Since executing its IPO in July of 2011, Skullcandy (SKUL) has seen nothing but hard times as market demand has continued to shift away from the company's core brand of products, ear buds. Ear buds are the company's most profitable product category, but now only constitutes around 50% of the Skullcandy's business. As previously stated, there has been a rapid shift in consumer demand away from the ear bud category and into on-ear and over-ear headphones. Unfortunately for Skullcandy, the on-ear and over-ear headphone category, which is growing in strength and sales volume, is not as profitable as the ear bud category.
Ear buds carry less production cost due to the lack of technology input; as such the category has higher gross margins. The other product category, let's just call them ear-phones for now, offer lower gross margins due to the highly technological aspects introduced into the form, fit and functionality of the products. The steady migration toward headsets at higher price points than ear buds brings with it a highly competitive landscape for Skullcandy. The company is up against some heavy hitters like Sony, Bose, Monster (Beats by Dr. Dre), and Soul by Ludacris just to name a few. With the target market for these products being teenagers and young adults, the fickle nature of the target demographic is one in which a company can rise and fall quite quickly if the company fails to innovate and remain relevant.
Here is the brutal honesty the SKUL faithful may not appreciate hearing, "Management has failed to execute on the business model and its core objectives." In other words, the company has allowed for market share erosion. As the competitive landscape and consumer demand has shifted, management failed to address the changing climate in a timely manner and the company is now reacting to the changes in the marketplace. But that's ok if an investor still believes in the SKUL story as one fiscal year does not forecast the next in all situations.
As quickly as the company has begun losing market share, the same target demographic, which began leaving the company can help the company gain it back. Skullcandy is still a top tier brand in the ear-phone space and if you believe in what the company says, as consumer demand shifts away from ear buds and into ear-phones/headsets, the marketplace will consolidate around four-five key brand providers that can deliver quality product. The bottom line here is very simple, Skullcandy's management needs to spend money to make money if it desires to regain market share. While the company adapts its product line toward the shift in consumer demand, it continues to lose market share at the lower end product category, ear buds.
Morgan Stanley's most recent analyst downgrade of SKUL highlights the competitive headset business and how it has and continues to impact SKUL. In the report, Morgan Stanley wrote, "We now expect competition to have a greater impact and see more risk. Four field observations drive our thesis change: 1) Our latest Target store visit revealed SKUL's high volume "Ink'd" product now selling for $16.99, down from $19.99 and 2) Monster is taking further peg share; 3) We have also seen Radio Shack 30% off SKUL discounts; and 4) Staples is replacing SKUL's high-price Aviator product with Soul's offering. Improved Apple earbuds are another negative." Morgan Stanley also lowered the price target from $21 to $15 on Skullcandy.
So what is management doing to increase the breadth of brand awareness in the marketplace? I could discuss the host of corporate spokespersons the company endorses, but this is no different than the other major competitors. So what is management doing to differentiate itself from the other major players? Well, for one thing the company is taking a leap into the gaming arena. While there is still competition in the gaming arena, none of the core competitors in the ear-phone gaming space carry with them a consumer brand base from outside of the space like Skullcandy. The headset gaming space is dominated by Turtle Beach Inc., which does not have a broad action sports lifestyle following, but boasts nearly 50% of the gaming headset sales market. At Capital Ladder Advisory Group, we feel that analysts covering SKUL have very much overlooked the possibilities for Skullcandy in the gaming category. Action sport lifestyle users of Skullcandy products entering the gaming space will be able to buy adjacent channel products from Skullcandy providers, like GameStop (GMS) and Best Buy (BBY). Beats by Dr. Dre and Soul do not currently offer gaming headsets and as they say, "while the cat is away, the mice will play."
The gaming headset industry is estimated to be $1.0+ billion as of YE 2012. Skullcandy recognized this growing phenomenon in 2011 and paid $10.8 million for Astro Gaming to address this growing market. At the time, Astro was a small niche business, achieving approximately $10 million in annual sales and targeted primarily at professional gamers. It had great products and a highly respected brand, but its product margin was below 30% direct-to-consumer, making it difficult to sell anywhere but its own website.
After purchasing Astro Gaming, Skullcandy took apart the company's products, refined and refinished them using Skullcandy technology in order to achieve a higher gross margin product suitable for retail. Astro headsets (A40 and A50) are aimed at the premium gaming market segment while Skullcandy headsets (Slayer) are being marketed to mainstream gamers. During Q4 2012, Skullcandy's new Slayer gaming headset rolled out to almost 2,000 retail doors after receiving positive reviews. With a multi-branded platform in place, SKUL now has the ability to look at accessory-related gaming products, which it estimates to be a $6 billion to $7 billion market globally. With a global footprint in roughly 80 countries, Skullcandy is bound only by its dedication to achieving operational excellence.
Skullcandy estimates the total global gaming accessories market is roughly $6.5 billion (inclusive of gaming headsets). This particular portion of the earphone market is growing rapidly. In Skullcandy's most recent investor presentation, the company outlines growth drivers for this particular market segment:
Factors Driving Growth
- Upcoming launch of next-generation consoles will drive new growth in console accessory purchase.
- Rising popularity of mobile gaming.
- A resurgence in PC gaming and the success of the "freemium" model.
- Increasing quality of game play (graphics, audio, multiplayer interaction).
- Popularity of online multiplayer games.
During Q3 of 2012, Skullcandy launched Astro PC gaming headsets on-line. Additionally, the company has both the Astro A40 and A50 gaming headsets chain-wide in Best Buy and the Skullcandy Slayer gaming headset at Target and select Gamestop stores.
While I may certainly be focusing a great deal of time on the gaming headset market and opportunity within this business segment for SKUL, it is important to understand that it will take a certain sizable marketing spend to develop a profitable brand adoption rate in the category going forward. The near-term impact on gross margins will likely suffer due to such product development and marketing efforts. This important fact should not be lost on investors.
Let's move on from here to discuss the company's distribution model, which has undergone some improvements in recent quarters. In the past, Europe was a market that SKUL sold products in through distribution partners. However, the company now owns its distribution channel in Europe to a great degree, offering the company higher margin sales in the region than in the past. In Q1 of 2012, the company opened an office in Shanghai to address its consumers and the market directly in China. Management believes the emergence of music and the audio accessory category are two very positive long-term trends for the business in China. In Q3 of 2012, the company also opened a small office in Japan to build its direct business in this region, which has a high propensity for purchasing electronics and electronic accessory devices.
Skullcandy products can be found in most retail outlets whether it is Skullcandy, 2XL or Astro brand. The 2XL has been more geared toward the convenience/drug store channel such as Walgreen and CVS. There is one major U.S. retailer that is still lurking in the shadows, but has not adopted Skullcandy products to date. That's right investors, that retailer is Wal-Mart (WMT). While Wal-Mart certainly carries Phillips, Sony (SNE) and Beats by Dr. Dre products you will not find Skullcandy products in stores. With this key piece of information or growth opportunity at retail channels yet unrealized by Skullcandy through Wal-Mart, investors will be keeping a close eye on the mass market retailer. With over 6,000 stores, Wal-Mart could provide Skullcandy with 30% revenue upside in 2013 by conservative measures, in and of itself.
Forecasting methodology is always difficult for growing companies, especially those growing internationally. Skullcandy recognized this as a concern early in 2012 and invested back into the business. The recent implementation of a new demand planning software tool has provided the company with a higher degree of precision in forecasting the sales patterns of larger customers. This should result in better inventory management and demand planning going forward.
Ok, so maybe the company has been pro-active in its business plan, but the share price tells a different story and so are the analysts covering SKUL. Let's face it though, the analysts aren't always right and sometimes their timing can be way off.
In a more recent filing by SKUL, the company renegotiated its longstanding credit facility to include the prevision for the company to buyback up to $28 million of its outstanding shares. No buyback plan has currently been announced nor are we suggesting one will be announced, but the company has increased flexibility with its new credit facility terms. While many point to the terms of the enhanced credit facility as depicting a share buyback program, it is also plausible that the credit facility was enhanced in order to meet advancing distribution needs, to fill greater pipeline builds and to invest in new product development.
Skullcandy needs to see some more flow through from its grass roots marketing campaign going forward. Significant market share has eroded the company's growth and shareholder sentiment. With shares already down nearly 5% on the year and having plunged more than 80% from their IPO price listing, we think the negative sentiment is fully reflected in the stock price, which in large part discounts the underlying fundamentals and earnings growth going forward. The current stock price also suggests that Wal-Mart would never adopt Skullcandy products, which we view as highly unlikely, especially with Wal-Mart executives holding talks with Skullcandy management at the most recent Consumer Electronics Show, where new and inspiring products were revealed to thousands of buyers from across the globe.
Insider sells have been high as of late with the company's CEO selling roughly 100,000 shares in the last four months alone. With respect to these sales of common stock, a vast majority of the sales were planned sales.
Capital Ladder Advisory Group is initiating full scale coverage of Skullcandy for institutional clients and the retail investor base following at capitalladders.com. We specialize in channel check, production and manufacturing capacity utilization analysis and consumer survey market data compilation and analysis. If you have any questions related to Skullcandy, feel free to contact us at firstname.lastname@example.org.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.