Skullcandy’s Quarter and Year: Good Results, Same Strategic Issues and Opportunities

You recall that Skullcandy found itself in turnaround mode when it sold too much poor quality product in low priced distribution that wasn’t consistent with its preferred branding and market positioning. I suppose that happened when the newly public company tried to meet Wall Street growth expectations.

CEO Hoby Darling came in and put a stop to it. His five pillar strategy included, and continues to include, marketplace transform, create the innovation future, grow international to 50% of the business, expand and amplify known-for categories and partnerships, and team and operational excellence. I’ve reviewed each of those in detail in previous articles, and won’t do it again here. You can find his progress report in each one, as always, in the conference call transcript. And while I’m at it, here the link to the 10K.

Those pillars are all important and necessary. But to my mind marketplace transform was the essential first step, as the company pulled back from questionable distribution for the sake of growth and focused on working with the right retail partners in the right way. Note that this includes Walmart as well as specialty shops, and that tells us something about how the market has changed.

Because of progress in all five of those areas, financial results have improved and things look much better. But the company still has to confront the not insignificant competitive circumstances it’s faced since going public. If I were to sum it up, I’d say that I love what they are doing and have a lot of respect for the progress so far. However, it still feels like there might be some conflict between being a public company and the market position they want to have. We’ll look at the numbers, and then return to that issue.

For the Year and the Quarter

Revenues grew 18% from $210 to $248 million in the year ended December 31, 2014. International sales (by which they mean everything but the U.S.) rose 16.2% from $62.9 to $73.1 million and represented almost 30% of total revenues. The international growth was “…primarily due to increased sales in Canada, and to a lesser extent Mexico and China as a result of expanded distribution.”

One customer (I’m pretty sure it’s Best Buy) was 12% of sales. Last year, one customer was 14% of sales and I’m pretty sure that was Best Buy too. Wonder if there will be a second one over 10% as Walmart takes off.

The gross profit margin rose slightly from 44.3% to 44.6%. The international gross margin was 43.9% compared to 44.9% for domestic. The overall increase was “…due to a shift in product sales mix into higher margin products, including licensing, and decreases in logistic costs as a percentage of net sales and warranty expenses as a result of improved product quality.”

Interestingly, SG&A expense was up only about $700,000 to $98.8 million. As a percentage of sales it fell from 46.7% to 39.9%. They note, “We expect to make critical investments in the business to support long-term growth. In particular, we intend to continue to invest in marketing, demand creation and innovation efforts at the same level or higher levels while also continuing to invest in increased amounts for product innovation and for development efforts.”

“Total demand creation marketing spend was approximately $26.0 million , $27.1 million and $26.0 million for the years ended December 31, 2014 , 2013 and 2012, respectively…Amounts paid to individuals and teams for contractual sponsorships were approximately $1.8 million , $2.3 million and $1.6 million for the years ended December 31, 2014, 2013 and 2012, respectively.”

As a result, operating income improved from a loss of $5 million to a profit of $11.8 million. Other expense rose from $0.5 to $1.6 million, with the increase being the result of currency effects. Income tax went from a benefit of $2.9 million to a cost of $2.5 million. Net income rose from a loss of $3 million to a profit of $7.6 million.

Sales for Skull’s fourth quarter were up 34% from $72.2 to $96.8 million. The gross margin fell very slightly from 43.5% to 43.3%. SG&A expenses rose from $26 to $31.1 million. Net income was $7.2 million compared to $3.7 million in the same quarter last year. Basically, Skull made all its money for the year in its last quarter. That’s not really a surprise. Ain’t the holiday season grand?

The balance sheet is in good shape, with inventory and receivables up consistent with sales growth. They did note in the conference call that inventory might be about $3 million higher than it should be due to product stuck in ports during the longshoremen’s slowdown. There’s no long term debt, the current ratio is over 3 times, and equity, at $153.5 million, is a bit less than three times total liabilities.

The company recorded a $1.5 million expense for excess and obsolete inventory at the end of the year. Last year, it was $1.1 million, but the increase seems consistent with the sales growth. Overall, that’s a pretty small number. Looks like old inventory problems are over. They note in the conference call that they expect to use more than half their inventory during the first four months of 2015.

 Competitive Strengths?

Let’s take a look at the five things Skullcandy cites as its competitive strengths in the 10K. First, they say that they are a “Leading, Authentic Lifestyle Brand.” I think they are. That gets us back to the dilemma of finding growth in a public company that’s consistent with staying that way. I’ve written before that as you expand distribution, the new customers you target may know your brand name, but they may not know and associate with your story.

I’m guessing CEO Darling would admit there’s something to that, but that they are countering it in a couple of ways. First, they are being careful who and where they sell to. They are more interested in increasing sales with good retail partners than in opening new ones for the sake of growth. Second, with some limits, good merchandising can make channels you might not otherwise want to be in work. They continue to reduce off price sales and, as he puts it, “We have the unique ability to tell our brand story and let the consumer experience our product hands on with over 15,000 listening stations, which are at some of the most trafficked retailers in the world as well as influential lifestyle and fashion doors.”

They are also doing it through their second competitive strength: “Brand Authenticity Reinforced Through High Impact Brand Ambassadors.” These are not team riders in the traditional action sports sense, though of course there’s an element of that.

Hoby says, in his introductory remarks, “Increases in technology from handsets, content provider software and our ability to innovate will create enhanced communication and media experiences with content from music, to movies, games and video. Our consumer lives in the digital world and we believe that audio will become a more integral part of their ecosystem.” The best way I know to say this is that they are trying to get their ambassadors to belong to that same ecosystem so they can influence it. I think this is the correct approach.

Here’s how Skull puts it in the 10K. “We build relationships that run deeper than a traditional sponsorship agreement by seeking to create unique opportunities for each member of the Skullcandy family. Our athletes, artists, musicians and trendsetters are ambassadors for our brand who live the values of our brand anthem and we incorporate them into the Skullcandy brand in a way that goes beyond traditional endorsements.”

Third, they talk about their “Track Record of Innovation.” The 10K notes, “In recent years we have increased employee headcount and spend towards research and innovation. We have over 80 issued patents, with many others pending, and one-third of our workforce is dedicated to research, innovation or product development.”

As to the quality of their patents and innovations, I have no idea, though it sounds like some of them are being well received in the market. Are those things important? Sure. Can do they do more and better than their larger, better resourced competitors? Only if those larger competitors decide to let them, perhaps because Skull is more focused than they are.

Next is “Targeted Distribution Model.” We’ve talked about that some, and I agree it’s crucial. The 10K says, “We control the mix and distribution of our products to protect our brand and authenticity.”

So you can be in Walmart, but you have to be in there with the right product, the right pricing, and the right merchandising. Where can’t you be, then, if you do those three things right?

Maybe Radio Shack. But then Radio Shack just declared bankruptcy, and nobody is going to be in them before long. Skull did “…over $14 million of good gross margin business with Radio Shack last year…” Is Radio Shack one of those places where it’s okay to be because your pricing, merchandising and assortment is good, even if the stores don’t (in my judgment) really fit with Skull being a “leading, authentic, lifestyle brand?”

They tell us they’d been supplying Radio Shack on a consignment basis so Skull owned the inventory in case bankruptcy did rear its ugly head. Smart.

Speaking of Walmart, Hoby tells us, “Today, Walmart has been a strong partner and we are generally at or exceeding our plans. During 2015, we plan to be in approximately 3,600 doors in the U.S. or approximately 80% of all domestic Walmart’s. We will have 4-foot sections and fixtures and approximately 1,500 of the doors where we will also have some increased assortment. These 1,500 doors will reset in approximately early June. We will generally have 2 to 4-foot sections in the remainder of the doors, though the space might sometimes be smaller than 2-feet and will vary on a door-by-door basis.”

They say, “We have a sales and distribution strategy intended to allow 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 is designed to build our brand authenticity with our specialty retailers while creating a robust product pipeline for the future.”

That, I suppose is their answer to how you grow as a public company without screwing up distribution. I would sure like a little more information on how, exactly, that works.

What I’d like to know, in terms of targeted distribution, is just what distribution is the off price distribution they are reducing? Is off price defined only by price or is off price distribution characterized by other factors which make it undesirable?

Finally, they say a competitive strength is a “Proven Management Team and Deep-Rooted Company Culture.” I certainly believe they’ve moved in that direction. Perhaps their focus on a single, smaller market means they can do it better than some of their larger, multi-market competitors.

Summarizing where Skullcandy is, they reported good income statement results and a strong balance sheet. In the short term, they’ve got the challenge of replacing the Radio Shack business and managing the impact of the stronger dollar. Neither of those is unique to Skull. They also note that retailers have started to introduce private label headphones, and recognize that potential challenge.

Their longer term success will be determined by their ability maintain what they consider to be their competitive advantages in the face of way bigger and better financed competitors. You can, of course, that about most companies in this industry. But, if I close where I started, meeting the requirements of Wall Street and being a “leading, authentic, lifestyle brand” is challenging. But so far, so good.