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

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.”

A paragraph or so later he notes, “We’ll continue to be very selective in adding new accounts for the time being, unless they are of particular strategic importance.”

So what does it mean if they can increase existing retailer revenue significantly? It could just mean they’re getting their share of a growing market (I don’t know if or how much the market is growing). But I think it will mean they’re taking some share and that their retailers are getting sell through at good margins. It will suggest they are differentiating the Skullcandy brand.

How exactly do they plan to do that? First, by “…reinforcing Skullcandy’s accessible yet premium brand ethos at retail, and improving full-priced selling.” This includes reducing the off price business and enforcing online pricing as well as “…significantly upgrading the look and feel of our in-store real estate with several key accounts.” The company is “…hiring a new service provider to ensure that all our listening stations are working properly, and our POS materials meet our aesthetic guidelines.” CEO Darling notes that they have to “win in-store.”

Every brand in our industry is trying to reach consumers at all their touch points with the product. They need to. I’m thinking this is necessary for Skullcandy, but it’s expensive to do. If you’ve walked through a Best Buy lately, you’ve noted the kind of resources brands are committing to their in-store presence. Some of those brands are Skull’s competitors, but sell a much wider range of product than just headphones and can spread the in-store cost over a much bigger revenue base.

Skull needs to be part of this, but doing it selectively with “several key accounts” is probably the right approach for both marketing and financial reasons. At the same time, Skull is just selling headphones and (so far) speakers, so don’t need the kind of space those brands need to make an impression across their broader product lines. After all, it’s about the sound.  “It’s about the sound.” Hmmmm. I like it. Might make for an effective marketing campaign.  It’s so obvious it’s probably already been used.

Adding distribution (though cautiously, as noted above) is another way they expect to transform their market. The previously announced roll out with Walmart is underway. Initial test products will be in select stores about now. The numbers we’re talking about now don’t include any Walmart sales.

I don’t quite know if Walmart qualifies as cautious distribution, but I think they need to give it a try if only because their competitors are there. And, as a public company, they need some meaningful revenue growth. I’m intrigued to think about how their improved and upgraded listening stations might be received there, assuming they are being used in Walmart.

They are also working to “…drive awareness and deep connections to our brand and products through more creative and effective marketing.”   Who isn’t? As you know, I think controlling distribution and reducing price point sales will go a long way towards accomplishing that. Related to that, they see their target pricing zone as being from $20 to $100, though gaming is higher.

They’ve also pulled design and development in-house, and tell us they are starting to see the benefits of that.

Finally, they are working to identify and focus on certain market niches. So far, these include women’s and sports performance training. I don’t pretend to understand the size and potential of these market segments for Skull’s products. However, I do believe that if the potential customers in these segments are aligned with the brands ethos and market positioning, they could be good niches.

Now, on to the numbers.

Revenues for the quarter ended March 31 rose 5.5% from $37 in the same quarter last year to $39.1 million. It would be interested to know how much off price business they cut during the quarter. The 10Q tells us that “The increase in net sales was primarily attributable to gaming and international sales.” As there’s still some cleaning up of the off price market going on, I’m okay with that for this quarter.

North American sales were $29.0 million, compared to $28.7 million in last year’s quarter. That’s an increase of 1.3%. International sales rose 21.2% from $8.4 to $10.0 million. Note that North American sales include $600,000 in sales that were shipped outside of the U.S. In last year’s quarter the number was $2.1 million.

One customer represented 14% of sales and a second, 11%. They don’t identify the customers, but from comments in previous conference calls, I’m pretty sure they are Best Buy and Target. The first one was 10% a year ago. The second, less than 10%.

There’s a provision for sales returns and allowances of $5.18 million. We find in the notes that Skullcandy has “…executed an open return program with a major retailer allowing for an unlimited amount of returns.” I imagine that’s what requires that provision.

The gross margin rose from 44.5% to 46.5%. It rose in North America from 43.5% to 47.0%. For international sales, it declined from 48.1% to 44.9%. “The increase in gross margin was primarily attributable to a shift in product sales mix into higher margin products, decreases in shipping related costs, and reductions in warranty related costs.” CFO Jason Hodell noted in the conference call that part of the improvement was due to an improved ability to use returned product. That makes me feel good about the quality of their inventory. They expect gross margin for this quarter and for the whole year to be 44.5%.

SG&A expense fell by 16% from $26.3 to $22.1 million. As a percentage of sales, it was down from 71% to 56.5%. The reduction”…is primarily due to a decrease in write-downs of tooling, fixtures and furniture, reduced severance, and a reduction in performance-based compensation.” In other words, the turnaround and restructuring adding a lot of costs in last year’s quarter. We also learn that some of the compensation has been deferred to a later quarter.

The operating loss fell from $9.8 to $3.9 million. Almost all of that operating loss was in North America. The international operating loss was $30,000. CEO Darling refers to the U.S. as a bit of turnaround.

The pretax loss fell from $10.5 to $4.1 million and net income improved from a loss of $7.1 million to a loss of $3.4 million. However, the income tax benefit was lower by about $2.6 million, so you might want to focus on the pretax number.

On the balance sheet, we see a slight improvement in the already strong current ratio from 4.2 a year ago to 4.4 times. The highlights here are the increase in cash from $33.5 to $48.2 million and the reductions in inventories from $51.2 to $42.7 million while sales increased. I assume this is related to the reduction in their off price business.

There’s no bank debt, and current liabilities are essentially unchanged from a year ago at a bit over $30 million. At 23%, total liabilities to equity are about where it was next year and is low (a good thing).

In the words of Winston Churchill (speaking in 1942 about a British victory in Egypt), who would probably roll over in his grave if he saw himself quoted here, “This is not the end.  It is not even the beginning of the end.  But it is, perhaps, the end of the beginning.”

I’ll go out on a bit of a limb here and speculate that Skullcandy’s initial decision to sell off-price product to the very broad distribution channels they choose in the years prior to their IPO was an intentional strategy to accomplish an IPO they had to get done. You know I questioned the strategy from the moment I saw their prospectus, characterizing their strategy as “trying to be cool in Fred Meyers.” I’m not sure it ever had a chance to succeed.

Well, hell, they are the ones who built this business- not me and just making it happen is quite an accomplishment.

Now, they are pursuing a strategy that makes more sense to me. I have the feeling of pieces starting to fit together. I don’t yet know if they are all the right pieces, if the strategy will be compromised by public market pressures, or if Skull’s can succeed against its larger and better resourced competitors. But there is progress here.