Skullcandy’s March Quarter: Great Sales Growth. Where’s the Income?

There’s a lot of interesting information in this10Q and the conference call. Let’s start with the income statement to see where we want to focus.  You can see the whole 10Q here.

First, we see a 47.9% growth in sales from $36 million in the quarter ended March 31, 2011 to $53.3 million in the same quarter this year. But net income rose only 4.4% from $1.07 million to $1.117 million. As a percentage of revenue, it fell from 3% to 2.1%. There was actually a $103,000 operating loss in North America. Europe’s operating income was $1.587 million. 

The gross profit margin fell from 50.8% to 48.8%. Selling, general and administrative expenses rose 70% from $14.4 million to $24.5 million. There was no related party interest expense this quarter compared to $1.72 million of such expense in the same quarter last year.
Okay, so those are the big numbers from the income statement. Let’s see what’s behind them.
International sales (meaning mostly Canada and Europe) increased 44.1% or $3.3 million to $10.9 million and represented 20.5% of sales. It was $7.6 million or 21.1% of sales in the quarter last year. Of that increase, $2.2 million was the result of the acquisition of their European distributor. 
Online sales were 9.7% of sales or $5.2 million, an increase of 69.4%. Management notes that the increase was mostly the result of the acquisition of Astro Gaming.
Domestic sales were up 46.5% to $37.2 million and were 69.8% of total sales. Management comments, “This increase primarily reflects increased volume to existing retailers.” That comment takes me to the 10Q footnote on concentration of credit risk note.
Skull mentioned unidentified customers A, B, and C. Customer A was 15% of the quarter’s sale. In the same quarter the previous year, A was less than 10%. Customer B fell from 14% of sales in the quarter last year to less than 10% in this year’s quarter. We don’t know how much less than 10%. Customer C was 14% in last year’s quarter and 13% in this year’s.  Sales to their top ten domestic customers accounted for 51% of sales during the quarter compared to 48% in last year’s quarter.
Accounts receivable owed by A, B, and C combined accounted for 36% of total receivables of $39 million, or $14 million at the end of the quarter. 
To me, this is a pretty significant concentration. Either customer A or C is Best Buy and the other one is Target. Best Buy has been having some problems and announced in April they were closing 50 stores this year. It had 1,103 U.S. Best Buy stores at the end of fiscal 2012.
Currently, Skullcandy sells in Best Buy, Target, Dick’s, Fred Meyer, Sports Authority, and Walgreens, as well as the usual specialty channels and no doubt in some others I don’t know about. I’ll get back to this when we discuss strategy.
The organic sales increase then (the increase ignoring acquisitions) came mostly from the U.S. but didn’t generate any profits.
Okay, the gross margin. Skull says “The decrease in gross margin was due primarily to lower margin sales to the closeout channel in connection with our transition to an updated product and packaging collection…” They also note that they “…are experiencing higher product costs due to increasing labor and other costs in China. If we are unable to pass along these costs to our retailers and distributors or shift our sales mix to higher margin products, our gross profit as a percentage of net sales, or gross margin, may decrease.”
In their prepared remarks, management noted that both unit volume and the average selling price increased double digits in the first quarter. The price increase was driven by a move towards higher priced, over the ear headphones. But the over the ear headphones have lower gross margins than the in the ear product, so that’s another reason for downward pressure on the gross margin. 
There was also an interesting disclosure and discussion related to gross margin in the conference call that said the following:
“Late in the quarter we made the decision to clear out a sizable amount of miscellaneous older products in our warehouse. This was an assortment of older odd lot products that had accumulated over the past several years. This revenue transact (sic) at margins lower than is typical for the close out channel which impacted overall gross margins by 150 basis points. While this resulted in downward pressure to our gross margins that we had not planned for in the quarter, it improved the quality of our remaining inventory on hand.”
This closed out inventory represented “a couple of million dollars” in incremental revenue.
I understand managing quarterly earnings as a public company and that inventory is part of that. But anybody in this industry who has any inventory that has “…accumulated over the past several years” and has increased in value should let me know so I can tell everybody your secret. I’ve never seen a good reason not to get rid of old inventory sooner rather than later. Well, aside from a systems issue that made it hard to identify the obsolete inventory or not wanting to take the earnings hit I mean. Still, it doesn’t sound like it’s enough to be concerned with, though it did lead to a couple of questions from the analysts.
Three quarters of the gross margin percentage decline, then, was the result of the closeout sale of old inventory and more current inventory in old packaging. All else being equal, we can expect margin to recover by that 1.5% in the next quarter though, as I’ve mentioned, they do point to some other potential margin pressures.
The increase in selling, general and administrative expense (sg&a) was “…primarily the result of $4.1 million in additional payroll related expenses, $1.8 million in additional marketing and advertising expenses and $1.0 million in additional depreciation and amortization based on increased investments in property and equipment and the acquisition of certain intangible assets in August 2011.”
As a percentage of revenue, sg&a increased from 40% to 46%. They refer to the growth as “critical” spending to support long-term growth, and I can see why they need to do it given the stage of the company’s development and its revenue growth. In response to a question during the conference call, they tell us that sg&a spending will be lower during the rest of the year’s quarters, and use trade show spending as an example of why the first quarter was higher. That makes sense to me, but obviously this spending can’t continue to increase as a percentage of sales. Getting that percentage to decline is a way to pull some bucks to the bottom line.
I don’t have much to say about the balance sheet. A year ago it kind of sucked (negative equity) because of $63 million in related party long term debt. That went away with the public offering. The March 31 balance sheet shows $11 million in cash, $110 million in equity, no long term debt and a solid current ratio. Acquisitions also make balance sheet comparisons a bit difficult.
Due to online price competition, Skullcandy revamped their web site and, more importantly I think, reduced by more than 60% the number of retailers approved to resell product online. The remaining retailers have agreed to follow minimum advertised pricing policies, and Skull has implemented online product tracking to enforce their policies.
Another thing that’s going on is the rollout of their new packaging. This of course leads to questions about what happens to the product in the old packaging. Do retailers transition gradually or all at once? How do they price and sell the old product? Skull says they “… worked with all of our retailers to map out a transition strategy that varies from linking old and new skews for a period of time to a complete reset on a certain day. In this transition we’ve anticipated the certain level of returns of the old package items and will look to steadily sell through most of this over the next several quarters.”
 Fair enough. It’s kind of an inevitable pain in the ass that is going to happen when you make this kind of change. It has some costs but comes under the heading of ordinary course of business.
If you follow Skull’s stock, you know that the market wasn’t happy with these results and management’s explanation even though Skull characterized the net income as in line with expectations. I’ve discussed above some of the things that might have given some holders of the stock pause.
In the past, I’ve characterized Skull’s strategy as trying to be cool in the very broad market. I’d add that it’s trying to bring coolness to some of its non-core retailers and convince those retailers that can be an asset. That’s kind of an oversimplification, but I like oversimplification when discussing broad strategies. Other industry brands, of course, are broadening their distribution, but I don’t expect to see most of them in Fred Meyer.   
Whether or not Skull can do that is really the bet you place when you buy Skull’s stock (I don’t own stock in any company I write about). Skullcandy management knows that keeping a first mover advantage in any market is a hard thing to do. Not only are they growing sales quickly, but they are investing in people and infrastructure, bringing product development in house, making changes in packaging, trying to merchandise differently in mass market retailers, and generally spending a whole bunch of money trying to secure and strengthen their position. They hope/believe that there is some combination of branding and technology that minimizes the extent to which headphones become commoditized. 
Even if they are making all the right decisions, that kind of change and growth (positive chaos maybe is a good term) has some costs and consequences, and we saw them in this review of their quarterly results. I had to spend way longer than usual trying to interpret what Skullcandy was saying in their quarterly report and conference call and it makes my Spidey senses tingle. Hopefully, for no good reason.   



Skullcandy Releases Its 10K (Annual Report)

I wrote about Skullcandy back on February 24th shortly after they’d released their numbers for the year and last quarter and held their conference call. You can see that article here. Now they’ve released the 10K and, as promised I’ve been through it. There’s not that much new, different or surprising that I want to highlight, but there’s a thing or two.

First, because it’s kind of fun and interesting, I want to point out that it was noted in a couple of places that the stock jumped on release of the annual report. The actual increase from the close the day the report was released (after the market was closed) to the close the next day was 3.25%.

The implication seemed to be that the numbers had made the stock rise. Maybe they did. Damned if I know. But back when the same numbers were released in press release form after the market’s close on February 22nd and the conference call was held, the stock dropped 7.4% the following day on the highest volume it’s had since it went public.
The learning here is that the stock market is a strange and mysterious place. The same numbers (though in different forms) released on two different days weeks apart seem to engender reactions of the stock in opposite directions. I’ve been through the 10K and I don’t see any difference that would account for the divergence.
Like I said when I wrote the above linked Skullcandy article referring to another issue, correlation does not necessarily equal causality. The apparently obvious factor isn’t necessarily the one having the impact. That’s a really good thing to remember on a lot of occasions.
Second, the only thing that really caught my attention in Skullcandy’s 10K was its description of its competitive strengths and its growth strategy. They are on pages two and three of the 10K which you can view it here if you want and see their discussion.
Here’s what they describe as their competitive strengths:
1)      Leading, Authentic Lifestyle Brand.
2)      Brand Authenticity Reinforced Through High Impact Sponsorships.
3)      Track Record of Innovative Product Design.
4)      Targeted Distribution Model.
5)      Proven management Team and Deep-Routed Company Culture.
It’s not that any of those are wrong or misdirected, but they are more or less the same five things most brands in our industry would list. That’s not a criticism of Skullcandy. The point is that as an industry we’ve gotten to the point that competitive strength tends to come from the ability to execute better than the other company rather than from a fundamental competitive difference.
The one thing I’d like hear them talk more about is the Targeted Distribution Model. It seems like they are targeted more or less everywhere. Maybe what they mean is that they are only selling to retailers, humongous or tiny, that buy into and support their brand distinctiveness.
Meanwhile, here are their growth strategies:
1)      Further Penetrate Domestic Retail Channel.
2)      Accelerate Our International Growth.
3)      Grow Our Premium Product Offering.
4)      Expand Complementary Product Categories.
5)      Increase Our Online Sales.
Again, I’d argue that none of these are distinctive to Skullcandy and are a matter of executing better than their competition. They don’t mention in this list increasing their average selling price, though it was something they focused on in their report. I guess it’s probably subsumed under selling more premium product.
Talking about product design and development, they made the following comment:
“We are able to bring new products from concept to market in approximately 10 to 24 months depending on the technology integration and complexity of the product. In situations where we are launching new products based on existing designs and do not require tooling, we can accelerate the concept-to-market process to approximately 6 to 12 months.”
Feels to me like keeping their competitive strengths and implementing their growth strategies would be easier if they could speed this up a bit. I imagine they are working on it.



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.     



Skullcandy’s Strong Quarter; It’s Amazing What an IPO Can Do for Your Balance Sheet

My favorite footnote in Skullcandy’s 10Q for the quarter ended September 30 is footnote nine and specifically the table on long term debt (Yes, I know it’s kind of sad that I have favorite footnotes). It shows no long term debt at the quarter’s end compared to $73.4 million on December 31, 2010. They raised $77.5 million through the IPO, and you can see what they used it for. Equity is now $92 million compared to a deficit of $16 million a year ago. The current ratio improved slightly from 1.89 to 2.19. They’ve got $15 million in cash at the end of the quarter compared to $2.3 million a year ago. Their bank debt is up a bit from $11.2 million to $14.2 million. 

Sales rose 58% from $38.5 million to $60.6 million. But they said in the conference call that sales in the 3rd quarter last year were impacted by late deliveries, difficulties getting product made, and inventory shortages. They note as a result that “…our increased sales guidance implies second-half sales growth of 38%, this year, versus 29% last year.” International sales were up 75.9% to $14.6 million. They closed the acquisition of their European distributor on August 26th. Online sales were up 413% to $6.2 million. That growth includes $2.9 million of sales of Astro Gaming products which Skull acquired in May.

Skull notes that they “…rely on Target and Best Buy for a significant portion of our net sales.” Each accounted for more than 10% of sales in 2010. Best buy continues to account for more than 10% in the first three quarters of 2011. As I noted when I reviewed their initial public offering documents, the bet Skull is making is that they can be very widely distributed but still be cool and desirable to their target market.
The gross profit margin fell from 52% to 47.5% though gross profit rose from $20 million to $28.8 million. Like most companies, they are experiencing higher product prices in China and they rely on two manufacturers there for “substantially all” of their product line.
Selling, general and administrative expenses were up from $13.3 million to $20.6 million. As a percentage of sales, they declined slightly from 34.5% to 33.9%. There was an additional $1.3 million of marketing expenses during the quarter.   Interest expense to related parties was $2.77 million during the quarter. That’s gone with the IPO complete and will mean improved profitability in future quarters. Profit was $952,000 compared to a loss of $1.22 million in the same quarter last year.
I’ve laid out the numbers first so we could talk about Skull’s strategy and positioning a bit. Skull is the first mover in a market they identified. The brand reflects “…the collision of the music, fashion and action sports lifestyles.” They have stylized “…a previously commoditized product… The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position.”      
As you’ve probably noticed, many companies are jumping into the market Skull created. There are limited barriers to entry and, right now at least, not a lot of technological product differentiation. In those circumstances maintaining and improving its market position requires Skull to grow quickly and continue to spend freely on advertising and promotion because that’s what the product differentiation is based on. And they are.
But growing costs money. You need more people and more inventory and continued marketing. In the 10Q Skull notes that they “…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…Retailers regularly request reduced order lead-time, which puts pressure on our supply chain.”
It would really be interesting to know more about the order cycle so we had a better understanding of how much Skull has to build inventory with growth.
Skull’s management talked in the conference call about how they are addressing some of these competitive issues. They indicate they are transitioning to “…an in-house ODM model, where we originate and control more of the design and manufacturing process.” The goal is to help them create new, proprietary products. They’ve also hired a “very senior acoustics engineer” to work with the product development team. “Dual sourcing remains a key priority…” Approximately 10% of products were dual sourced at the end of the third quarter, and this is to increase over the next year.
Importantly, they refer to an increasing average selling price (ASP), though they don’t give any specifics. They say that was “…driven by growth in our own premium category along with mid-shift towards higher priced products across our entire line of headphones.” Domestically, their ASP was up double digits.   That’s great. When you spend a bunch of money on creating the brand, you’ve got to get higher product prices for the business model to make senses. That’s why you build a brand.
High end headphones feel a bit like a little luxury people can afford (and need) in a tough economy. Maybe that’s why there’s room to move up in price point. I really wish all the money from the public offering hadn’t gone right out the door to pay the investors. I’ll bet Skull could do even better things with some more working capital.                 



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.   



Skullcandy Licensing Agreement with Sonomax

Don’t know how many of you saw this (I missed it for a while), but back in June, Skullcandy signed a licensing agreement with Sonomax to use its technology in Skullcandy’s headphones. Here’s the press release on the agreement and some information on Sonomax. The direct to consumer web site for Sonomax product is here. As far as I can tell, Skullcandy didn’t announce the deal. As they weren’t public yet, they didn’t have to.

Basically, Sonomax head phones allow you to go through a four minute process that sculpts your ear buds to your ear, giving you a custom fit. It works with a “…disposable fitting system that delivers a customized earpiece.”

I gather they aren’t cheap, but as somebody who’s had his share of trouble getting and keeping comfortable ear buds, I’m interested.
“Sonomax intends to modify its current earphone product line to incorporate Skullcandy’s industrial design and branding. The companies will work towards creating a line of Skullcandy products featuring SonoFit,” the press release says.
It’s a non-exclusive deal, but I’m glad to see Skullcandy bringing some more technology to its product, even though others will eventually have it too. At least Skullcandy is first. It’s not clear how long it will be until the product is actually available for purchase.
Sonomax is a small, almost development stage, company. Its calendar 2010 revenues were $643,000 Canadian and it lost $4.15 million. Its balance sheet is none too wonderful and I’d say it’s going to need to raise some more cash expeditiously if it hasn’t already since the end of 2010.
Skullcandy releases its first quarterly earnings tomorrow. I’ll take you through them once I have the 10Q.       



Skullcandy: The IPO is Moving Forward

Skullcandy filed another amendment to their S-1 today with many of the blank spaces from the previous iterations of it filled in as the next step in their initial public offering.  It appears they postponed it due a rough patch in the market.  Smart.

They list the maximum offering price as $19 a share. They are registering 9,583,334 shares and if they sell all of those, the offering will raise a bit over $182 million. But that includes the underwriters optional over allotment of 1,250,000 shares and is before expenses.

A big chunk of the proceeds go to the selling shareholders rather than the company. After underwriting discounts, commissions, and estimated expenses, the company expects to net about $66.6 million assuming a sale price of $18 a share.
$16.7 million will be used to pay off their unsecured, subordinated promissory notes. They’ll pay $17.5 million in “additional consideration…pursuant to our securities purchase and redemption agreement.”  $4.4 million will be paid in accrued interest that has to be paid when the notes are converted.
That leaves $28 million for “general corporate purposes,” as the saying goes.
This will clean up their balance sheet nicely. Proceeds, of course, could vary depending on how many shares are sold and at what price.
I hope this is the final amendment and I can get onto reading about Tilly’s IPO. 



Skullcandy’s Latest Filing for its IPO

On June 1st, Skullcandy filed a third amendment to the registration statement for its initial public offering. Once again, I haven’t compared the documents word for word to spot every change. The addition I want to bring to your attention is the inclusion of financial statements for the quarter ended March 31, 2011. Here are the summary financial statements for the quarter directly from the filing.



Three Months Ended March 31
         ( in millions of dollars)



Net Sales



Cost of Goods Sold



Gross Profit



Selling, General and Admin. Expense



Income from Operations



Other (Income) Expense



Interest Expense



Pretax Income



Income Taxes



Net Income








You can see the improvement from last year’s first quarter to this year’s yourself. Sales were up 66 percent. The gross profit margin stayed constant at 50.8% and instead of a loss of eight hundred thousand dollars they made a bit over a million bucks. Domestic sales rose $9.5 million, or 50.3%. They represented 78.9% of first quarter sales. $4 million of the increase was due to “…net sales to large national retailers, including Best Buy and Target…”  It’s worth noting that during the quarter, three customers accounted for 37% of sales (two were 14% each and one was 9%) and 51% of receivables. I assume Target and Best Buy are two of them.
They provide two March 31 balance sheets. The first is the actual one and the second a proforma balance sheet that assumes that certain convertible debt and preferred stock is converted into common stock as if the public offering had occurred on March 31st.
The actual balance sheet shows negative stockholders’ equity of $20.2 million. The pro forma balance sheet has a positive equity of $8.9 million due to those conversions. But this pro forma balance sheet does not include the capital that would be raised by the offering. Skullcandy really needs that capital to solidify its balance sheet and pursue its growth strategy.
I wrote about Skullcandy when they first filed for their IPO, which they filed the first amendment, and the second. My thoughts really haven’t changed. Let’s hope that in a couple of more weeks, we see their team on CNBC ringing the opening bell on their first day of trading.    



Skullcandy Files Another Amendment to Its S1

Skull filed another amendment to its S1 on May 11. You can see it here I confess that I have not compared both documents side by side and word for word to discover differences. I can tell you that the newly amended S1 has pretty pictures in it at both the beginning and the end which will be part of the prospectus.

I spot checked the numbers and did not notice any changes. That doesn’t mean there aren’t any. A smart guy named Fred made some interesting comments when I posted my article on the first amendment. You can see those comments below the article. He suggested we’d probably see another amendment showing strong first quarter numbers, but those numbers are not included in this filing.  I imagine we will see them before this deal is done.

Here are Skull’s net sales and net income numbers for the last five years ended December 31 of each year (in thousands of dollars).






Net Sales






Net Income (Loss)





Next, here are the “adjusted EBITDA” for the same five years. EBITDA is earnings before interest, taxes, depreciation and amortization but in this case it’s not that because it’s “adjusted” as described below.






Adjusted EBITDA





Obviously, the adjusted EBITDA trend looks better than the net income trend. Here’s what management says about the adjusted EBITDA numbers. Sorry for the long quote, but I’d prefer you hear it directly from them rather than get my interpretation. Please do take the time to read it. I recommend slowly.
"EBITDA, for the periods presented, represents net income (loss) before interest expense, income taxes and depreciation and amortization. Adjusted EBITDA gives further effect to the recording of compensation expense associated with one-time charges of $17.5 million in management incentive bonuses and $2.9 million payable as additional consideration to certain employee stockholders pursuant to the securities purchase and redemption agreement, and to the recording of additional other expense of $14.6 million, which represents the fair value of amounts payable as additional consideration to non-employee stockholders pursuant to the securities purchase and redemption agreement. For a more detailed description of this transaction, see “Certain Relationships and Related Party Transactions—Series C Convertible Preferred Stock Financing and Stock Redemption—Securities Purchase and Redemption Agreement.” These expenses were one-time charges associated with a historical capital transaction and management believes they do not correlate to the underlying performance of our business. As a result, we believe that adjusted EBITDA provides important additional information for measuring our performance, provides consistency and comparability with our past financial performance, facilitates period to period comparisons of our operations, and facilitates comparisons with other peer companies, many of which use similar non-GAAP financial measures to supplement their GAAP results. Our management team uses this metric to evaluate our business and we believe it is a measure used frequently by securities analysts and investors. Adjusted EBITDA does not represent, and should not be used as a substitute for income from operations or net income (loss) as determined in accordance with GAAP. Our definitions of EBITDA and adjusted EBITDA may differ from that of other companies."
There- that’s clear enough, right? And if you understand it, but note and agree with their admonition that adjusted EBITDA “…should not be used as a substitute for income from operations or net income (loss) as determined in accordance with GAAP,” what do you decide as a potential buyer of the stock?
That’s the tactical issue for the people trying to sell this stock. They have to explain. Regardless of the quality of the business model, GAAP accounting shows declining profit leading to a loss on higher sales over three years.
Tell the truth- some of your eyes glazed over when I asked you to read the explanation above. Hell, my eyes glaze over sometimes when I have to read this stuff. If you were selling this stock, which would you rather say? “Here’s a fast growing company with a great business model that’s increasing its profitability with its sales,” or “Here’s a fast growing company with a great business model that lost $10 million last year but don’t worry, I’ve got an explanation you might understand if your eyes don’t glaze over.”
You’d like to have investors focusing on the viability of the business strategy and the company’s financial position after the offering. When I first wrote about Skull’s public offering on February 4th, I summarized their strategy this way. “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.”
I still think that puts it pretty well.



Skullcandy’s IPO; What’s New?

I guess it was around the time of the SIA show in Denver that Skullcandy announced they were going to do an initial public offering. They came out with the draft of the prospectus, and I took a pretty detailed look at it.

Typically, the “quiet period” after you file with the SEC lasts 40 to 90 days while they review your prospectus (known as a form S-1). When 90 days passed and I hadn’t heard anything, I got a bit curious. The company isn’t allowed to tell me anything so I went to the Security and Exchange Commission web site and searched for Skullcandy documents. Guess what? I found a revised S-1 dated April 28th.

The original S-1 had an income statement for the nine months ended September 30, 2010 that showed (in millions of dollars):
Net Sales                                           $95,940
Cost of Goods Sold                          $46,629
Gross Profit                                        $49,311
Selling, General and
 Admin. Expenses                            $30,206
Operating Income                            $19,105
Other (Income) Expense                $14
Interest Expense                             $6,559
Net Income                                       $7,645
The amended S-1 shows the income statement for the whole year ended December 31, 2010 and the picture is a bit different.
Net Sales                                            $160,583
Cost of Goods Sold                          $75,078
Gross Profit                                        $85,505
Selling, General and
 Admin. Expenses                             $67,602
Operating Income                             $17,903
Other (Income) Expense                 $14,556
Interest Expense                               $8,387
Net Income (Loss)                           $(9,723)
If you look back at the sales numbers for the 2009 complete year, you see that sales in 2010 grew nearly 36%. The gross profit margin was 48.6% in 2009. It was 53.2% in 2010. That’s a good improvement. So how did they turn a nine month profit of $7.6 million into a loss of $9.7 million for the year and $17.3 million for the final quarter of 2010?
For the whole 2010 year, compared to 2009, Selling, General and Administrative Expenses rose from $27 million to $67 million. This included, in the fourth quarter, “…one-time charges of $17.5 million in management incentive bonuses and $2.9 million payable as additional consideration to certain employee stockholders pursuant to the securities purchase and redemption agreement.”
The “Other” expense of $14.6 million in the fourth quarter “…consisted primarily of $14.6 million resulting from recording the fair value of amounts payable to non-employee stockholders as additional consideration pursuant to the securities purchase and redemption agreement.”
They also disclosed that “Additionally during the quarters ended March 31, June 30, September 30 and December 31, 2010, we recognized other expense of $1.5 million, $2.2 million, $3.7 million and $7.2 million, respectively, which represents the changes in the fair value of amounts payable as additional consideration to non-employee stockholders pursuant to the securities purchase and redemption agreement.”
Meanwhile, over on the year-end balance sheet, there’s a stockholders’ equity deficit of $22.7 million, up from $18.8 million a year ago. Next to that is an unaudited pro-forma balance sheet for the same date that “… gives effect to the conversion of all outstanding shares of preferred stock into 321,980 shares of common stock, the conversion of the convertible note into 275,866 shares of common stock, the payment of accrued interest on the convertible note and the reduction of deferred debt issuance and debt discounts related to the convertible note, as if an initial public offering occurred on December 31, 2010.”
Doing all this gets their stockholders’ equity up to $6.4 million. Against that, the pro forma balance sheet shows total liabilities of $77 million. That’s a debt to equity ratio of 12 times and that’s high. The current ratio, at 2 to 1 is fine.
Here’s how I read this. Skullcandy is counting on the success of its IPO to reduce its leverage and give it the working capital it needs to execute on its plan. Shareholders and executives have taken a bunch of cash out of the company in the fourth quarter, resulting in a big loss. They were entitled to do that under existing agreements, but how does it look to a potential stock purchaser? Those potential investors also see a company whose 2008 net income of $13 million fell to $3.5 million in 2009 even as sales grew 47% to $118 million. Now, on sales of $160 million, there’s a loss of almost $10 million.
It can be explained as I did above. But if you have to explain, you have a problem. I’m not quite sure people are in a hurry to invest in companies that lose money, even with a valid explanation. It will be interesting to see if this deal happens and what the pricing is. It may be even more interesting to see what Skullcandy does if it doesn’t happen.