Skullcandy’s Strategic Positioning and Annual Results

Somehow, I didn’t see Skull’s 10-K with their results for the December 31, 2015 year when it came out and then I found myself busy with a couple of clients.  But it’s not so much that I want to give you a deep dive on the financials, but that I want to talk about their strategic balancing act a bit. There are some things we can all learn.

Let’s take a brief look at the numbers and then move on to that.

By the Numbers

I’ll start by telling you that their balance sheet looks great.  I always like to see that.  The current ratio rose from 3.05 at the end of the previous year to 4.54.  Total debt to equity is down from an already very comfortable 0.38 to 0.23.  They reduced inventory 24.2% from $55.0 to $41.7 million even as sales increased.  Their inventory is at 67 days of sales, the lowest in the company’s history.  Receivables were up 14.2% on a sales increase of 7.4%, but I can live with that.  There’s no long term debt.  Cash fell, but so did accounts payable and accrued liabilities, as Skull made some early payments to suppliers in exchange for discounts.  Wonder how much that helped their gross margin.

Total sales rose 7.5% from $247.8 to $266.3 million.  Domestic sales were up 9.3% to $190.9 million.  International rose 3.1% to $75.4 million.  The domestic increase was largely the result of a 9.2% increase in prices.  International volume rose 13.1%, but prices were down 8.9% and there is an additional decline of 1.1% due to the impact of foreign currencies.  A single customer accounted for 19% of revenues during the year and 26% of receivables at year end.

“Domestic net sales increased primarily due to product mix shift towards higher priced wireless headphones and gaming products.  This trend of slow domestic volume and increased average selling price is expected to continue as the headphone market continues its transition towards wireless products and away from traditional wired products. International net sales increased primarily due to increased sales of both gaming and audio products in Europe and Japan, and to a lesser extent Canada.”

I feel strongly both ways about the domestic trend they describe.  On the one hand, it’s a bit concerning that they didn’t grow their volume at all.  On the other hand, the ability to raise prices, or at least sell higher priced products, which is what they may mean, seems consistent with positioning Skull as a specialty brand.  Doing more and better business with their existing retail base is something they’ve focused on in the past.

The gross margin fell from 44.6% to 41.3%.  The domestic gross margin fell from 44.9% to 42.1%.  International was down from 43.9% to 39.2%.  Of the overall decline, 120 basis points were due to currency.

Operating expenses were up from $98.8 to $100.9 million but declined as a percentage of revenues.  $1.6 million was the result of a bad debt from a Chinese distributor.  Skull spent $28.2 million on “demand creation marketing,” up from $27.1 million the previous year.

Operating income fell 23.9% from $11.8 to $9.0 million due largely to the decline in gross profit.  Domestic operating profit rose 23.8% from $5.25 to $6.50 million.  International operating income dropped 62.1% from $6.54 to $2.48 million.  Net income of $5.3 million was 30.1% below last year’s $7.6 million.

Sales during the last quarter of the year fell to $96.1 million from $96.8 million in last year’s final quarter.  Net income from the quarter was down from $7.2 to $5.9 million.  As you can see, the last quarter was largely responsible for the net income decline during the whole year.  They note in the conference call how hard the last quarter was.

You know, in this market my bar is just getting lower than it used to be.  I just love a company with a strong balance sheet that’s making a profit and has a strategy that makes sense.  Let’s move on to that strategy.

The Balancing Act

Pretty much the day he took over, CEO Hoby Darling made it clear Skull has to be a specialty brand and minimize off price sales.  As far as I can tell, he’s been consistent in pursuing that strategy but (here it comes) it’s not an easy thing to do as a public company.  He says in the conference call that Skull held back on $3 million in shipments late in the fourth quarter to discounters because it “…would have been detrimental to the brand, gross margin and our long-term business plan.”  Good for them.

Two of the competitive strengths they note in the 10-K are “Leading Authentic Lifestyle Brand” and “Brand Authenticity Reinforced Through High Impact Ambassadors.”  Those are both hallmarks of specialty brands.  But they also, to my mind, limit or at least slow distribution until the brand is very, very well established.

They cite another competitive strength as having a “Target Distribution Model.”  They say, “We control the distribution and mix of our products to protect our brands and their authenticity.”  But of course they are in Target, Walmart, and Fred Meyer among others (so are their competitors).  Perhaps Hoby feels the brand is more developed than I do and maybe it’s partly the pressure of being public.  It’s fair to note that the way retail is evolving, being in some of these channels isn’t necessarily the death of your authenticity it used to be and perhaps you don’t really have a choice.

If I could ask Hoby Darling one question, it would be, “Just what, exactly, do you mean by ‘targeted distribution model?’”  There’s a partial answer in the 10-K where they note:

“We are selective about the national retail partners that we align with as well as with the product mix we offer to these retailers in order to reinforce our Skullcandy’s brand positioning as the original

performance lifestyle audio brand, Astro Gaming’s brand positioning as the premium leader of gaming headphones that lives at the epicenter of technology, lifestyle and design. Historically, we have managed our relationships with these large retailers through independent, commission-based sales representatives. However, we continue to build out our team of in-house sales professionals focused on driving the business with our top retailers and connecting our internal sales, marketing and product teams. Our national sales team enables us to improve the frequency and level of interaction with these retailers. Our other large retailers are managed by our regional sales managers through independent sales representatives where we can put the best team in place to meet the needs of our retailers and our business.”

So it’s not just about where they sell, but which products and how they work with the retailers.

Both Hoby and CFO Jason Hodell bemoan the fact that they don’t have enough product to meet demand for their newer offerings.  While I can understand why they might be disappointed, I’m sitting here thinking that maybe a little scarcity (not too much) isn’t a bad things as you build a specialty brand.  I’m also wondering if it isn’t an interesting time to think about a price increase.

That’s a particularly intriguing idea given their discussion of 2016 expected results.  They expect net revenue to grow in the “…mid to high single digits.”   But, “…total unit volumes are planned to be down…while increases in our ASP [average selling price] drive revenue growth.”  Sounds like a specialty brand strategy to me.

It’s a tough market, and Skull is competing with some heavy weights with way more resources.  But what you want in this kind of market is a strong balance sheet and a solid strategy consistently applied.  Skull seems to have both of those.  They may not get as much immediate growth as the public markets would like, and they do have a bit of a balancing act to manage.  Bluntly, when this turnaround started I wasn’t sure they could pull it off.  Let’s say I’m waxing more optimistic.