Skullcandy has a Strong Quarter

Skull’s sales for the quarter ended June 30 rose 46.4% to $52.4 million over the same quarter last year. Net income more than doubled from $2.1 to $4.3 million. This was helped by an income tax rate that fell from 56.6% to 41.6%. Gross margin essentially stayed the same, falling just one tenth of a percent to 51.1%. You can see the 10Q here.

Selling, general and administrative expenses rose $7.9 million or 84% to $17.2 million. There was a $3.7 million increase in payroll and $2.9 in marketing expenses. There were, obviously, also higher commission expenses on higher sales. As a percentage of sales, these expenses increased 6.8% to 32.9%.

Income from operations rose, but as a percentage of revenue it fell from 25% to 18.3%.
Skull is dependent on two Chinese manufacturers for their product. Like everybody else, they are experiencing higher costs from China and note that their gross margin might decline if they can’t pass these costs on to consumers.     
Remember that this quarter closed before they went public. As a result, we have $1.9 million in related party interest expense that wouldn’t be there if the offering had closed during the quarter. Also, I’m not going to spend any time on the balance sheet as it improved dramatically after the IPO. A bunch of cash has that impact on a balance sheet.
Just one balance sheet comment. Inventories grew 86% from $22.6 to $41.9 million. They discuss this in the conference call. Part of the growth was due to inventory levels being too low last year, and part is because of the acquisition of Astro Gaming. They also decided to increase their stock levels in 2011 to better service their retailers.
In discussing their outstanding orders, Skull says, “We typically receive the bulk of our orders from retailers about three weeks prior to the date the products are to be shipped and from distributors approximately six weeks prior to the date the products are to be shipped….As of June 30, 2011, our order backlog was $10.1 million, compared to $10.0 million as June 30, 2010. Retailers regularly request reduced order lead-time, which puts pressure on our supply chain.”
Obviously, they can’t wait for orders from retailers before placing orders with their factories. They say in the conference call inventory growth was roughly in line with sales if you ignore those three factors. But it looks to me like some of the inventory increase results, as Skull puts it, from “…pressure on our supply chain” that’s requiring some inventory growth in excess of sales growth.
Okay, one more balance sheet comment. There was a statement on the call about how, because they carried their inventory under FIFO, product margins had benefitted so far this year. In the second half of the year, as they start to sell the higher cost product, that benefit will go away. This inventory accounting stuff is going to start to matter with costs rising. I wrote about it in a bit more detail when I took my last look at VF Corporation.
The company’s net proceeds from the public offering in July were $77.5 million. Of that amount, $43.5 million, or 56.1% of the net proceeds, went right back out the door to pay accrued interest on convertible notes, unsecured subordinated promissory notes to existing shareholders, notes in connection with already accrued management incentive bonuses, and a bunch of other moneys due to existing stockholders. They used an additional $8.6 million to pay down their asset based line of credit in early August, and they may use a portion of the proceeds to buy back their European distribution rights. If that happened, that would leave them with $10.4 million of the offering proceeds, but they continue to have availability under their line of credit. 
If I had all the time in the world I’d like to go review and understand in detail how Skull financed its growth. It’s always hard to finance fast growth and it got harder when the economy went south. It must have been an interesting experience. Ah well, what doesn’t kill you makes you stronger.
In the conference call Skull management laid out its five major strategies. The first was to further penetrate the domestic retail channel. Skull is currently in Best Buy, Target, Dick’s and AT&T wireless. Domestic sales were about 80% of the total. During the quarter net sales to three customers totaled 27.4% of total sales and represented 44.4% of receivables at the end of the quarter.   That’s down from 33.2% of total sales and 46.9% of receivables at the end of the same quarter the previous year.
The second was to accelerate its international business, which is largely in Canada and Europe. It grew by 47.1% in the quarter and represented about 20% of total sales. A dispute with their European distributor had reduced 2010 sales, so part of the growth is catching up.
They sell in 70 countries and have 26 independent distributors. They want to distribute directly in key markets. This is a strategy most other companies in our industry have utilized.
57 North, their European distributor, represented more than 10% of their sales during the first half of 2011. In June, Skull entered into a non-binding letter of intent to buy those distribution rights back from 57 North for $15 million. As noted above, Skull has had a previous dispute with 57 North, and from the way they describe it in the 10Q, it sounds like there’s some uncertainty the deal will close. Maybe that’s just what they have to say because it’s a non-binding letter and negotiations are still ongoing. 
The third strategy is to expand their premium priced product category. The “vast majority” of their products are priced in the $20 to $70 range. They said they had premium products in the pipeline that could be released in the next 24 months. I’m pretty sure they said “could,” so unless they just used the wrong word, there seems to be some doubt as to the timing.
One of their existing premium products is the Aviator. They launched it in Apple stores and it was exclusively available there for six month. I like that distribution strategy but of course it may cost you some sales early on.
A fourth strategy is to expand complimentary product categories. This includes Astro Gaming’s head phones. They bought the company in April for $10.8 million. Astro sales are obviously included in the June 30 quarter. I don’t know exactly how much those sales were.
The fifth strategy is to increase online sales. Those sales were $4.3 million in the quarter, or 8.4% of net sales. In the quarter last year, online sales were 3.9% of total sales. $2.5 million was organic growth, which tells us that $1.8 million in online sales came from the Astro Gaming product. Organic online growth was 117% over the same quarter last year.
These are all fine strategies. In fact, they are so good that most companies are trying to implement them. What Skull says they have done is, “…revolutionized the headphone market by stylizing a previously-commoditized product and capitalizing on the increasing pervasiveness, portability and personalization of music.” I think they are right, but we’ll have to keep watching to see if they can continue to do it better than anybody else.   



PPR Buys Volcom, Probably

You know, I should have seen this coming and been sitting on 10,000 shares. But no such luck and anyway, I don’t own shares in companies I write about. Still, the deal’s not a complete surprise. Vans, DC, Reef, Sector 9 and Hurley are a partial list of industry companies that have been acquired by larger companies that wanted to get into or expand their action sports offering and grow their credibility with that customer group. Consolidation is not new, and most successful companies in our industry seem to reach a point (usually as they start to grow into the larger fashion market) where they perceive they need some help to continue growing and succeed in that broader market.

Volcom has been showing some symptoms of needing that help. Last time I wrote about them, in March, I said,

“But there comes a time, especially as a public company, when that strong brand positioning with a targeted consumer can make growing more of a challenge as the new customers you need don’t feel a strong connection with the brand and the customer you have may feel alienated if and as you do what you have to do to build a connection with the new one.”
“It’s not like this is a surprise to anybody who’s been around our industry for a while. Large or small, public or not, every company deals with this when they grow. I wrote last week about how Quiksilver is pushing its DC brand and my concern that they might push it too hard. Burton, when it changed its name from Burton Snowboards to just Burton, was dealing with this issue.”
I noted in the article that Volcom was counting on some broader distribution including the department store channel for growth, but that I wasn’t quite sure a company with the motto “Youth Against Establishment” fit in the department stores.
I went on to say, “Volcom says they make premium product that typically sells at premium prices and they’ve got a very distinctive image they’ve worked hard and successfully to build over 20 years. That sounds boutique like to me- not department store. Just saying.”
They’ve also had some issues with dependence on PacSun and too much inventory. In 2010 revenues were up 15.2% over the prior year, but net income increased hardly at all, from $21.7 million to $22.3 million. A decline in gross margin from 50.2% to 49.2% explains most of that.
During PPR’s conference call announcing the acquisition, one analyst ask why, if Volcom actually believes it can earn $2.20 to $2.40 a share in 2014 it was selling now for this price. The PPR CEO answer was something along the lines of “Uh, oh, well, I guess they think it’s a fair price.” Great question I thought and maybe Volcom’s answer has something to do with the issues I raised.
By the way, the reason I put “probably” in the article title is because no deal is done until it’s closed. Also, from time to time an offer from one company will result in a higher offer from another company. The board of directors of a public company has a fiduciary responsibility to do what’s in the best interest of their shareholders. They couldn’t just ignore a better offer they think has an equal chance of closing. Of course, what’s “better” can be open to interpretation. I don’t actually expect there to be another offer. PPR, as we’ll get to next, is an 800 pound gorilla and I consider the deal fully priced.
PPR had 2010 revenues of 14.6 billion Euros (2.3 billion of which was sold online). That’s north of $21 billion at the current exchange rate. Western Europe is about 59% of their revenues.  North America is 16%. They have 60,000 employees and their products are distributed in 120 countries. Volcom, at $321 million in revenues in 2010 is a tad smaller, but much, much cooler. It’s around 1.5% of PPR’s revenues. I’d like to tell you all about them, but their web site is in French. I guess I can at least say they are a French company.
 Oh- wait- here’s the English version. Their luxury group of brands includes Gucci, Bottega Veneta, Yves Saint Laurent, Balenciaga, Alexander McQueen, Boucheron, Sergio Rossi, and Stella McCartney. I’m pretty sure none of these brands are hanging in my closet even though I’m such a fashion forward guy. The Stella McCartney stuff just doesn’t accentuate my bust.
They also own PUMA, FNAC and Redcats. Okay, I know what PUMA does. FNAC is apparently in the process of being sold. In 2010, the luxury group was 27% of sales and PUMA was 18%. PPR has over 800 stores globally. Here’s a link to the English version of their 356 page reference document which I am not reading. It has some easy to absorb graphics you might be interested in. It’s a big file and a bit slow to download.
This is PPR’s first adventure into the action sports market. It should be interesting to watch. On an operational level it seems obvious that Volcom should benefit from PPR’s size in terms of systems, manufacturing, access to capital and operations. Those synergies are usually real, but also usually harder to achieve than people expect. I guess Volcom will report through PUMA. It was interesting to hear PPR management say that Volcom was complimentary to PUMA and then note that PUMA was not involved in action sports. Maybe they just meant complimentary in terms of getting Volcom into shoes in a much bigger way, which apparently we can expect.
PPR, of course, is particularly well situated to increase Volcom’s presence in Europe, where both Volcom and PPR think they have a lot of room to grow. It sounds like we can expect to see quite a few more Volcom stores worldwide (no numbers given). I wonder if Volcom product would fit into any existing PPR owned stores. Many PPR brands can reasonably be characterized as boutique brands and, as I suggested before, if Volcom’s description of their brand and its positioning is accurate, maybe that’s where they belong. But I have a hard time seeing Volcom in a Gucci store at the moment. Maybe Europe is different.
Volcom may be strategically important to PPR, but it’s an awfully small piece of the whole. As I listened to the PPR executives describe Volcom, it felt like they were reading Volcom’s description of itself and its market position right out of Volcom’s 10K. Even though they’ve been talking for a year, I was left unsure if PPR “got it” or not. Over the years, I’ve watched European companies try to break into the U.S. action sports market and just do it wrong. I’ve watched U.S. companies have the same problem going to Europe, if only because we start out thinking of Europe as one market.
One European analyst called Volcom a “sports” company and inquired of management if they were thinking of launching a PUMA action sports brand. Happily, PPR made it clear that was a bad idea. There was also a question about whether Volcom and PUMA could be distributed together.
PPR talked about “…building the Volcom business globally while maintaining its authenticity” and keeping it positioned as it is today without changing the target customer. Of course that’s what they want to do, or they wouldn’t be buying Volcom. But as I’ve written, it’s also the challenge. Every action sports brand comes up against this. At some level growing and maintaining authenticity becomes as challenge. PPR has, of course, dealt with all forms of distribution and growth issues, but I am not aware that PPR management has experience with this in the youth culture market. Growth, after some point, requires changing, or at least expanding, the target customer.
They will be relying on the Volcom team to continue managing the brand. The deal, however, is an all cash one at $24.50 per share (22.6 P/E ratio according to one investment banker) with no earn out component we learned in the conference call. I sure hope Richard Woolcott and his team are happy working with PPR.
Given the challenges Volcom faces, they’ve made themselves a good deal at the right time. PPR can certainly make them more efficient operationally, in manufacturing, and financially. They will help Volcom grow especially in Europe, and there will be an expanded retail presence. In the longer term, if PPR and Volcom managements have some patience with each other, we might see Volcom make a transition into the fashion market in a way no other action sports brand has done.
Youth Against Establishment indeed.




Who’s Jeff?

Jeff Harbaugh

Jeff has been active in the action sports and youth culture industries since 1991 as a manager, consultant, analyst and investor. He received his MBA in finance and international business from the Wharton School and spent some years in international banking, corporate development, consulting and turnaround management. In 1991, he walked into Nitro Snowboard’s U.S. distributor in a three piece suit. The suit lasted about a day and a half.