Skullcandy’s March 31st Quarter; Confronting the New Retail Environment

I’ve been writing, talking and thinking a lot lately about the evolution of the retail market; about HOW YOU SELL STUFF TO PEOPLE and WHY THEY BUY IT.

Skullcandy CEO Hoby Darling has a plan, and he sure talks pretty about how the company is making it happen. I recommend you read his opening statement in the recent conference call. As he does on every call, he reviews his five strategies. They are, as a reminder,

“…one, marketplace transform; two, create the innovation future; three, grow international to 50% of our business; four, expand and amplify known for categories and partnerships; and five, team and operational excellence.”

Skull is a public company or I probably wouldn’t be writing this. As such, it needs quarterly growth and, as I’ve written, there can be a conflict between getting that growth and differentiating your brand if your brand’s distinctiveness is based mostly on marketing.

Two years ago, when he first became CEO, two of Hoby’s first actions were to pull back off price distribution and to improve product quality. If the Skullcandy brand was going to have a chance, those were two things that had to happen fast, and I applauded them. Still do. And because Skull was an acknowledged turnaround, the Wall Street analysts had low initial expectations and Hoby could do what needed to be done even though the financial results were poor.

But the clock’s ticking, and it’s time for Skull to show how it can grow sales but still be “cool” and keep the brand a leader.

The biggest bet Skull is making is that merchandising, product segmentation and building and listening to your customer base (dare I say community?) can overcome what might have once been perceived as issues of distribution.

We’ve already been told that they are making a push into Walmart. They will have listening stations and select product at something like 1,500 Walmart stores eventually. We’re told in this conference call that they will now be testing Amazon and hoping to grow that business. I don’t think they will have listening stations there.

I’ve been suggesting for a while now that distribution decisions are no longer as simple as they were back in the good old “core” or “not core” days. Every choice a brand makes to sell to a new retailer is a complex decision.  To make a really complex issue sound simple, you can now sell any place your customers expect you to be.

Hoby makes a compelling argument for why that includes Amazon. He talks about it as the place Skull’s target customers go to get information on products before they buy.

He started his tenure at Skull by pulling back from some off price distribution, but nobody would argue that Walmart and Amazon aren’t, at some level, exactly that. I see two things going on. First, it wasn’t just that the channels he pulled Skull back from were off price. They were low price, but they were also places where price was all that mattered and where you couldn’t merchandise effectively. You couldn’t build a brand and sell higher end products. That decision, to me, had elements of being tactical- the bleeding had to be stopped so the patient could be stabilized and then resusitated.

Second, as I’ve mentioned, the Skull team has decided that what matters is where their customers want to shop and whether they can represent the product well there. If so, it’s good distribution no matter how it’s been traditionally viewed. It’s pretty obvious that Skull’s customers like Amazon just fine. It’s not quite so clear to me that its customers like Walmart. I think CEO Darling would respond that all his competitors are there and that they are going to overcome any shortcomings related to being in Walmart by good merchandising via their listening stations.

And of course they are also going to overcome it through their brand ambassadors and, they tell us, by offering better technology and performance in their products at lower price points. As I’ve said before, I’m not sure they can win the technology battle, but we’ll see.

The income statement for the quarter tells us this is still a work in progress. Sales rose 18.2%. Domestic sales were up 18.9% from $26.1 to $31.1 million and represented 67.2% of total revenue during the quarter. International sales were up 16.8% from $12.96 to $15.14 million. One customer (which I assume to be Best Buy) accounted for 17.8% of the quarter’s revenues, up from 14% in last year’s quarter.

The Radio Shack bankruptcy cost them $4 million in revenue this quarter compared to last year.

I want you a see a comment they make in their 10Q that relates to revenue. “The Company sells products to customers through consignment arrangements and had approximately $568,000 and $634,000 of inventory consigned to others included in inventories at March 31, 2015 and December 31, 2014, respectively.”

At this point, it’s not like consignment is a new thing. But that’s inventory that’s at the stores but hasn’t been booked as revenue. This is the first time I remember seeing a note like that. Maybe that’s all Radio Shack inventory they didn’t want to sell and then not get paid for. But one wonders how you think about the revenue numbers on an income statement when brands are doing other than just selling to retailers. What if, for example they were selling but guaranteeing a certain margin to the retailer? I hope the disclosures required in SEC filings cover stuff like that.

Gross margin dropped from 46.5% to 40.5% and total gross profit was essentially constant, rising from $18.2 to $18.7 million. Gross margin on domestic sales fell from 47.5% to 39.5%. International was down from 44.4% to 42.6$. “Total gross margin decreased across both segments primarily due to increased air-freight and warehousing expense to overcome West Coast port slowdowns, and product mix shift to gaming products which have lower margins partially driven by higher third party licensing and royalty costs, and foreign currency depreciation.”

CEO Darling expects gross margin to improve through, “…one, increasing the penetration of higher margin digital sales,…two, shifting some international markets to direct retailer arrangements versus distributor models over time; three, pursuing more licensing opportunities to take advantage of our strong youth culture of brand and technologies; four, reengineering certain products and renegotiating old licensing arrangements to bring cost down… and five, expanding our hedging programs.”

None of these opportunities, except maybe hedging, seem like to have an impact quickly.

SG&A expenses were constant at a bit over $22 million, but dropped as a percentage of revenue from 56.5% to 48.4%. “The increase in SG&A expenses is primarily due to increases in demand creation and research and innovation expenses, partially offset by decreases in bad debt and professional fees.” That sounds promising.

Operating income improved 7% from a loss of $3.92 million in last year’s quarter to $3.65 million this year. Net income fell from a loss of $3.46 million to a loss of $3.84 million.

There are various short term reasons for the gross profit margin decline. But when you increase sales by 18%, you’re supposed to do better than only have a slightly higher loss.

Skullcandy, by its strategy, seems to be embracing the omnichannel culture and recognizing that a brand’s relationship with, and way of influencing its customers, is continuing to change. I’d love to have the chance some time to ask Hoby Darling his thoughts on distribution. I think Skull is taking the right risks.