Who isn't bearish on Skullcandy (SKUL) at this point? After the company reported a miss on Q4 2012 earnings and a slight beat on Q1 2013 earnings, shares of Skullcandy fell more than 20% in the after hours trading session. The steep decline came on the heels of the company's guidance for Q1 2013 which assumes a loss of $.25 a share for the quarter. Now, if you are one of those die hard SKUL investors who think that maybe the company is low-balling expectations; I'd take on a second perspective that views the quarter as nearly over when the company offered this guidance to investors on March 7, 2013. I'm pretty sure they have a good idea of what the numbers look like at this point, so you may not want to fool yourself into thinking management is under promising and might over deliver. Frankly speaking, that hasn't been the Skullcandy way either.
Let's take a quick look at Q4 2012 before moving on:
- Revenues: Up 21% to $101 million
- Earnings: $.47 vs. estimates of $.48
- North American sales increased 12% to $82.7 million and international net sales increased 90.2% to $18.3 million.
- Gross margin was 44.7% as compared to 49.7% in the same quarter a year ago.
- Operating income in the fourth quarter was $17.7 million, down from $20.4 million in the fourth quarter of 2011.
Clearly the company was and has not been firing on all cylinders based on the results noted above. Additionally, guidance for Q1 2013 left much too be desired. Now let's look a little more closely at what resulted in such a dramatic gross margin contraction YOY. The company notes that three factors resulted in the gross margin contraction during Q4 2012: 1. The shift in sales towards higher-priced, low-margin products accounted for 200 basis points of the decline. 2. Two, higher levels of promotional sales and retailer discounting accounted for 180 basis points of the decline. 3. Product liquidations through the off-price channel, which contributed 140 basis points to the decline.
On February 7, 2013, Skullcandy's CEO Jeremy Andrus decided to step down from his positions as President and Chief Executive Officer and a Company director to join a private investment firm. He will serve as a consultant to the Company over the next 12 months. The Board is initiating a search for a permanent Chief Executive Officer. During the interim, the Board of Directors has named Rick Alden, the company's founder, former Chief Executive Officer and a current director, as Interim Chief Executive Officer.
The recent changes in management have served up greater speculation than ever, leading many investors and would-be investors to believe that Skullcandy could be an acquisition target or, at the very least, be taken private. Again, we would advise investors to think twice about such notions. In general, a competitive company would not look upon the recent failures by Skullcandy and its product line as a needs based acquisition. A faltering company in such a fickle industry would be left to its own accord to fall further, possibly out of the marketplace entirely. However, we don't believe the latter statement of falling out of the marketplace entirely will hold water with Skullcandy as its developing markets hold incredible sales strength and vital distribution net worth. This should not be overlooked by investors and is just one of the many reasons we retain our current position in SKUL. But, we are not of the opinion that the company is entertaining buy-out, merger or taking the company private notions at this time. Rarely identifiable recognition of whether a company is in play or not is by the dissolution of analyst coverage. Should you see analysts discontinue covering SKUL in the future; it is highly likely that some type of buy-out, merger or private undertaking is being considered and/or in advanced stages. Analysts' firms know which firm is likely going to get the business end of the deal and as such they curtail their respective involvement with regards to making markets in shares of SKUL and discontinue coverage sometimes altogether.
Noted below is a recent look at analysts' downgrades of SKUL upon the release of Q4 2012 earnings results:
- Craig-Hallum downgraded SKUL from Buy to Hold with a price target of $8.00 from $15.00.
- B of A/Merrill Lynch and DA Davidson downgraded SKULL from Buy to Underperform.
- Raymond James downgraded SKUL from Market Perform to Underperform.
- Piper Jaffray downgraded SKUL from Neutral to Underweight with a price target of $4.00 from $7.00.
- Northland Securities downgraded SKUL from Outperform to Market Perform with a price target of $6.00 from $12.00.
- In their recent report to investors, Morgan Stanley lowered their respective price target on SKUL to $8.00.
In light of a lot of bad news that has recently depreciated shares of SKUL, what is management doing to counter the recent pitfalls the company has fallen into. According to Rick Alden, Skullcandy is still the #4 performing audio brand in total dollar sales and the #2 brand in unit sales at the most elite retailers in North America. The primary objective the company is focusing on to re-establish itself as a major competing brand in audio headphones in 2013 is by addressing low-quality sales that comprise roughly 10% of total 2012 revenue, much of which was driven through the off-price channel. The company has planned to cut this back significantly for 2013. First quarter guidance reflects this effort, and the long-term benefit to gross margins and relationships with full-price retailers is certainly the focus moving forward.
Packaging is the next hurdle the company has planned to tackle. This is a much more cumbersome and complicated overhaul for the company however. The company's current product line packaging, in the words of Rick Alden, is too clean, clean lines, clean fonts, lots of negative white space, all of which surrounds a small window through which you can barely see a pair of headphones. This initiative will likely take a couple of quarters to show itself cleanly in the marketplace as packaging commitments are usually contracted for long periods of time.
The company will focus more attention on its brand ambassadors. The company hopes that this effort will impact the consumer on the selling room floor, in retail stores and at the point of sale. Derik Rose of the Chicago Bulls is a huge brand ambassador for Skullcandy, but the All-Star Point Guard has been sidelined for the majority of the year as he continues his road back from knee surgery in the off season. One key addition to the brand ambassador team recently was including two-time Sports Illustrated cover girl Kate Upton.
Lastly, the Skullcandy team will focus more on product initiatives and product development. Rick Alden fully admits to and acknowledges that the company has fallen off track and become more of a reactionary company to the trends than a proactive company. Bluetooth is heavily in the market, Skullcandy is not sufficiently there yet and this is yet another example of Skullcandy falling behind the curve of the advancing marketplace for headphones.
Here is the important takeaway with regards to all of the noted initiatives the company is set to embark upon in 2013 … money! All of these initiatives take time and lots of money, we would encourage investors whom are looking at SKUL for the long term to focus heavily on revenues over the next several quarters as gross margins and earnings will likely take a back seat due to the heavy cash spend the company will need to lay out in support of the stated initiatives. The true sign of success for Skullcandy will largely be identified through sales/revenues. If management is successful with its initiatives in 2013, investors will be able to see the direct benefit in sales/revenues in the back half of 2013 and beyond. It is one thing for a retailer to buy into your product line, but an entirely different thing for the consumer to provide you with restocking orders via strong sell-through, which incidentally proved to be the company's major pitfall in 2012.
Some key points of interest from the Q4 2012 Conference Call with analysts shows that the Mr. Alden has great confidence in the company's ability to execute its plans for FY13. The company's Q4 launch of Astro gaming headsets has proven to be an effective strategy, with Skullcandy diving deeper into the gaming category. When asked about how sales of the Astro were performing, Mr. Alden said, "Sell-through has been fantastic".
Additionally, on the conference call Mr. Alden noted that chasing price points is not the direction the company will be moving in, but rather moving in a direction that displays new products as being more innovative, cool and relevant. In other words, the company plans to think "cool first" and price second. Visual representation of this think "cool first" strategy will show itself more boldly to the consumer and investment community through stated packaging initiatives. Plans on packaging are aimed at telling a better story by using more color, opening up windows and doing a better job of presenting the product.
Rick Alden will likely only be in position for the next couple of months as the company seeks out a qualified candidate to take his place at the helm of Skullcandy. An announcement, solidifying the CEO role could act as a near term catalyst for the stock in the coming months. Mr. Alden developed this niche product category and as interim CEO and founder of the company he is looking to steer the company back onto the right course even if temporarily. Mr. Alden has his work cut out for him in this increasingly competitive and ever-changing product category.
Capital Ladder Advisory Group does anticipate some key developments on the product development front and the retail distribution front in 2013 for Skullcandy. Mass market retailers will be going through plan-o-gram resets later in the year and ahead of the holiday selling season. An extension of or addition to the Skullcandy product line could possibly find its way onto SHELVES (not pegs) later in the year at participating retailers.
Our most recent discussion with retail buyers proves that the company is in advanced talks with retailers to be announced for greater product distribution. Additionally, Capital Ladder Advisory Group has recently achieved monthly, company-wide channel check sales data from Best Buy (BBY) which will aid us in better gauging sales trends for Skullcandy products and its competition. In the coming weeks, we will disclose certain store generated channel checks on-line via capitalladders.com. We have an anticipatory publication date of April 2, 2013 for these highly sought after channel checks.