Skullcandy’s September 30 Quarter; This is Going to Get Interesting

Since Skullcandy went public, I’ve characterized the bet they are placing as “whether or not you can be cool in Fred Meyer.” I’ve also asked if coolness is enough of a market differentiator in a product which, especially at the lower end, is increasingly something of a commodity. And finally, I’ve wondered if Skull can have any lasting technological advantage given the resources of some of their competitors. 

Let’s see what their 10Q and conference call tells us about these issues.
The Income Statement
Sales for the quarter ended Sept. 30 rose 17.1% from $60.6 million in the same quarter last year to $71 million. Gross profit rose from $28.8 million to $34.1 million as the gross profit margin rose from 47.5% to 48%. Operating income was up from $8.2 million to $10.6 million, and income before taxes grew like mad from $3.39 million to $10.2 million. That seems pretty good, but there are complications.
The first thing you should know is that interest and other expenses were $4.84 million last year. This year during the quarter they totaled $403,000. That’s a pretax improvement of $4.4 million that has nothing to do with selling headphones and related products. Most of that expense in last year’s quarter was related to the initial public offering and was a one-time expense. Without that, the income before taxes improvement wouldn’t be nearly as great.  Skull points this out in their public information.   
Next, keep in mind a transaction from last year. On August 26, 2011, Skull acquired Kungsbacka 57 AB. That was the company’s European distributor. Once they acquired it, in the middle of last year’s quarter, their numbers changed. Before the deal, they sold to Kungsbacka at a lower margin, but didn’t have any of the operating expenses of running a European business. Once the deal was complete and they were going direct, their sales and gross profit rose, but so did their operating expenses.
I think getting control of your distribution as you grow is a good idea, and it’s common in our industry. But Skull notes in the 10Q that, “As a result, the three month ended September 30, 2012 are not comparable to the three months ended September 30, 2011…” That’s neither bad nor good. It’s just inevitable and you need to keep it in mind.
If we can’t just compare quarters, let’s dig into some details and try and figure out what we think.
North American sales as reported rose only a little from $56.3 million to $57.4 million. International sales accounted for almost all of the net sales growth, rising from $4.4 million to $13.6 million. But remember the impact of the Kungsbacka deal. Last year, until the deal date, Skull only operated in one business segment. With the acquisition, they are now in two; North America and International.
The 10Q says, “Included in the North America segment for the three months ended September 30, 2012 and 2011…are international net sales of $6,015,000 and $10,713,000… that represent products that were sold from North America to retailers and distributors in other countries.”
In last year’s quarter, before the acquisition closed on August 26, sales to Kungsbacka were just sales. After the closing date, they were part of the international segment. And, with a whole quarter under their belt in this year’s quarter, international sales in North America fell, as you’d expect because they got moved to the international category.
Let’s take all those international sales out of both quarters and see how things are going just in North America. Skull tells us that North American sales included $10.7 million of international sales not all of which, I guess, were to Kungsbacka. If we subtract, we find that North American sales were $45.54 million. That includes Canada and Mexico.
This year, North American sales were reported as $57.41 million, including $6.02 million of international. Subtracting, we come up with $51.39 million of sales in North America. So sales in North America, excluding any product sold internationally from North America, rose from $45.5 million to $51.4 million, or by 13%. Total international sales were up 29.7% from $15.1 million to $19.6 million.
You can expect, they tell us, that more sales will transition from the North American to the International segment.
On an as reported basis, the 2.1% North American sales increase was “…primarily driven by increased Astro Gaming sales of $4.7 million.” We also learned that online sales, as a percentage of net sales, fell 3.8% to $6 million compared to last year’s quarter. Skull notes that, “An increase in Astro Gaming online net sales was offset by declines in our direct audio consumer business.” Online sales fell from 9.1% to 8.3% of revenues in the nine month period ending September 30 of each year.   “Online sales,” we’re told, “continue to be negatively impacted by price competition in the ease of online price shopping.”   
Total gross profit in the North American segment declined by $54,000 to $27.18 million in the quarter compared to last year’s quarter. The gross margin fell to 47.3% from 48.4%. They attribute the decline to “…a shift in sales mix to higher price point products with lower gross margin structures” as well as how some of the Astro Gaming inventory had to be accounted for at acquisition. I would have expected that the Kungsbacka acquisition would have had a positive impact on North American gross margins (because North America would no longer be selling to Kungsbacka at distributor pricing, or at all for that matter) and I was surprised they didn’t mention that.
The mention of lower gross margins on the higher price point merchandise was a concern to some analysts. As you know, I’ve been a champion of focusing on gross margin dollars as well as gross margin percentage so I’m maybe not so concerned.
The Strategy
CEO Jeremy Andrus reminds us in his conference call comments that Skullcandy is “…focused on 4 key strategic areas to drive continued long-term growth. Raising our average selling price, expanding the gaming category, growing international and developing other brands and categories.”
Here are some numbers from the conference call for the quarter that tell us something about their sales breakdown worldwide.
Product that retails for $30 or less represented 38% of dollar volume and 67% of units. Over the ear products were 26.5% in dollars, but only 7.4% in units. Products in the $30 to $75 range were 28.1% in dollars and 15.4% in units. And products retailing for $100 and over were 5.3% in dollars and 1% in units. The numbers don’t exactly to add to 100% and I can imagine that “over the ear” includes product in more than one price category, but you get the picture. At the moment, the less expensive products are their biggest sellers by units and dollars.
Management notes in a couple of places that there is increased competition in the low end buds and that they have lost some market share to competitors in that segment. While I’m obviously not the target market, I paid $2.99 for a recent pair of buds I bought because I knew they were going to get broken at the gym, lost, or left in a pocket and put through the wash.
That low end buds would become a bit of a commodity (try to name a consumer electronics product that hasn’t eventually become one- especially at the lower end) can’t be a surprise to anybody. Skull management pretty much acknowledged this when they introduced their 2XL brand “…developed to sell into drug, convenience and grocery channels.”
The Skullcandy brand is already in certain retailers (like Fred Meyer) that I’d say is equivalent to where the 2XL brand is be sold. I wonder if 2XL will replace the Skullcandy brand at certain price points and retail outlets, or if they will both be sold in the same place. 2XL, they say without giving any numbers, is small but growing quickly.
The Astro gaming headphone brand was about $10 million in international sales at the time Skull acquired it. Skull is pursuing the gaming market with both Astro and Skull branded products. Astro will be the premium product in Skull’s gaming offerings. They’ve just launched the Skull gaming product so it’s not a lot of business yet.
In international, Skullcandy is “…still in the early stages of building our direct business in Europe and expanding distribution in other foreign countries.”
They are also working to move up their average price points. They think they have a lot of potential in the $50 to $100 price range and “…have invested heavily on product development and are reengineering the development process through an in-house team of designers, developers and acoustic engineers. Everything from the form, function and sound quality are now being controlled in-house.” During the quarter sales in this price range rose 60%, but “…this segment is still relatively small.”
What’s It All Mean?
They’ve got the 2XL brand, but it’s still small. They see a lot of potential in Europe, but that’s at early stages. They are focusing on higher price point products in both the Astro and Skullcandy brands, but are just rolling them out. Meanwhile, they’ve got some competitive pressure in the $30 dollar and under price point which was their largest by units and dollars during the quarter. Online sales, except for Astro, declined.
How’s the overall business environment? “We are confident in our ability to continue to drive long-term sales and earnings growth. That said, the overall retail environment is definitely a bit uneven right now in the U.S. and overseas, particularly in Europe. Over the past few months, we have seen retailers become more cautious in their outlooks for the holiday season and at this point, it is impossible to gauge the impact of Hurricane Sandy.” Those problems aren’t unique to Skullcandy.
What’s the short term impact of this? “As a result, the company is lowering its operating margin and profit projections in the fourth quarter and revising its fully diluted earnings per share outlook for 2012 to a range of $1 to $1.04 from the previous range of $1.10 to $1.20.” Management expects “…the fourth quarter to roughly mirror what the third quarter has been in terms of revenue.”   They would not provide a lot of guidance for 2013 because they are in the middle of their budget process, but CEO Andrus did say“…my general sense is that operating margins will be flat next year.”
Here we are at the crossroads that every successful, fast growing company eventually arrives at. It’s no surprise that Skull’s lower priced products (that produced 38% of revenue and 67% of unit sales during the quarter) are to some extent becoming commodities and are under competitive pressure. I’d expect that to continue. If there’s continued price and margin pressure there, one wonders what kind of volume they need to do to be competitive in this segment. Their new 2XL brand is to be part of the solution to that.
Skullcandy management sees growth opportunities in Europe and in moving to higher price points with both the Skullcandy and Astro brands, but those are at early stages of development. How quickly can they be expected to compensate for the lower priced, more competitive business in North America? And if, in these small but growing niches, competitive positioning is based on the cache of the Skullcandy name- it’s “coolness” if you will- how big is that market?
Like I said, this is going to get interesting.



2 replies
    • jeff
      jeff says:

      Thanks Al. It gets easy after you’ve read the first four or five thousand SEC filings. And judging from what the stock market did to Skullcandy’s stock after the earnings were announced, it looks like I wasn’t the only one with some questions and concerns.


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