Skullcandy Going Public; What We Can Learn From Their SEC Filing

It’s always interesting when a company in the industry decides to go public. They’ve got to drop their drawers and provide you, in their S1 filing, with information you could only speculate about previously. If you want to see it, the whole thing is here.

As of last week, Skullcandy’s drawers are well and truly dropped. Since I returned from the excellent SIA show in Denver, I’ve been through the complete filing. I’ll review the numbers with you, but what’s more interesting to me is their market positioning and strategy.

They’ve grown quickly by recognizing and exploiting the “…increasing pervasiveness, portability and personalization of music.” They stylized what had been a commodity product and connected action sports, youth culture and music in a way it hadn’t been done before. Rick Alden and his team get all the credit in the world for recognizing and capitalizing on an opportunity that was staring us all in the face.

The question for me is whether Skullcandy can retain its “first mover” advantage against companies like Sony and Nike as they inevitably expand their distribution to grow, which they will have to do as a public company. That’s the intriguing part of the discussion, but let’s go over the numbers first.
Historical Financial Results
In 2005, Skullcandy (hereafter known as SC) had revenue of $1.33 million. Over the next four years, its revenues were $9.1, $35.3, $80.4, and $118.3 million for the years ended December 31. Its 9 month revenues for 2009 were $70.7 million compared to $95.9 million in the first 9 months of 2010. Domestic sales represented 72.5% and 81.1% of revenue for 2009 and the first 9 months of 2010 respectively. During both these periods, Target and Best Buy each represented more than 10% of their net sales. SC products are also sold in Radio Shack, Fred Meyer, Dicks, and The Sports Authority in additional to independent retailers and specialty chains.
Their gross profit percentage has been north of 48.5% for 2007-2009. It was 48.2% for the first 9 months of 2009 and 51.4% for the same period in 2010. That increase in 2010 was largely the result of domestic sales, with higher margins, growing compared to a temporary decline in lower margin international sales. They had a now resolved dispute with their European distributor that cost them a few million in revenues.
Selling, general and administrative expenses, as a percentage of sales, have risen every period. They were 20.8% in 2007. They rose to 22.4% in 2008 and 22.9% in 2009. In the first 9 months of 2009 they were 26.4%. The number was 31.5% in the first 9 months of 2010.
Typically, you might see that percentage decline with growth after a certain point. I’m thinking (and I can’t ask SC because they are in what’s called the “quiet period” that follows this kind of SEC filing) that they recognize that first mover advantage doesn’t last forever and they are trying to maximize their market penetration before players with a lot more resources than they have start to catch on and catch up. They state that of the $11.5 million increase for the first 9 months of 2010, $4.1 million was for advertising and marketing. Advertising costs by themselves for the years ended December 31 2007 through 2009 were $922,000, $3.55 million, and $3.1 million respectively. Interesting to see that decline in 2009. 
When they talk about their athlete and musician sponsorships, they list snow, ski, skate, surf, moto, wakeboarding, BMX and Bike teams totaling 83 athletes. There is also a five member NBA crew, a 21 plus music family, and 24 members of the DJ family. But they go on to note that, “The majority of the individuals and groups listed above do not have contractual relationships with us but support our brand by wearing our products and participating in Skullcandy events and marketing activities.” I guess that means that the majority are people they flow product to and hope that product shows up being used by the personality.
Income from operations has risen each year. There was an operating loss of $274,000 in 2005. There were operating profits of $954,000, $9.8 million, $21.2 million and $30.4 million from 2006 through 2009. But as a percentage of revenues operating income has declined. It was 27.8% in 2007, 26.4% in 2008 and 25.7% in 2009. For the first 9 months of 2009 and 2010, it fell from 21.7% to 19.9%. With the rise in selling, general and administrative expenses and the sales to more price sensitive customers, I suppose that’s not a surprise. Given their distribution and apparent growth plans, I’d expect some further decline in that percentage. 
Interest expense was fairly low the first three years of SC’s life. It rose to $586,000 in 2008 and to $8.9 million in 2009. During the first 9 months of 2010 it was $6.6 million compared to $6.5 million in the same period of 2009. Well, growth takes capital and SC raised some pretty expensive money. Notes payable to related parties totaled $27.5 million at the end of 2008 and $52 million at the end of 2009. Stockholders’ equity was $20.7 million at the end of 2008 and fell to negative $18.6 million at the end of 2009. Cash was $19.4 million at the end of 2008 but only $1.7 million at the end of 2009.
You can see the rationale for going public. It will clean up the balance sheet, get rid of most of the interest expense, and give them growth capital. It was probably either that or sell the company.
Net income was $13 million in 2008, up from $6.3 million the prior year. In 2009, net income was $13.5 million, only slightly above the prior year in spite of increasing revenue from $80.4 to $118.3 million. You can see the impact of the rise in interest expense there.
Market Positioning and Strategy
Here it is in a nutshell: “We believe the increasing use of portable media devices and smartphones, and the growing popularity of action sports, support our anticipated long-term sales growth.”
Now let’s look at what they see as their competitive strengths as they describe them and, as possible, talk about each. These competitive strength statements are quotes from SC’s filing.
Leading, Authentic Lifestyle Brand. Skullcandy fuses music, fashion and action sports, all of which permeate youth culture. We believe the power of our brand has driven our strong market share.
Fair enough. Their success to date would suggest they’re right about that. But of course somewhere between lots to all successful brands in our industry would make more or less the same statement. And all those companies, at some point in their growth, have run into difficulties (not necessarily insurmountable) associated with distribution and the size and resources of their competitors as they’ve stepped away from action sports and into fashion. Why might SC be different?
They would probably make two arguments. First, that with each of Best Buy and Target accounting for over 10% of their sales, they’ve leaped over the distribution issue without damaging their brand and have placed SC in those channels before their hugely larger and stronger competitors could get there with comparable offerings. Second, they’d point (they do point!) to the continuing growth in portability they are taking advantage of.
My perception is that all products in our industry that have pushed their distribution have ended up with some competitive pressure on their prices and the extent of that pressure has been dependent on the speed and extent of their distribution.   At some point, growth requires that you end up selling to customers who are more utilitarian and price conscious and less concerned with “cool.”
The bigger the market, and the more attractive the opportunity, the sooner you attract competitors and the stronger they are. Nike stumbled around in action sports for a while before they got it right, but they did get it right. Skate brands will tell you what happened when the Chinese decided they could make skateboards and the market was big enough to warrant the effort. 
Are headphones somehow different because they’re an electronic product even though SC has positioned itself as an action sports company? At the end of the day, there’s no easy answer and it’s a question of SC’s ability to implement its strategy. It always is. How do they stay an “authentic lifestyle brand” as they grow?
Brand Authenticity Reinforced Through High Impact Sponsorships. We believe we were the first headphone brand to sponsor leading athletes, DJs, musicians, artists and events within action sports and the indie and hip-hop music genres. We believe this has increased our brand awareness and reinforced our credibility with our target consumers.
It’s an element of faith in our industry that sponsorships matter and SC seems to have done a hell of a job here. But there’s nothing stopping Sony or Nike from doing the same thing in SC’s market. Nike in particular does know a few things about sponsorship.
Track Record of Innovative Product Design. Our company was founded on innovation, and we employ innovative materials, technologies and processes in the design and development of our products.
One of the things that particularly impressed me was their focus on getting product to market quickly. I think that’s key. The company has gone from one SKU in 2003 to over 1,200 as of September 30, 2010. Note that 1,200 SKUs translate into basically 20 models with various colors and graphics. Headphone represented 87% of gross sales for the 9 months ended September 30, 2010. It was 90% in 2009.   SC talks about having utility patents on certain features and technologies and about having filed for others. They aren’t specific and I suppose they shouldn’t be. But I’d love to know if any of these offers a proprietary advantage in the market.
Talking about their product, they note that, “…Two of our manufacturers together accounted for 72% of our cost of goods sold in 2009 and 73% of our cost of goods sold for the nine months ended September 30, 2010. Each of these manufacturers is the sole source supplier for the products that it produces.” They have 19 independent manufacturers in total. They are working on developing some more sourcing flexibility and have opened an office in Southern China. Good idea.
Targeted Distribution Model. We control the distribution and mix of our products to protect our brand and enhance its authenticity.
Now wait a minute. I know what works and doesn’t work in distributing a product has changed, and I know the company’s been around since 2004, but as they describe it, it sounds like SC’s distribution is being targeted with a blunderbuss. They could explain it in a much more positive way.
Essentially, I think SC management believes, due to the nature of the product and the market, that they can be “cool” in Best Buy and that some of the distribution constraints that would apply to other action sports products don’t apply to head phones. They may be on to something. Not to get the lawyers in an uproar, but I suggest you say that in the S1 if it isn’t too late. The assumption, or the hope at least, may be that SC can eventually be almost anywhere headphone are sold without damaging the brand. This isn’t really targeted distribution as we think about it in our industry. But that doesn’t mean it isn’t carefully thought out.
Growth is not just anticipated to be through domestic retail. They expect to increase their international penetration, which was slowed by a dispute with a distributor in Europe (now resolved) and sell more on line. Current on line sales are 4% of revenues. They have started to add premium products selling well above the $10 to $70 retail prices of existing product. Finally, they expect to branch out in to complementary products such as cases and speaker dock models. The first of these will be out this summer.
Proven Management Team and Deep-Rooted Company Culture.
From what I’ve read and know, I’d have a hard time saying anything but, “Yes, they do.”
When the public offering is complete, they hope to have raised up to $125 million.  SC will use about $45 million of the proceeds to pay down debt. The balance will be “for working capital and other general corporate purposes,” which is what these things always say.
As I said when I started, Rick Alden and the Skullcandy team have done a great job identifying and taking advantage of a market opportunity that, in hindsight, looks obvious. Hell, they all look obvious in hindsight. I think the key to being able to continue their growth while keeping their profitability up is as simple, and as difficult, as keeping SC cool in Best Buy and other places as their distribution grows.
They are going to run into some heavy duty competition and I’m not aware that they can make a technically superior product. Or at least they don’t talk about it in the S1. But you know what? If you’re successful in business you run into competition, and that’s just the way it is. Skullcandy has done about the best job I’ve ever seen of using their first mover advantage and I look forward to watching this play out.