Selling Less In a Good Cause; Skullcandy’s Strategy and Quarter

In the quarter ended June 30, Skull’s sales fell by 30% to $50.8 million from $72.4 million in the same quarter the previous year. Their gross margin fell from 48.6% to 44.9%. Selling, general and administrative expenses actually rose slightly from $23.5 to $24 million, but if you exclude the almost $1 million that’s included for the move from San Clemente to Park City, it fell a bit. Net income, not surprisingly, declined from a profit of $6.8 million to a loss of $689,000. 

It’s not that I’m thrilled to see these results, but I think they are indicative of Skull pursuing the only strategy they can reasonably pursue. Here’s how CEO Hoby Darling puts it:
 
“While I do not believe we will turn our sales trajectory positive this year, we’re decisively taking action based on learnings from some historical missteps and being more disciplined around distribution, retailer and product segmentation, discounting and importantly, the alignment of product, marketing and sales. These are necessary first steps to protect the brand and set us up for long-term healthy growth.”
 
You remember that last quarter Skull was cutting back on the sales through off price channels (year to date those sales are down 50%). Now we find out they’ve actually held back some product from some retailers to protect their brand position. As CEO Darling puts it, “We need a clear distribution channel and to have retailers and consumers seeking out our products.”
 
One more quote:
 
“We will continue to aggressively rebalance our distribution pyramid so that demand and supply are more closely matched. This includes minimizing the end-season product sales in the off-price channel, protecting our map pricing policy and supplying our retailers with the right amount of product to match healthy demand. We will continue to protect profitability, while investing in our most important growth initiatives in demand creation.”
 
Oh hell, just one more:
 
“As we think about our future, the main tenets of our strategy are based on the following: first, transforming the marketplace. This includes rebalancing and segmenting our distribution pyramid to amplify with winning retailers and match supply to market demand and clarifying our brand message, with a strong focus around digital and planned sale.”
 
Regular readers will know why I’m all a dither about this strategy. I’ve been pushing for some years the idea that with sales growth harder to come by, gross margin dollars and control of operating expenses was where you needed to focus to improve profitability. I’ve said that distribution and deciding who to sell to is way harder than it used to be. But I’ve also said that if you recognize the relationships between operations (especially inventory management) on the one hand and sales and marketing on the other, you can achieve better results while spending a lot less.
 
Like Quiksilver and Billabong have done and are doing, Skullcandy is also working to “…create a cohesive organization by removing the operating silos that were hampering communications, alignment and culture between different areas of the business." CEO Darling, by the way, thinks they can probably spend less on demand creation. He makes that comment in kind of an offhand way, but if the company approaches their customer segmentation, pricing, and distribution in the way he describes, it might be a lot less. Overall, what Skull is doing kind of reminds me of Spy’s strategy. And the bottom line is that Skull is going to have to reduce its SG & A spending as a percentage of sales unless sales grow way faster than they seem to expect.
 
There’s just one fly in the ointment. Like Billabong, Quiksilver and Spy, Skullcandy is public. These are four companies that would be better off if they were private and free to pursue brand strategies unconstrained by the need for regular, quarterly growth. Skull is purposefully restricting sales to defend and strengthen their brand and market position and, I’m expecting, greatly improving their overall profitability. Great decision.
 
But there’s that pesky Wall Street revenue growth bias out there. What to do? Skull expects that their current actions will increase their sales in their core market, though not until 2014. CEO Darling describes the brand as “…fun, young and irreverent, woven in with creative and active.” Good definition. “As small and creative company, we have the opportunity to be special and more unique than our larger competitors.” I agree. But that focus also limits growth because it limits your available customers.
 
What to do? Product extensions, which the analysts ask about every quarter, are one answer. Sell more to the same customer. The Air Raid Bluetooth speaker will be in retail in the fourth quarter. And you also look for growth by “…expanding beyond our core audio headphone market and partnering with other brand leaders and their respective consumer categories will assist in broadening our region appeal to give Skullcandy added legitimacy outside of our core market position.” They use a deal they are making with Lululemon as an example. Sell more to a new customer.
 
Let’s assume that as a result of implementing these strategies I like that Skullcandy solidifies its position in its core market, grows sales slowly (slower growth initially is implicit in its strategy), and improves its profitability on those sales significantly. As a private company, that might arguably be a great result. As a public one, not so much. So along come the brand extensions and the partner deals “to give Skullcandy added legitimacy outside of our core market position.”
 
How’s that worked out in this industry in the past for public companies? As I’ve pointed out, Zumiez is the only action sports based company that’s public and doing well. Others are all having difficulty or have been acquired.
 
Skull has the balance sheet to pursue its strategy. They’ve got no long term debt, $30 million in cash (up from $7 million a year ago) and a strong current ratio. Operations provided $12 million in cash flow during the first six months of the year compared to using $8 million in the first six months of last year. Inventory over the year fell 17% from $50.5 to $42 million. I might have expected a larger drop given the sales decline. They tell us the decline wasn’t greater “…due to higher gaming inventories support retail and the building of inventory in China to support our direct sales model there.” I’d be interested to know how much of their existing inventory is price point product they still need to move.
 
Much of the sales decline was due to a reduction in the off price sales, but they also mention “…lower sell-in at a key customer and a decline in sales to several of our specialty retailers.” They have one customer that represented 18.3% of sales during the quarter compared to 11.4% in last year’s quarter. While I imagine that increase is explained by their decision to reduce price point sales, it’s still quite a concentration.
 
They make the interesting comment that they see some market movement from over the ear product to in ear. They don’t tell us the extent of the change. That’s interesting because in their last call they talked about moving towards higher priced but lower margin (generating more margin dollars) product that was largely over the ear. I was surprised no analyst asked about that.
 
Skullcandy has a strategy I fully support, but wonder how it will be received in the public markets. They have some personnel, relocation, and operational changes going on that it’s just going to take a little time to work through. I will wait to see how their product extensions work out. I hope they aren’t too aggressive in that area.