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