Skullcandy’s Quarter; Consolidating to Grow

Skullcandy’s 10Q for its September 30 quarter came out yesterday. I’ve been through it and the conference call. They are continuing to apply the tactics they’ve adopted as part of their turnaround strategy. That means, in the words of CEO Hoby Darling, “…as we go into Q4, we’re going to do the exact same things that we did in Q3 that are working. And that is we’re going to continue to edit off-price, we’re going to continue to cut accounts that are brand-dilutive. We’re going to continue to cut accounts that break map pricing and don’t allow us to control our brand online.” 

As you know, I like these things. Well, let’s not say I like them so much as I don’t think brands like Skull have much choice. Given their competitors and the nature of the product, what else can they do but start by trying to stake out a market niche they can be a leader in and, hopefully, grow from? If they watch their distribution, and are the leading brand in the youth culture “cool” niche, I suspect they can improve their margins, reduce operating expenses, and bring more money to the bottom line. I’ve described in various articles how I think that works in general.
And that would be a fine result if they weren’t a public company. But they are, and the markets want to see regular revenue growth. Skull management thinks they can resume their growth (though they aren’t specific about how much growth) in the second half of 2014. But they are preparing for that growth by hunkering down in a niche where they see the brand as having a competitive advantage.  Ask Burton or Volcom, just to name a couple of brands, how easy it is to grow out of a niche you are strong in when the competitors are big and well resourced.
Okay, hold that thought while we take a look at the numbers.
I’m going to start with the balance sheet just to get it out of the way. There’s not much to say. It’s pretty strong. Cash has risen to $34.7 million from $1.9 million a year ago. Receivables are down from $60 to $41 million, consistent with the decline in revenue. Inventory has fallen from $55.4 to $48.7 million.
Given the sales decline, I might have expected more of a year over year inventory decline. Part of the reason it isn’t down more is that they’ve got $2.5 million of inventory newly tied up in direct distribution in Canada that they started in the September 30 quarter. But they acknowledge that they’ve got some current inventory of high end product that isn’t selling well, and they are working to get rid of it.
Notice that the lawyers made them add “Our business could be harmed if we fail to maintain proper inventory levels” as a risk factor in the 10Q. Now, lawyers take an abundance of caution approach to risk factors, but it wasn’t included before and now it is. I conclude that whatever the level of excess inventory is, it’s not completely insignificant. An analyst might have asked about this in the conference call, but the call is before the 10Q is released so they didn’t know about it.
Aside from a few bucks in deferred taxes, there’s no long term debt, and equity has risen from $129 to $136 million. The current ratio and total debt to equity are solid.
Revenue fell from $71 million in last year’s quarter to $50 million this year. They’ve got two customers who represented $21.4 million of total revenues for the quarter, or 43%. They don’t say this, but I suspect they are Target and Best Buy. That’s kind of a serious concentration.
North American sales, which include Canada and Mexico, were $34.8 million down from $57.4 million in last year’s quarter. That’s a decline of 39.4%. International sales rose from $13.6 to $15.2 million, or by 11.8%. They point out that, “Included in the North American segment for the three months ended September 30, 2013 and 2012 are international net sales of $932,000 and $2,976,000, respectively, that were sold from the United States to customers with a “ship to” location outside of North America.”
They talk a lot about the tactics I highlighted at the beginning of this article. Get out of off price, enforcing pricing, etc. Good stuff. But when we get to the 10Q and they talk about the reasons for the sales decline, here’s what they say:
“Contributing to the decrease in net sales is increased competition in the audio and gaming headphone markets. Additionally contributing to the decrease, and consistent with the strategy stated in previous quarters, we continued to scale back our sales to the off-price channel, which were down approximately $4.4 million, or 74.6%, compared with the three months ended September 30, 2012. We expect sales to the off-price channel to continue to be down more than 50% in the fourth quarter of 2013. There was also a decrease in net sales of $2.2 million as a result of the transition to a direct distribution model in Canada. We also actively stopped selling products to certain retailers and distributors that were violating our policies on minimum advertised prices which further contributed to the decrease in net sales.”
Long quote. But what I noticed was that they started the explanation by talking about increased competition, not their distribution and pricing tactics. Does that imply that increased competition is more of a factor than intentionally reduced tactics? I don’t know and no analyst had an opportunity to asking in the conference call. 
Gross margin fell from 47.4% to 44.9%. As reported, it was 43.4% in North America, down from 46.6% in last year’s quarter. For the international segment, it was 48.1%, down from 51%. Eventually, they’d like to grow the international business to 50% of their total from 25% right now. I am sure the better margin has something to do with that.
The theory is that if you tighten up distribution and enforce pricing agreements, your gross margin is supposed to improve as you cut off price sales. Interesting that we’re not seeing that. Maybe it’s too soon. “The decrease in gross margin was primarily attributable to increased allowances to the Company’s retail customers and a shift to a lower margin product mix,” they tell us.
The “allowances” are from 1% to 1.5% that they are giving certain retailers who have inventory of the high end product I mention above. The “shift to lower margin product mix” I’m a bit confused about. Some of you may recall that under Hoby Darling’s predecessor, they were pursuing higher priced, over the ear product that had lower margin, but generated more gross margin dollars. Now, we’re told, they are going to focus on the $100 and under market where they have a strong market position but which apparently has a lower margin than the higher price products, which I thought had lower margins and they are moving away from. That’s another clarification I’d be asking for if I were an analyst and had the 10Q before the conference call. Yes, I’m kind of on a “Conference calls are useless unless you have the actual filing and time to look at it,” rant. Just ignore me.
In the conference call they refer to difficult conditions in Europe, an expectation of a highly promotional holiday season, and the ongoing industry consolidation. Those things are not usually good for margins.
Selling, general and administrative expenses (SG&A) fell from $23.1 to $22.4 million, or by 3%. There was $1 million in expense associated with closing the San Clemente office. Without that, the decline would have been 7.4%. As a percentage of net sales SG&A rose from 11.3% to 43.8%.
In discussing these expenses, they note they invested an additional $300,000 in “marketing and demand creation efforts” and there is discussion about how Skull is continuing to “…leverage our powerful portfolio of brand ambassadors and roster of athletes in fun and compelling ways that generated consumer excitement and demand.” In case anybody hasn’t figured it out, this is a youth culture and fashion brand- not an action sports brand in spite of its roots there.
Operating income fell from $10.6 million to $514,000. It went from $7.4 million in North America to a loss of $2.2 million. In international, operating income fell from $3.2 million to $2.7 million. Net income declined from $6.5 million to $1.1 million. Net income was higher than operating income during the quarter due to an $842,000 tax credit.
Over on the cash flow, we see that they’ve generated $18.8 million in cash from operating activities during the nine months ended September 30. During the same period last year they used $11.3 million. That’s quite an improvement. You’d expect it given the balance sheet.
In 2014, Skullcandy “…plans to selectively add new distribution in the U.S. in underserved geographic areas and where our consumer expects to find us based on where our competition sells.” They are also going to open their first outlet store in Park City before the end of this year. They will be looking to open some additional ones during next year. As you’re all aware, outlet stores have evolved way past where they are just a place to get rid of slow moving merchandise.
They are also launching this quarter a blue tooth speaker called Air Raid that will retail for $149. This is their first non-headphone technology product and it’s probably a place they need to go to get the revenue growth they require. As CEO Darling puts it, “…expanding into new adjacent audio categories is an important part of our growth strategy.”
Skullcandy is tightening its distribution and pricing with the goal of solidifying its brand positioning. They are trying to lead in the youth culture “cool” headphone space in the $100 and under price range and also offer distinctive product, both in terms of performance and branding, to their customers. If they can do that in what they characterize as a highly competitive, consolidating market, then they have to figure out how to grow out of that niche while maintaining the positioning they are working so hard to achieve.
In the action sports business, that’s been damned difficult. We’ll watch to see if their different positioning, even though they are action sports based, makes it any easier.



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