Skullcandy’s Year and Quarter: Still Comes Down to Whether They Can Be Cool at Fred Meyer
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.
Based on my experience… Hoby is a talented and highly intelligent leader. I (for one) believe he will right the ship.
Hi LB,
I don’t dispute his management ability. As I noted, I even agree with most of his strategy. Can you be a little more specific about what part of my analysis you disagree with?
Thanks for the comment,
J.