Skullcandy’s Quarter: I Think I Recognize This Strategy

New President and CEO Hoby Darling has been at Skull north of two months now, and the company has released its first 10Q and had its first conference call with him at the helm. The outlines of his strategy are starting to become clear. Interestingly, you’ll note some similarities with the strategy of certain VF brands as I described it yesterday and with what I’ve been generally recommending for a while now. Let’s start with the numbers and then move on to that strategy. 

Financial Results
Net sales were down 30.4% to $37.1 million for the March 31 quarter. They were $53.3 million for the same quarter in the prior year. North American sales fell 37.9% from $46.1 million to $28.7 million. Part of the reason for the decline was a 67% reduction in “…the highly discounted off-price channel….” They had said they were going to do that and I think it’s a great move, consistent with the strategy they outline. Gaming headphone sales (Astro) rose 43.8%, but CFO Westcoat also notes in the conference call that “All of our full price audio channels were down.” He also notes gains in their 2XL brand business.
He made another interesting comment, saying that, “With respect to pricing bands, sales of under $100 declined due primarily to promotion and mix while sales in the over $100 band increased 29.1%, primarily from the sales of our premium gaming headphones.” I know they’ve been pushing the higher priced products, but he makes it sound here like traction at the higher price points was only with gaming. 
International sales were up 17.5% to $8.4 million but “Included in the North America segment in Q1
2013 and Q1 2012 are net sales of $2.1 million and $3.4 million, respectively, that were sold from North America to customers with a “ship to” location outside of North America. Adjusting these sales into the international segment, international net sales decreased 0.6%.”
The overall gross profit margin fell from 48.1% to 44.5%. In North America it was down from 47.1% to 43.5%. They tell us this was due to “…an increase in tooling depreciation and a write off of $0.8 million of inventory related to end of life products (“EOL”).” I assume the tooling depreciation is an ongoing expense. Assuming the inventory write downs are done, gross margin should begin to improve based just on its absence. We’re told in the conference that 2.2% of the decline was a result of the inventory write-off. We couldn’t, in the conference call, get a definitive answer that there was no more inventory to be written down.
If they’ve got overvalued inventory, I’m thrilled to see them recognizing that it sucks and writing it off. I recommend this to everybody. Inventory delusion disease is a terrible condition, but treatable with a dose of reality. I also see the write down as consistent with Skull’s strategy as I’ll explain.
The international gross margin fell from 54.4% to 48.1%. This was due to the bankruptcy of retailer HMV in the UK and higher levels of discounting.
Skull is and has been in the process of moving to some higher priced but lower margin products. As you know, I’m all about how many gross margin dollars you can generate as opposed to just the gross margin percentage. I like that approach and, once again, think it’s consistent with the strategy they outline. What I don’t know is what the impact of the 67% reduction in sales in the off-price channel was on the gross margin. Were those lower margin products and how many dollars are we talking about?
Selling, general and administrative expenses rose from $24.1 million to $26.3 million. As a percentage they jumped from 45.3% to 71%. Unless they chose to gut their expenses, a big percentage increase was inevitable given their sales decline. There was also $1.2 million in costs there resulting from Jeremy Andrus resigning as CEO and $2 million associated with property and equipment related to the inventory that was written off. Ignoring those one-time items, they did cut their spending, but I’d say they maintained it at a level consistent with their branding and market positioning.
The bottom line was a loss off $7.05 million compared to a profit of $1.12 million in last year’s quarter. This quarter’s result was helped by an income tax benefit of $3.35 million.
Turning to the balance sheet, cash was up to $34 million from $11 million a year ago. Receivables fell 11% from $39 to $35 million and inventory was pretty much constant at $51 million. I might have expected more decline in both receivables and, especially, inventory given the sales decline and the $800,000 inventory write-off.  They don’t offer any details about receivables. CFO Kyle Wescoat tells us in the conference call that “The principal reason for higher-than-expected inventory is Best Buy’s shift of their reset, which was originally scheduled for March but changed to June, and higher Astro inventory to support the brand’s rollout to retail, which was initiated in the back half of 2012.”
Skull has two large customers (Target and Best Buy) that accounted for 33% of their revenue in the first quarter. One was 15% and one 18%, but we don’t know which is which.
Skull has no long term debt and no bank debt.                 Current ratio has improved from 3.04 to 4.22 and total liabilities to equity is, oh hell, too strong to bother calculating.
Issues of Strategy
Let’s start with the questions CEO Darling says he asked himself before he took the job:
·         Are headphones commodities, and does innovation matter?
·         Does the audio category have defensible barriers to entry?
·         Will the market continue to grow?
·         Does the Skullcandy brand resonate with its core consumers and can it resonate more broadly, giving us opportunity to expand?
Great questions. I guess he must have answered either “yes” or “probably” or he wouldn’t have taken the job. My answers are some headphones are commodities (but some aren’t), innovation matters, any barriers to entry will be based on branding but it seems like an awfully crowded space, so maybe there aren’t really any, the market will continue to grow, Skull resonates with its core consumers (or they wouldn’t be its consumers) and I don’t know.
He goes on to say, “What I believe ultimately determines which companies separate themselves from the pack and thrive over the long term is consumer-focused innovation and creating deep emotional connections to consumers through clear messaging and brand identity.”
He takes quite a bit of time to discuss what the company has to do. More clearly defining the brand comes first. He wants the best ideas to go forward- not merely good ones. And they need to be products that meet a customer need rather than one that just fills a place in the product line or reacts to what a competitor is doing. His goal, I think, is fewer, more distinctive, relevant products.
There are going to be some changes in distribution. “We need to do a better job segmenting our retailers by consumer and aligning our product and marketing assets,” Darling says. There will also be some new products in adjacent categories like speakers, but not until they have the right, distinctive, product. He believes “The company has developed an R&D and audio engineering function that I believe is unrivaled in the industry” to help Skull accomplish that. Quite a claim given who some of the competitors are.
But to me the most important thing he says is that about how the company expects to grow. He sees Skullcandy using its foundation in action sports as the basis for its growth in youth culture- not the mass market. If you’ve followed any of my writings, you know I think that the farther you get away from the foundation of your brand into very broad distribution, the harder it is to connect with a customer in a meaningful way. They may know your brand, but they won’t know your story.
So it looks to me like we’ll see Skull being a little more cautious and thoughtful in its distribution, and I think that’s great. Bluntly, I think it’s their only choice. As he puts it, “We believe we are one of the only audio companies that has brand permission to play across all of youth culture and we intend to take better advantage of it moving forward.” That’s a big bet, but I think it’s the right one.
Part of that bet is going to be a focus on relationships with their retailers. As I wrote yesterday when talking about VF, as I said at the Skateboard Industry Summit, and as I’ve been writing in my column for a while, distribution is way more complicated now than “core” or “noncore.” Each decision to sell (or not sell) to a retailer, be it a chain or a single specialty shop, has to be made based on how, in concert with that retailer, you can reach your target customer and represent the brand well. That what Skullcandy says it’s going to do.
Hoby Darling does a great job laying out a vision of a Skullcandy that’s more product driven, and is focused on utilizing its credibility in action sports as a springboard for the broader youth culture market, but not the mass market. He describes a process where you do it right, if not as quickly as you might want. I think that ends up generating a better bottom line with less risk, even if it doesn’t give you quite the rate of revenue growth you might want.
The problem, of course, is Skullcandy is a public company with pressure for increasing revenue. After he’d laid out this detailed vision and strategy one of the analysts asks when they could expect to see some of Skull’s new, recently introduced products in Best Buy and Target.
To his credit, he calmly explains that “…part of our plan is we launch these innovative products going forward as we generate demand at the core before we roll them out.” I think it’s exactly the correct strategy for Skull, but I wonder if Wall Street gets it.
The strategy makes sense, but doing it right is going to take time and probably constrain top line growth some.