy they outline. What I don’t know is what the impact of the 67% reduction in sales in the off-price channel was on the gross margin. Were those lower margin products and how many dollars are we talking about?
 
Selling, general and administrative expenses rose from $24.1 million to $26.3 million. As a percentage they jumped from 45.3% to 71%. Unless they chose to gut their expenses, a big percentage increase was inevitable given their sales decline. There was also $1.2 million in costs there resulting from Jeremy Andrus resigning as CEO and $2 million associated with property and equipment related to the inventory that was written off. Ignoring those one-time items, they did cut their spending, but I’d say they maintained it at a level consistent with their branding and market positioning.
 
The bottom line was a loss off $7.05 million compared to a profit of $1.12 million in last year’s quarter. This quarter’s result was helped by an income tax benefit of $3.35 million.
 
Turning to the balance sheet, cash was up to $34 million from $11 million a year ago. Receivables fell 11% from $39 to $35 million and inventory was pretty much constant at $51 million. I might have expected more decline in both receivables and, especially, inventory given the sales decline and the $800,000 inventory write-off.  They don’t offer any details about receivables. CFO Kyle Wescoat tells us in the conference call that “The principal reason for higher-than-expected inventory is Best Buy’s shift of their reset, which was originally scheduled for March but changed to June, and higher Astro inventory to support the brand’s rollout to retail, which was initiated in the back half of 2012.”
 
Skull has two large customers (Target and Best Buy) that accounted for 33% of their revenue in the first quarter. One was 15% and one 18%, but we don’t know which is which.
 
Skull has no long term debt and no bank debt.                 Current ratio has improved from 3.04 to 4.22 and total liabilities to equity is, oh hell, too strong to bother calculating.
 
Issues of Strategy
 
Let’s start with the questions CEO Darling says he asked himself before he took the job:
 
·         Are headphones commodities, and does innovation matter?
·         Does the audio category have defensible barriers to entry?
·         Will the market continue to grow?
·         Does the Skullcandy brand resonate with its core consumers and can it resonate more broadly, giving us opportunity to expand?
 
Great questions. I guess he must have answered either “yes” or “probably” or he wouldn’t have taken the job. My answers are some headphones are commodities (but some aren’t), innovation matters, any barriers to entry will be based on branding but it seems like an awfully crowded space, so maybe there aren’t really any, the market will continue to grow, Skull resonates with its core consumers (or they wouldn’t be its consumers) and I don’t know.
 
He goes on to say, “What I believe ultimately determines which companies separate themselves from the pack and thrive over the long term is consumer-focused innovation and creating deep emotional connections to consumers through clear messaging and brand identity.”
 
He takes quite a bit of time to discuss what the company has to do. More clearly defining the brand comes first. He wants the best ideas to go forward- not merely good ones. And they need to be products that meet a customer need rather than one that just fills a place in the product line or reacts to what a competitor is doing. His goal, I think, is fewer, more distinctive, relevant products.
 
There are going to be some changes in distribution. “We need to do a better job segmenting our retailers by consumer and aligning our product and marketing assets,” Darling says. There will also be some new products in adjacent categories like speakers, but not until they have the right, distinctive, product. He believes “The company has developed an R&D and audio engineering function that I believe is unrivaled in the industry” to help Skull accomplish that. Quite a claim given who some of the competitors are.
 
But to me the most important thing he says is that about how the company expects to grow. He sees Skullcandy using its foundation in action sports as the basis for its growth in youth culture- not the mass market. If you’ve followed any of my writings, you know I think that the farther you get away from the foundation of your brand into very broad distribution, the harder it is to connect with a customer in a meaningful way. They may know your brand, but they won’t know your story.
 
So it looks to me like we’ll see Skull being a little more cautious and thoughtful in its distribution, and I think that’s great. Bluntly, I think it’s their only choice. As he puts it, “We believe we are one of the only audio companies that has brand permission to play across all of youth culture and we intend to take better advantage of it moving forward.” That’s a big bet, but I think it’s the right one.
 
Part of that bet is going to be a focus on relationships with their retailers. As I wrote yesterday when talking about VF, as I said at the Skateboard Industry Summit, and as I’ve been writing in my column for a while, distribution is way more complicated now than “core” or “noncore.” Each decision to sell (or not sell) to a retailer, be it a chain or a single specialty shop, has to be made based on how, in concert with that retailer, you can reach your target customer and represent the brand well. That what Skullcandy says it’s going to do.
 
Hoby Darling does a great job laying out a vision of a Skullcandy that’s more product driven, and is focused on utilizing its credibility in action sports as a springboard for the broader youth culture market, but not the mass market. He describes a process where you do it right, if not as quickly as you might want. I think that ends up generating a better bottom line with less risk, even if it doesn’t give you quite the rate of revenue growth you might want.
 
The problem, of course, is Skullcandy is a public company with pressure for increasing revenue. After he’d laid out this detailed vision and strategy one of the analysts asks when they could expect to see some of Skull’s new, recently introduced products in Best Buy and Target.
 
To his credit, he calmly explains that “…part of our plan is we launch these innovative products going forward as we generate demand at the core before we roll them out.” I think it’s exactly the correct strategy for Skull, but I wonder if Wall Street gets it.
 
The strategy makes sense, but doing it right is going to take time and probably constrain top line growth some.

 

 

Skull Candy’s Results and Management Change; Rick Alden Rides Again!

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I have been writing recently about organizational dynamics, changing CEOs, and the situational authority you have when you walk into a turnaround. My own experience is that when things suck and you walk in as the new guy, it’s really liberating because you can try anything. 

About five weeks ago, Skull’s founder Rick Alden returned as interim CEO in the wake of Jeremy Andrus’s departure. You may recall that Rick was replaced by Jeremy during the middle of Skull’s initial public offering process. The circumstances surrounding that transition were kind of unusual. That leaves me wondering if he won’t go from interim to permanent. Based on what he’s doing so far, I’d like that.
 
What’s good for a company in the longer run often doesn’t always support the regular, predictable improvement in sales and profits wall street likes to see. To Rick’s credit, he doesn’t seem too worried about that. Let’s see what he’s up to. If you’re interested, you can see the 10K here.
 
Changes
 
As I write this, the Skull’s stock is trading at $5.28 a share and has basically trended down since the public offering. It closed at $6.78 on March 7, the day of the earnings announcement and conference call, so has lost 22% since then.  Announcing that first quarter 2013 revenue would be 30% lower than the first quarter last year and there would be loss of $0.25 to $0.35 a share for the quarter didn’t help. We also hear from CFO Wescoat that "…the way I think you should be thinking about this is that sales are expected to decline over the rest of the year at an improving rate in each of the quarters beyond Q1".     
 
There are two things I want you to think about. First, there was no way Jeremy Andrus could, as CEO, have announced the changes Rick Alden announced (discussed below) without trashing his own credibility. Second, I suspect (though don’t know) that the first quarter loss will be bigger than it had to be because CEO Alden has chosen to go fast and hard at these changes. Like Andy Mooney at Quik and Launa Inman at Billabong, we’ve got a CEO at Skullcandy who, because they are new and because of the situation of the company, can do anything that needs to be done. And Rick Alden comes in with the added credibility of being the founder who built the business.
 
It’s not that I don’t think Skull still has some strategic issues. I’ve been writing about them since before the company was public and I’ll discuss them below. First, here’s what Rick’s up to.
 
He says, “An immediate personal focus will be the low-quality sales that comprise roughly 10% of our total 2012 revenue, much of which was driven through the off-price channel. Not only do we need to cut this back significantly, which is already being implemented for 2013, but we also need to make sure that we do not rely on this channel in the future. Our first quarter guidance reflects this effort.”
 
Those of you who have read what I’ve written about distribution know I love this. In the short run, it costs them some sales and profits. In the longer run, it supports the brand, improves the gross margin and, I think, improves competitive positioning.
 
They are going to redo their packaging which was, well, redone in 2011 and introduced in the first quarter of 2012. Alden tells us it didn’t “…support acceptable sell through metrics throughout the year.” He also thinks it set them on a course for more reliance on off price sales. He’s going back to an earlier approach to packaging which was “…incredibly unique, creative, colorful; told a great brand, product and feature story.” The new packing will flow into retail as the other stuff is sold. It won’t be a change out from one for the other.
 
Talking about Skull’s brand ambassadors, he says there will be “…better utilization of our brand ambassadors in telling product stories, especially at point of sale, and offering transparency around product differentiation and improving the activation of our marketing assets.” He doesn’t think they’ve been well used, though he isn’t specific.
 
He also notes that among the brand ambassadors, his personal favorite is “…our supermodel crew, including two-time Sports Illustrated cover girl Kate Upton.” That’s probably one of those things you’re not supposed to say in conference calls, but I think I’d feel the same way. He notes a couple of times that he’d said something he probably shouldn’t say. But you know what? Good for him. I actually managed to read this transcript without resorting to chewing coffee beans and thought I got some unusual insight into how the organization will function under Rick.
 
Then he talked about product, and I really liked this. He notes that they’ve been bringing out product in some cases just to meet a price point. He indicates that’s over and that new products will come out because they offer a new feature or meet a customer need. In fact, he says he’s“…stuck a fork…” in some products because they didn’t do that. He refers to the new product pipeline as “thin,” an acknowledgement probably not likely to help the stock price but I love it. Hell, you can’t solve your problems until you acknowledge they exist. 
 
Some of you remember when the snowboard companies all expanded their board lines beyond all reason in response to what other companies were doing. I remember hearing the justification that “Competitor X has a board like this one at that price point, so we need one too.” That was lazy and irrelevant competitive analysis. It’s harder to figure out what your customers want, but way more valuable, and that is the direction CEO Alden is taking Skullcandy.
 
In this vein, he notes that Skullcandy has not “…kept up with changing trends, nor have we led with our own innovations. This is unacceptable, and we need to get back to creating the leading edge rather than waiting to see what our competitors are doing.”  
 
He continues this approach, addressing the criticism the company has faced for not entering the premium price market aggressively. He says we know, we are, and we will be there, but that “…we will not enter the premier price points merely for the sake of raising prices…when we are motivated by the right product and inspired to tell our story at a specific price point, we will not hesitate.”
 
He also alludes to a big retailer customer who had expressed disappointment that Skull hadn’t yet extended its brand “…into adjacent categories such as speakers and mobility products. Brand extension is a long-term opportunity and absolutely a major shape for the future of Skullcandy.”
 
My guess is that such extensions will be absolutely necessary if Skull is to grow as quickly as the markets will require.
 
The Numbers
 
Sales for the year grew 28% from $232 to $298 million. That requires some explanation. On August 26, 2011, they finished buying their European distributor. After that, they operated and reported in two segments (North America and International) instead of one. 
 
“As a result, the twelve months ended December 31, 2012 are not comparable to the twelve months ended December 31, 2011 as the prior year does not include a full year of activity for our international segment…”
 
“Also, included in the North America segment for 2012 and 2011 are net sales of $26.1 million and $33.8 million, respectively, which represent products that were sold from North America to retailers and distributors in other countries…Adjusting for these sales from North America… North America net sales increased 21.4% to $224.2 million from $184.6 million in 2011 and international net sales increased 53.7% to $73.5 million in 2012 from $47.8 million in 2011. Included in the increase in international net sales, was an increase in net sales in Europe of $13.6 million, or 45.2%, to $43.6 million in 2012 from $30.0 million in 2011. Net sales made prior to August 26, 2011 in Europe were to 57 North.”
 
Of the adjusted increase in North American sales, $22.4 million, or 57%, came from sales of Astro Gaming product. Excluding that, North American sales of Skullcandy branded product rose 9.3%.
 
Gross profit rose from $115 to $140 million, but gross profit margin fell from 49.7% to 47.3%. In North America it fell 3.4% from 50.2% to 46.8%.  This was “…mostly due to a shift in sales mix to higher price point products with lower gross margin structures, lower margin sales to the closeout channel and an increase in the level of discounting provided to our customers.” The international gross margin was up 8% to 50% due to the acquisition of the European distributor. I’ll spare you the accounting specifics.
 
Talking about the overall gross margin decline, CFO Kyle Wescoat says, “…the shift in sales towards higher-priced, low-margin products accounted for 200 basis points of the decline; two, higher levels of promotional sales and retailer discounting accounted for 180 basis points of the decline; and finally, product liquidations through the off-price channel, which contributed 140 basis points to this decline.
 
I’ve always been a gross margin dollars rather than a gross profit margin kind of guy, so I’m just fine with lower margins on higher priced products as long as the sales increase justifies it. As noted above, CEO Alden has the company headed that way as the product and consumer demand permits it. He seems to be all over the issue of discounting and product liquidations.   
 
Selling, general and administrative expenses rose from $73 to $99 million. As a percent of revenue, they rose from 31.6% to 33.4%. That includes $1.5 million for the bankruptcy filing of a big UK retail customer. 
 
Operating income fell from $42.2 to $41.5 million. It fell from $39 to $32 million in North America and rose from $3.2 to $9.6 million in International. Net income rose from $18.6 to $25.8 million, but that was exclusively because interest expense fell by $6.8 million and Other Expense was down $1.3 million.
 
The balance sheet is stronger than a year ago. Inventories are down a bit even with the sales increase, falling from $44 to $41.6 million. Part of the decline was from “…selling off older and end-of-life…” inventory. Interestingly, Wescoat notes that “…we’re coming into the first quarter with a much higher level of inventory in the channel than we had at this time last year, and that is one of the things that we’re concerned about.” As a result, it’s hard to know how to think about the inventory decline.
 
Receivables rose from $51 to $76 million due to later sales in the fourth quarter and a $13.7 million increase for the launching of the Astro product at retail.
 
Strategy
 
The 10K says that the following are Skullcandy’s competitive strengths:
 
-Leading, authentic lifestyle brand
-Brand Authenticity reinforced through high impact sponsorships
-Track record of innovative product design
-Targeted distribution model
-Proven management team and deep-rooted company culture
 
There’s been some management turnover. And we’ve just heard from that new CEO that the brand ambassadors aren’t being correctly utilized, that the new product pipeline is “thin” and that he’s unsatisfied with how and why products are being developed.
 
With regards to targeted distribution, CEO Alden notes, “We really have had a target as calling out product differentiation to the different channels to make sure that we had unique and specialized product for those specialty retailers. And I will tell you straight up, we’ve done a really poor job of doing that. We tell the story real well. We just don’t deliver the product highly differentiated from one channel to the other.”
 
So the strengths aren’t being utilized as they need to be, and Alden is in the process of changing that. The competitive environment is getting tougher, and Skull acknowledges that in their expanded section in the 10K (page 11) on the competition.
 
I find myself compelled to repeat what I seem to have said every time I write about Skull, starting with their IPO prospectus. “Can you be cool at Fred Meyers?” Or Walgreens, or Best Buy, etc. Maybe, if you execute on those competitive strengths listed above and if the product doesn’t become a commodity.
 
You may recall that Skullcandy’s balance sheet and debt structure really required it to go public. But it feels to me like we’ve got yet another industry company with some problems that could be solved a lot easier if it wasn’t public. I applaud the steps Rick Alden is taking even as I recognize that some of them, as they strengthen the brand and its competitive position, will make it harder to meet investor expectations in the short to medium term. As a private company, Skull might rule the niche it created, growing sales slowly while controlling distribution and improving its bottom line. Public company pressure puts it in a tougher competitive environment.

 

 

Skullcandy’s September 30 Quarter; This is Going to Get Interesting

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Since Skullcandy went public, I’ve characterized the bet they are placing as “whether or not you can be cool in Fred Meyer.” I’ve also asked if coolness is enough of a market differentiator in a product which, especially at the lower end, is increasingly something of a commodity. And finally, I’ve wondered if Skull can have any lasting technological advantage given the resources of some of their competitors. 

Let’s see what their 10Q and conference call tells us about these issues.
 
The Income Statement
 
Sales for the quarter ended Sept. 30 rose 17.1% from $60.6 million in the same quarter last year to $71 million. Gross profit rose from $28.8 million to $34.1 million as the gross profit margin rose from 47.5% to 48%. Operating income was up from $8.2 million to $10.6 million, and income before taxes grew like mad from $3.39 million to $10.2 million. That seems pretty good, but there are complications.
 
The first thing you should know is that interest and other expenses were $4.84 million last year. This year during the quarter they totaled $403,000. That’s a pretax improvement of $4.4 million that has nothing to do with selling headphones and related products. Most of that expense in last year’s quarter was related to the initial public offering and was a one-time expense. Without that, the income before taxes improvement wouldn’t be nearly as great.  Skull points this out in their public information.   
 
Next, keep in mind a transaction from last year. On August 26, 2011, Skull acquired Kungsbacka 57 AB. That was the company’s European distributor. Once they acquired it, in the middle of last year’s quarter, their numbers changed. Before the deal, they sold to Kungsbacka at a lower margin, but didn’t have any of the operating expenses of running a European business. Once the deal was complete and they were going direct, their sales and gross profit rose, but so did their operating expenses.
 
I think getting control of your distribution as you grow is a good idea, and it’s common in our industry. But Skull notes in the 10Q that, “As a result, the three month ended September 30, 2012 are not comparable to the three months ended September 30, 2011…” That’s neither bad nor good. It’s just inevitable and you need to keep it in mind.
 
If we can’t just compare quarters, let’s dig into some details and try and figure out what we think.
 
North American sales as reported rose only a little from $56.3 million to $57.4 million. International sales accounted for almost all of the net sales growth, rising from $4.4 million to $13.6 million. But remember the impact of the Kungsbacka deal. Last year, until the deal date, Skull only operated in one business segment. With the acquisition, they are now in two; North America and International.
 
The 10Q says, “Included in the North America segment for the three months ended September 30, 2012 and 2011…are international net sales of $6,015,000 and $10,713,000… that represent products that were sold from North America to retailers and distributors in other countries.”
 
In last year’s quarter, before the acquisition closed on August 26, sales to Kungsbacka were just sales. After the closing date, they were part of the international segment. And, with a whole quarter under their belt in this year’s quarter, international sales in North America fell, as you’d expect because they got moved to the international category.
 
Let’s take all those international sales out of both quarters and see how things are going just in North America. Skull tells us that North American sales included $10.7 million of international sales not all of which, I guess, were to Kungsbacka. If we subtract, we find that North American sales were $45.54 million. That includes Canada and Mexico.
 
This year, North American sales were reported as $57.41 million, including $6.02 million of international. Subtracting, we come up with $51.39 million of sales in North America. So sales in North America, excluding any product sold internationally from North America, rose from $45.5 million to $51.4 million, or by 13%. Total international sales were up 29.7% from $15.1 million to $19.6 million.
 
You can expect, they tell us, that more sales will transition from the North American to the International segment.
 
On an as reported basis, the 2.1% North American sales increase was “…primarily driven by increased Astro Gaming sales of $4.7 million.” We also learned that online sales, as a percentage of net sales, fell 3.8% to $6 million compared to last year’s quarter. Skull notes that, “An increase in Astro Gaming online net sales was offset by declines in our direct audio consumer business.” Online sales fell from 9.1% to 8.3% of revenues in the nine month period ending September 30 of each year.   “Online sales,” we’re told, “continue to be negatively impacted by price competition in the ease of online price shopping.”   
 
Total gross profit in the North American segment declined by $54,000 to $27.18 million in the quarter compared to last year’s quarter. The gross margin fell to 47.3% from 48.4%. They attribute the decline to “…a shift in sales mix to higher price point products with lower gross margin structures” as well as how some of the Astro Gaming inventory had to be accounted for at acquisition. I would have expected that the Kungsbacka acquisition would have had a positive impact on North American gross margins (because North America would no longer be selling to Kungsbacka at distributor pricing, or at all for that matter) and I was surprised they didn’t mention that.
 
The mention of lower gross margins on the higher price point merchandise was a concern to some analysts. As you know, I’ve been a champion of focusing on gross margin dollars as well as gross margin percentage so I’m maybe not so concerned.
 
The Strategy
 
CEO Jeremy Andrus reminds us in his conference call comments that Skullcandy is “…focused on 4 key strategic areas to drive continued long-term growth. Raising our average selling price, expanding the gaming category, growing international and developing other brands and categories.”
 
Here are some numbers from the conference call for the quarter that tell us something about their sales breakdown worldwide.
 
Product that retails for $30 or less represented 38% of dollar volume and 67% of units. Over the ear products were 26.5% in dollars, but only 7.4% in units. Products in the $30 to $75 range were 28.1% in dollars and 15.4% in units. And products retailing for $100 and over were 5.3% in dollars and 1% in units. The numbers don’t exactly to add to 100% and I can imagine that “over the ear” includes product in more than one price category, but you get the picture. At the moment, the less expensive products are their biggest sellers by units and dollars.
 
Management notes in a couple of places that there is increased competition in the low end buds and that they have lost some market share to competitors in that segment. While I’m obviously not the target market, I paid $2.99 for a recent pair of buds I bought because I knew they were going to get broken at the gym, lost, or left in a pocket and put through the wash.
 
That low end buds would become a bit of a commodity (try to name a consumer electronics product that hasn’t eventually become one- especially at the lower end) can’t be a surprise to anybody. Skull management pretty much acknowledged this when they introduced their 2XL brand “…developed to sell into drug, convenience and grocery channels.”
 
The Skullcandy brand is already in certain retailers (like Fred Meyer) that I’d say is equivalent to where the 2XL brand is be sold. I wonder if 2XL will replace the Skullcandy brand at certain price points and retail outlets, or if they will both be sold in the same place. 2XL, they say without giving any numbers, is small but growing quickly.
 
The Astro gaming headphone brand was about $10 million in international sales at the time Skull acquired it. Skull is pursuing the gaming market with both Astro and Skull branded products. Astro will be the premium product in Skull’s gaming offerings. They’ve just launched the Skull gaming product so it’s not a lot of business yet.
 
In international, Skullcandy is “…still in the early stages of building our direct business in Europe and expanding distribution in other foreign countries.”
 
They are also working to move up their average price points. They think they have a lot of potential in the $50 to $100 price range and “…have invested heavily on product development and are reengineering the development process through an in-house team of designers, developers and acoustic engineers. Everything from the form, function and sound quality are now being controlled in-house.” During the quarter sales in this price range rose 60%, but “…this segment is still relatively small.”
 
What’s It All Mean?
 
They’ve got the 2XL brand, but it’s still small. They see a lot of potential in Europe, but that’s at early stages. They are focusing on higher price point products in both the Astro and Skullcandy brands, but are just rolling them out. Meanwhile, they’ve got some competitive pressure in the $30 dollar and under price point which was their largest by units and dollars during the quarter. Online sales, except for Astro, declined.
 
How’s the overall business environment? “We are confident in our ability to continue to drive long-term sales and earnings growth. That said, the overall retail environment is definitely a bit uneven right now in the U.S. and overseas, particularly in Europe. Over the past few months, we have seen retailers become more cautious in their outlooks for the holiday season and at this point, it is impossible to gauge the impact of Hurricane Sandy.” Those problems aren’t unique to Skullcandy.
 
What’s the short term impact of this? “As a result, the company is lowering its operating margin and profit projections in the fourth quarter and revising its fully diluted earnings per share outlook for 2012 to a range of $1 to $1.04 from the previous range of $1.10 to $1.20.” Management expects “…the fourth quarter to roughly mirror what the third quarter has been in terms of revenue.”   They would not provide a lot of guidance for 2013 because they are in the middle of their budget process, but CEO Andrus did say“…my general sense is that operating margins will be flat next year.”
 
Here we are at the crossroads that every successful, fast growing company eventually arrives at. It’s no surprise that Skull’s lower priced products (that produced 38% of revenue and 67% of unit sales during the quarter) are to some extent becoming commodities and are under competitive pressure. I’d expect that to continue. If there’s continued price and margin pressure there, one wonders what kind of volume they need to do to be competitive in this segment. Their new 2XL brand is to be part of the solution to that.
 
Skullcandy management sees growth opportunities in Europe and in moving to higher price points with both the Skullcandy and Astro brands, but those are at early stages of development. How quickly can they be expected to compensate for the lower priced, more competitive business in North America? And if, in these small but growing niches, competitive positioning is based on the cache of the Skullcandy name- it’s “coolness” if you will- how big is that market?
 
Like I said, this is going to get interesting.

 

 

Skullcandy’s June 30 Quarter; Focus on the Strategy

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Skull had a strong quarter, and we’ll review the numbers. But what intrigues me more are the investments Skull is making and the steps they are taking to implement their strategy. That’s where I want to spend most of our time. In what was, and continues to be, an oversimplification I’ve written that the bet Skull was placing was that they could be cool in retailers like Fred Meyer. We’re going to dig a little deeper now and talk about some things they are doing that are consistent with the requirements for success in what we all know is a dramatically changing retail environment.

 
Sales for the quarter ended June 30 were up 38.2% to $72.4 million from $52.4 million in the same quarter last year. Domestic sales rose 34.1% to $50.6 million from $37.7 million in last year’s quarter. International sales rose $6.2 million or 59.9% to $16.5 million and represented 22.8% of total sales for the quarter. Skull acquired their European distributor in August of last year, and that increased its international sales.
 
As a reminder, each of Target and Best by accounted for more than 10% of Skull’s net sales during the first six months of 2012.   
 
Online sales increased $1.0 million to $5.3 million. That 22.8% increase is almost entirely the result of their acquisition of Astro Gaming in April, 2011. As a percentage of total sales, online sales declined from 8.3% to 7.4%. Skull says this was because they stopped using their web site to sell clearance product “…in order to better preserve the integrity of the brand.” Good decision.
 
Gross margin percentage fell from 51.1% to 49.2% in this quarter. As reported in the 10Q, “The decrease in gross margin is mostly due to a shift in sales mix to higher price point products with lower gross margin structures.”
 
It would appeal to my sense of organization to just review the financials then move on to the strategic issues but, unsurprisingly, it’s hard to separate them. It was many years ago that I first suggested that it might be a good idea to focus not just on your gross margin percentage but on the total gross margin dollars you earn, as that was what you paid your bills with. A few years after that, Cary Allington at Action Watch pointed me at the idea of Gross Margin Return on Inventory Investment. It was a more formal approach to what I’d already been saying and I urged the adoption of the idea in some presentations and in a Market Watch column. It’s a particularly valuable concept in a weak economy.
 
Skull’s management is apparently all over this. They noted that their average selling price increased by double digits in the quarter. One of the analysts asked how they should think the “…margin dynamics between these on-ear and over-the-ear versus buds?”
 
Skull VP of Finance Ronald Ross had already noted that Skull was continuing “…to see a mix shift toward over-ear styles and higher-priced product.” Responding to the analyst, CEO Jeremy Andrus indicated they viewed these trends very favorably. He acknowledged buds had less technology and materials in them, so were cheaper to produce. But he thought the trends would “…increase our revenue and the dollar share of gross margin.” Another executive noted that they saw the trend as positive not just financially, but for the brand as well.
 
So Skullcandy, though of course they would love a higher gross margin, is arguing that they end up with more gross margin dollars with a higher priced product even if the gross margin is a bit lower, and that’s okay with them. I agree.
 
Selling, General and Administrative Expenses (SG&A) rose from $17.2 million to $24 million. As a percentage of sales, it went from 32.9% to 33.1%. They note that “Approximately half of the increase was related to strategic investments in our direct international and gaming platforms, including expansion of personnel.” The areas they are investing in include, “…an in-house product design model, fixtures and point of purchase displays developed to improve our in-store presentation, property and equipment to support operational growth and the purchase of certain intangible assets related to our acquisition of the distribution rights in Europe.”
 
Another argument I’ve made from time to time is that a weak economy and tough competitive conditions offer opportunities to well positioned companies with strong balance sheets. I’m not going to spend a lot of time on Skull’s balance sheet, but since their public offering it’s been strong enough to allow them to pursue their strategy with few, if any, financial constraints. I mostly like where they are spending their money.
 
One of the facts of our new retail environment, whether you’re a brand or a retailer (and assuming we can still tell the difference), is that doing all the operational and back office stuff right is no longer a source of competitive advantage. It’s a minimum bar to have a chance to compete. Doing all that stuff right costs money and requires, I’ll say again, a strong balance sheet.
 
Also due to its public offering, Skull’s interest expense fell from $2.3 million in last year’s quarter to $147,000 in this year’s. Net income rose from $4.3 to $6.8 million, and you can see that without that decline in interest expense, the growth of net income would have been a lot lower.
 
With the financials reviewed, let’s move on to other strategic considerations. Skullcandy rather eloquently expresses the connection between action sports and its target market as follows:
 
“Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our consumer influencers are teens and young adults that associate themselves with skateboarding, snowboarding, surfing and other action sports. These consumers influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the youth action sports lifestyle, and headphones have become an accessory worn to express individuality.”
 
That action sports brands try and use their involvement with the core to reach a much broader customer base is hardly a new idea.   But Skullcandy draws the smaller core towards the much broader consumer market using the commonality of music and the actual product- the headphones. I’m sitting here trying to think of another company that has a product that can do this quite so well but I’m coming up blank. Maybe Nixon is another example. Perhaps this is the bedrock of Skullcandy’s success.
 
You’ll also note in the quote the term “consumer influencers.” We’re all aware of the declining role of traditional advertising and the importance of engaging with your customers. You do that, I think, by controlling as much of your value chain as you can. It’s especially important that you control it at the point of contact with the consumer, and Skull is trying to do that in various ways.
 
They are “…rolling out new point-of-sale fixtures and powered listening stations globally. By the end of the year, we plan to have over 5,000 in place.” About half of these are powered listening stations where you can listen to your own music on Skullcandy headphones as you make purchase decisions.  Some of them have video as well.
 
Their thinking is that higher price point products especially require a listening experience for the consumer at the point of sale. Where they’ve installed them, they’ve seen it “…impact sell-through from sort of low-double digits up to significantly higher than that, depending on the retailer or the fixture type.”
 
They have a retail education group within Skullcandy which is going into retailers and educating sales people on the Astro brand. I can’t see any reason you wouldn’t do that for the high end Skullcandy product as well.
 
They’ve been auditing all their retail customers in Europe since acquiring their distributor and it’s apparently leading to some changes in what they sell to whom; even at the initial cost of some sales.
 
They’ve launched the 2XL brand as a price point product they can sell to places like Walgreens and Rite Aid without damaging the Skullcandy brand. I guess I’m not quite certain why you can sell Skullcandy to Fred Meyers but not to Walgreens, but what do I know.
 
During the conference call, they were asked about selling to Walmart and the answer was along the lines of there’s no current active conversation or commitment, but we’re watching them and it’s kind of hard to ignore the biggest retailer in the world.
 
This goes back to the ability to control your value chain at the point at which it contacts the customer. If you can manage the experience the consumer has with your product so that it’s a positive one and represents the brand in the way you want, does it matter if you’re showing the product in a core shop or in Walmart? That’s an important point, and not just for Skullcandy. The breakdown of the traditional retail/wholesale distribution system requires that brands think about it.
 
Skullcandy’s financial results are good, and their balance sheet is solid. But what I really like is first, the way they are reaching their market using the commonality of music and headphones to draw together the action sports core and the broader market and, second, their strategic initiatives that seem to address the rapidly changing and emerging retail environment.