Skullcandy’s Quarterly and Annual Results and A Look at Their Strategic Bets

I’m working from the press release and conference call because it takes a while for the full year annual report to be released. But don’t worry; when it does come out I’ll go through it just to make sure something interesting didn’t get missed. 

Strategy and the Bets They are Placing
 
Strategy is always way more interesting than numbers and accounting, so let’s start with this quote from the press release.
 
“Skullcandy became the world’s most distinct audio brand by bringing color, character and performance to an otherwise monochromatic space; revolutionizing the audio arena by introducing headphones, ear buds and other audio and wireless lifestyle products that possess unmistakable style and exceptional performance.”
 
I guess we all kind of knew that. In terms of color, character and style they certainly did it and the challenge is to stay in the lead. In terms of exceptional performance, they are clearly working on it, but no doubt they’d acknowledge that the competition is pretty tough.
 
What are the bets they are placing to achieve these strategies?
 
“On the product development side, we continue to transition to a full in-house model where we originate and control our product design and development process. We believe this is critical to our long-term strategy of developing a steady stream of high-quality performance products and innovations that cater to a targeted audience.”
 
We all know you can’t go to China, pick some headphones off the wall, put your own graphics and packaging on them, and be a performance leader.
 
Next, “Partnering with elite athletes and musicians continues to be an important part of our marketing strategy; however, in keeping with our evolved brand positioning, we have consolidated the number of sponsored athletes from 170 down to 60, with a focus on the best athletes in our key categories, including NBA MVP Derrick Rose and All-Star Kevin Durant, in addition to a slew of athletes to be announced soon.”
 
I’ve always thought that focusing on a smaller group of higher quality sponsorship relationships made more sense than a larger number of less influential ones, though I guess we’ll have to wait and see how big this new “slew” is. A slew sounds like a lot.
 
Third, “…by the end of the fourth quarter approximately 40% of our units produced were dual sourced from more than one factory in China, and we remain on track to meet our goal to be more than 80% dual sourced by the end of 2012. Dual sourcing mitigates supply risk, leverages the best possible suppliers across the industry and helps us negotiate better pricing.”
 
I don’t know if it’s strategic exactly, but it’s sure as hell financial common sense.
 
Here’s numbers four.
 
“Sales to our top-10 domestic customers increased 23% and accounted for approximately 48% of sales versus 51% of sales last year. “
 
As I’ve said, they are betting they can continuously be cool in Fred Meyers, Best Buy, and similar retail outlets. That may be the biggest company bet of all, and they are doing a few things to support it.
 
They’ve got new packaging coming out. They are doing some displays that let the customers listen to the product. Intriguingly, they are educating some of these big box retailers (probably all of them) “…helping them understand that with a lifestyle brand, where we tell a story and provide a listening experience, we see a meaningful lift in revenues.” CEO Jeremy Andrus notes that, “…we saw a lift anywhere from 1.5 to 2.5 times sell through on those listening stations.”
 
I would like to remind everybody that in statistics, correlation does not equal causality. That is, maybe the people who are prepared to take the action of listening are already predisposed to buy. I don’t know that, but I bet nobody at Skullcandy can prove me wrong. It’s possible that it wasn’t the act of listening that improved sales. That’s not criticism of Skullcandy, but a reminder to all of us that we love to interpret statistics in ways that fit our desired outcomes. 
 
But still, I think Skull management is on to something when they try to get big box managers to understand that coolness can grow revenues.   
 
And last but not least, “ASPs [average selling price] increased double digits in the fourth quarter.” They are counting on being cool and improving product performance to allow them to get more dollars per customer and, as they did in the fourth quarter, raising that ASP.
 
Those, then, are the five things I’d evaluate as I consider Skullcandy’s prospects.
 
The Numbers
 
Let’s start by giving you the GAAP numbers, and then we’ll talk a bit about some subtleties.
 
Sales for the quarter ended December 31 were up 29% from $64.6 million to $83.4 million compared to the same quarter a year ago. The gross profit percentage fell from 56% to 50%. Selling, general and administrative expenses (SG&A) fell from $37.4 million to $21.2 million or from 57.9% of sales to 25.4% of sales.
 
Sales for the quarter were up 27% domestically, 10.8% internationally, and 73% online. The lower gross margin “…was the result of a shift in sales mix to certain products that carry temporarily lower gross margins and inventory acquired at a higher cost basis in the acquisition of Kungsbacka 57 AB and the transition to a direct model in Europe. The Company anticipates gross margin increasing on a full-year basis in 2012, as new sourcing initiatives and a higher mix of direct international sales are expected to benefit gross margin.”
 
The big decline in SG&A was largely due to $20.4 million in management incentive bonuses and compensation expense in the same quarter last year.     
 
Operating income rose from a loss of $1.2 million to a profit of $20.4 million. Other expense went from almost $7 million to next to nothing. But income taxes paid rose from a credit of $234,000 to $8 million. Net income was $12.3 million compared to a loss of $9.7 million in the same quarter last year.
 
Sales for the year rose 45% from $160.6 million to $232.5 million. Units sold and average selling price both increased “double digits” during the year. The gross profit percentage fell to 49.7% from 53.2% the previous year. Selling, general and administrative expense was up from $67.6 million to $72.4 million, but declined as a percentage of sales from 42.1% to 31.6%. Net income was $18.6 million compared to a loss of $9.7 million the previous year.
 
The balance sheet sure looks better. A year ago, before the public offering, they had a negative equity of $22.4 million. This year at December 31, it was a positive $106.8 million. Receivables, interestingly, have gone up over the year only from $46.7 million to $50.6 million. Pretty damn good given the sales growth.
 
Inventories over the year almost doubled, from $22.6 million to $44 million. But they note that much of the increase came from the acquisition of Astro Gaming and their former European distributor’s inventory. Ignoring acquisitions it grew, they say, only a bit faster than sales growth.
 
They also make the interesting comment that their products “…contain very little obsolescence risk.” That makes sense to me though you might ask if it remains true as they bring out better technology.
 
CEO Andrus also told us in the conference call that, “…we’re really not adding a significant number of new doors, and that’s been the case certainly in 2011, and that will be the same in 2012 as well.” Growth, in other words, won’t be from expanded distribution, but from more sales in existing accounts.
 
I’ve already discussed above a few of the things they’re doing to accomplish that. CEO Andrus notes that in Europe, “The one thing that I would note in terms of our strategy that will have some effect is that we’re really focused on some level of auditing of our retail partners, some consolidation where we feel there are doors that aren’t as good as others, and then on a new fixturing program which will roll out in Europe sometime during the summer.”
 
Skullcandy is trying to represent and merchandise their products in big box retailers using some of the techniques and approaches- vibe, if you will- that you might find in specialty shops. They are asking those retailers, and trying to educate them, to approach merchandising the Skullcandy brand in a way that’s different from how they’ve approached any of the other brands they carry.
 
Maybe that’s strategic bet number six, and it’s sure interesting to watch.