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Skullcandy (NASDAQ:SKUL)

Q1 2014 Earnings Call

May 01, 2014 4:30 pm ET

Executives

Patrick D. Grosso - Vice President of Strategic Initiatives and Corporate Affairs

Seth Darling - Chief Executive Officer, President and Director

Jason Hodell - Chief Financial Officer

Analysts

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

David M. King - Roth Capital Partners, LLC, Research Division

Ryan MacDonald - Northland Capital Markets, Research Division

Andrew Burns - D.A. Davidson & Co., Research Division

Rafe Jadrosich - BofA Merrill Lynch, Research Division

Operator

Good day, ladies and gentlemen. Thank you for standing by, and welcome to Skullcandy's First Quarter Fiscal 2014 Earnings Conference Call. Presenting on today's call will be Hoby Darling, President and Chief Executive Officer; and Jason Hodell, Chief Financial Officer. As a reminder, today's call is being recorded. [Operator Instructions] At this time, I would like to turn the conference over to Mr. Patrick Grosso, Vice President, Strategic Initiatives and Corporate Affairs.

Patrick D. Grosso

Good afternoon, and welcome to Skullcandy's First Quarter Fiscal 2014 Earnings Call.

Before we begin, let me remind you that certain statements made on today's call, either during our prepared remarks or in response to your questions, may constitute a forward-looking statement. These statements are made pursuant to and within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements are subject to both known and unknown risks and uncertainties that can cause actual results to differ materially from such statements. Those risks and uncertainties are described in Skullcandy's quarterly and annual reports on Form 10-Q and 10-K. Investors should not assume that statements made during the teleconference today will remain operative at a later time, and Skullcandy undertakes no obligation to update any information discussed on this call.

With that, I'd like to turn it over to Hoby Darling, Skullcandy's President and Chief Executive Officer.

Seth Darling

Thanks, Patrick, and thank you for joining us this afternoon. Our team's dedication to executing our focused 5-pillar growth strategy created a solid start to 2014, which further supports our belief in the long-term vision for our company. Many of our key performance indicators were at the high end of our guidance ranges or above, and we achieved both our strategic and financial goals. The work we've done over the past year to define our consumer and brand, better control our distribution and pricing, and excite our consumer on new innovations such as Crusher, has fueled increased demand from retailers and the end consumer. We're encouraged by our recent performance, and our team is highly motivated to build on our current momentum to drive further improvements across the business, both in the short and long term. We are on the attack.

On our Q4 call in March, we laid out in detail our plans for 2014. I'll review what we have accomplished towards our goals in Q1 and provide an update on how we are tracking towards the priorities within each of our 5-key growth pillars. As a reminder, those pillars are: number one, marketplace transform; number two, create the innovation future; number three, grow international to 50% of our business; number four, expand and amplify known for categories and partnerships; and number five, team and operational excellence.

Beginning with marketplace transform. We continued our editing initiative and at reinforcing Skullcandy's accessible yet premium brand ethos at retail, and improving full-priced selling. First, we continue to do the right things for the brand with our off-price business. In Q1, global and U.S. off-price sales were significantly below our internal guidelines and consistent with our editing process from last year. Second, through diligent monitoring of our digital channels, we continue to shut down accounts that do not follow our online pricing requirements. And so, we're in a much stronger position to maintain price integrity online with our key new styles: Crusher, Air Raid and our new women's Halo [ph] product, Knockout.

In terms of amplifying our in-store presence to drive demand and conversion, we've made good progress on this important front by significantly upgrading the look and feel of our in-store real estate with several key accounts. This included the rollout of additional Crusher rumble experience listening stations to key accounts during the first quarter. We've also been refining our training and retail marketing operations function to make sure that we win at the point-of-sale with our key retailers and their sales staff. While our in-store experience has come a long way in the past year, it still isn't where we need it to be to match the strength of our product offering. This is a top priority for our sales and marketing teams, and I'm fully confident we have the right plan and teams in place to execute this critical initiative. We have to win in-store.

This includes hiring a new service provider to ensure that all our listening stations are working properly, and our POS materials meet our aesthetic guidelines. This is especially important for our Crusher technology platform. The fixtures and merchandising need to be remarkable in order for the consumer to fully experience the immersive qualities of this new innovation.

The third prong of marketplace transform is adding distribution. As we announced on our last call, we are strengthening and diversifying our distribution network with the addition of Walmart. Everything is on schedule for product to hit shelves in late May for our initial test set. Walmart has been a great partner, collaborating closely with us to help ensure a smooth rollout. Our teams have been charging hard, and we're excited by this opportunity. With that said, we are taking a measured approach to capitalizing on this new distribution by focusing our initial efforts on the key doors that we believe allow us to best reach our core consumer and doing a great job in those locations.

With respect to our 14 distribution plans, the past few months have provided me the opportunity to have productive discussions with many of our key accounts. The vast majority fully grasped all that we have done to edit and to amplify distribution and now better understand the framework behind our ad strategy.

However, I was clear that our focus remains on how we amplify our current accounts. We need to be a brand that works within our existing retailers to organically grow versus just increasing revenue through new doors. This is somewhat new, as much of our historical growth came from continually adding new doors versus doing a great job in doors where we already sold.

This change will be a focus for our sales and in-store teams. We will win first with those doors we currently serve and then look at how we strategically add doors based on the same 5 questions we discussed previously, starting with where our consumer shops.

With amplifying our current store base and successfully rolling out to Walmart, we have achieved our top priorities for the first quarter in this area. We'll continue to be very selective in adding new accounts for the time being, unless they are particular strategic importance, like women's or sports performance, which I'll touch on in more detail shortly.

The fourth prong of marketplace transform is drive. an integral part of our recent turnaround has been our ability to drive awareness and deep connections to our brand and products to the more creative and effective marketing. Our focus continues to be on creating demand where our consumer gets information and forms opinions, which include digital, in-store and in moments when the world is watching and grassroots events.

On the digital side, we added our new head of digital, and he's making an immediate difference internally and focusing the team on repositioning Skullcandy.com to do a better job of highlighting the brand's youth culture-inspired story and innovative product offering. I expect to see big things from this team as we continue through the year, such as a new website for holidays to drive more traffic and also more social interaction with a focus on Instagram and amplifying events such as our recent women's launch party in New York, so that hundreds of thousands of our consumers can feel like they were at an intimate Skullcandy party, in this case, through a dedicated digital experience and women-specific Instagram at Skullcandy women.

On the world -- on when the world is watching side, we kept focused on enhancing our music presence post kicking off the New Year with our pre-Grammy's party with Roc Nation with a significant activation around Coachella. Coachella fits in perfectly with our brand, fun, young and irreverent, done the way that is creative, not in a recording studio or sanitized, more emotional, sweaty, gritty and culturally grounded, truly an immersive experience. Definitely a moment when the live music world was watching.

On the athlete's side, during the NBA All-Star weekend in New Orleans, we partnered with a great local nonprofit organization that mentors local kids to put on a cool event, featuring pickup games and shooting competitions on our custom-built Crusher court with special guest appearances from our NBA athletes. In addition, we had a DJ spinning music and street artist who painted a mural of the scene. It was a great atmosphere and the kids really enjoyed themselves. We are pumped to be part of such an awesome day.

Meanwhile, Kevin Durant is having an MVP type season leading to Oklahoma Thunder into the playoffs, and James Harden and Andre Iguodala are also looking to take their teams deep into the NBA playoffs. All are big fans of Crusher for pre and postgame and great representatives of the brand at the highest stages.

In the action sports space, Mick Fanning, one of the World Championships of Surfing as early season is off to a tear with the win at Bells Beach and Canadian snowboarder and Olympic bronze medalist Mark McMorris joined the Skullcandy family.

We will continue to invest in demand creation to drive the brand, as I believe it is essential to make sure that our consumers know about our new products and where we are going as a brand.

I occasionally get asked by investors where I feel our brand strength is currently. The short answer is that our brand strength is not where I want it to be yet; we are building it to be stronger. We're a team that is always driving for being better tomorrow than we are today. The brand is strong, make no doubt about that, though. I just spent an evening with 100 shop kids to do some teaching on our new products and enjoy our internal office playground with skate ramps, gaming stations and ping-pong tables, and the kids love the brand and wanted to help drive it even more. Those interactions give me great confidence of where we can take the brand and the authenticity we have with our core influencers.

With that said, it can be even stronger. There is opportunity there. While aligning brand and creating in Park City from California is the right long-term winning strategy to create a cohesive consumer attack with product sales and marketing, we were playing a few folks down in marketing for much of the year last year and early this year. With that said, I have complete confidence in our brand teams, that we'll continue to execute against our stated strategies of winning in digital and in-store and when the world is watching and at the grassroots level. With a clear brand ethos around fun, young and irreverent, done in a way that it's creative and active and aligned strategies of where we best reach our consumer, I believe our brand will continue to strengthen at the core level and throughout our distribution pyramid.

Let me also be very clear that I'll also probably never be satisfied with our brand strength. Great brand companies are always charging to get better and better every day. This is why it's so important that as we see our business turning back to positive and see the turnaround working, we'll continue to invest in demand creation, innovation and training, as Jason will talk about in his remarks.

Moving to our second pillar, create the innovation future. I'm stoked to share that the initial launch of our new women's line has been very positive. We introduced 2 new earbuds and one on your headphone engineered specifically for women. Our teams did an incredible amount of research and rework of typical specs, including the sound profile and fit and sizing to better serve our female target audience, and they developed a new aesthetic featuring graphic design influenced by 2 of our great athletes, Leila Hurst and Kimmy Fasani, that help reinforce the overall brand story and feel.

I'm not aware of any other brand that has gone the same length as we have to significantly innovate around how women hear and enhancing her listening experience. I'm really proud of the teams and see a very bright future with our women's division. As one high-profile women's magazine, SELF, wrote after attending the launch event and experiencing the product, my review in a nutshell, they're totally TDF or to die for, for those of you who are not versed in acronyms.

During the first quarter, we also unveiled our proprietary sticky gel technology which will serve as the key feature of our soon-to-be launched sports performance product line. As someone who's passionate about training and exercise, I believe this new technology is great. It significantly reduces 3 of the key issues with training while wearing buds. They fall out, they become uncomfortable and they potentially create an unsafe environment. The sticky gel technology creates approximately 30% more sticking power when it heats up or comes into contact with sweat. So when you perspire, you don't have to worry about your buds falling out. It also remains pliable and soft, so it stays comfortable for long-training sessions. In addition, several of the buds feature ambient noise adjustment for safety. We're taking out the friction points so our consumer can better enjoy their music and have more fun.

And finally, our Crusher technology continues to garner significant consumer interest and positive industry and consumer reviews. I believe Crusher has helped put Skullcandy firmly on the map when it comes to audio innovation. We are in the process of finalizing some of our key innovations that you'll see us bring to market in the next couple of years. I'm excited for the future.

These 3 innovations all come from a core innovation philosophy. When we obsess about our consumer and how they experience audio, we can create great products that take away their friction points like buds that won't fall out when sweating, and also excite them in ways they did not expect, like our Crusher tech, using haptic technologies to drop them into the front row of their favorite band's concert or into a video game or movie. We can bring these heightened experiences because of the resources we have invested in, in our product and innovation team, and the focus we have on our 3 key innovation swing lanes: immersion, self expression and connection, places we will dominate. With in-house resource and focus is a significant shift and it's something that separates us for most of the competition and allows us to bring homegrown and disruptive technologies to market. Our focus in additional team members hired and dollars spent on product and innovation changes are defining us as a company for the future that can deliver great innovative and quality products, something we're not known for historically and still need to fully teach our consumer and retailer.

We're just beginning to see the full benefits of our transition to an in-house design and development model. Starting with Crusher and then Air Raid and now women's and sports performance, we are bringing the market great products designed from the ground up by our engineers in Park City to ensure great experiences and tremendous sound quality. The data-selling styles with industry average sound and questionable quality are behind us. We now control our destiny, which is exactly where I want this company to be. It's also important to remind investors that we'll continue to focus on creating products in our kill zone price point of $20 to $100, with Halo [ph] products to drive brand and innovation at above $100 and when we can filter the technology to our kill zone products.

It was a tremendous first quarter for our third pillar, growing international to 50% of the business, as our business outside of the U.S. fueled our return to growth. Similar to the fourth quarter, the majority of our international increase came from our key focus countries: Canada, China, Japan and Mexico.

In Canada, demand for Crusher greatly exceeded expectations during Q1. This was driven by a reset at Best Buy in January, which included the rollout of new powered listening stations. Sell through spiked immediately and has been accelerating ever since, which is phenomenal, considering it's been at full price with minimal discounting or promotions during one of the slowest selling periods of the year, some great learnings to roll out across the globe.

In China, the major focus for Q1 was around marketing and building brand equity ahead of our major product launches for women's, Air Raid and sports performance in the second half of the year. Our effort centered around improving our in-store presentation and furthering the brand's authenticity in action sports and fashion. Our brand heat in Japan remains very strong. We hosted several launch events at various retail locations during Q1 with products selling out within minutes. Our team has done an amazing job segmenting product and aligning the brand with other key lifestyle and CE brands in Japan.

Crusher is now our #1 selling Skullcandy style in Japan. This speaks volumes about the brand equity and value that has been created.

Mexico is another market where our brand heat is very strong right now. We recently seeded the Mexico National Soccer Team with product and activated around social media ahead of the World Cup in June. Earlier in the quarter, we bundled headphones with the launch of Lenovo's new tablets, which generated great awareness for the brand.

Turning to Europe, we're outside of the impact on the business from the political unrest in Ukraine and Russia, there are a number of highlights for the quarter. As part of our win the world is watching marketing strategy, we created a line of World Cup products for the French, U.S. and German national teams. By March, we are already oversold and had to increase production to meet demand. Looking ahead, we've been informed we'll soon be receiving extra shelf space at HMV, our largest retailer in the U.K. This is a huge step in the right direction and sets us up well for the second half of the year.

There's also been a lot of activity lately with our fourth pillar, expand and amplify known for categories and partnerships. We recently kicked off our new women's line with a well-orchestrated launch that are used clearly at the center of our product, marketing and distribution strategies.

On products, we brought innovation that was specifically designed to enhance the women's audio experience while ensuring the look and feel of distinct, fun, appealing and undeniably feminine in Skullcandy. We teased the market with a limited-edition of our new Knockout headphone, that was a great product and marketing collaboration between Skullcandy and makeup powerhouse, Urban Decay. This generated significant buzz and positive coverage for many leading women's fashion publications and websites, including style.com, StyleBistro and GLAM. We then stepped up with a full-scale launch event in New York City that was attended by several of the hottest global media outlets and featured Corey Nordart [ph], one of the most influential models in the world right now, in the face of the campaign.

On the distribution front, we've been very selective. nordstrom.com [ph] and birchbox.com are our 2 featured digital distribution partners, and we focused on a limited number of leading women's boutiques, as well as our current lifestyle doors that best fit the feel of the campaign. Once the seed face proves success and the right retail partners are doing well with the brand, and we've created significant demand, we will look to scale distribution, but this likely won't be before late '15.

The early success of women's gives me added confidence on our ability to execute the upcoming launch of our new sports performance line of earbuds, featuring our proprietary sticky gel technology, which came from insights from our team of ambassadors and internal athletes. We have a great game plan in place to build both mind and market share. Sticky gel brings great innovation to the market that solves the consumer problem. In this case, as we talked about, it's the biggest problem facing active consumers, keeping their earbuds in during their workout or training session. We're very excited about positioning and innovations in the product that support how our athletes are actually training and playing, whether snowboarding or skating or training for more traditional sports. Much more with high-intensity functional movements, balance, speed and power and true sports performance training for their sports versus other products on the market is currently more geared towards sitting on an exercise bike or running slowly for long distances.

The sports performance training has gone through a revolution in the past 5 years. People are no longer just hitting the gym to do basic weight workouts and running standard 5Ks and 10Ks. Participation in a high-intensity interval training like CrossFit and mud runs and obstacle races is exploding. This more emerging sports market aligns perfectly with the Skullcandy brand, and our products are designed with the stability and durability required to take on this new type of training an athlete.

I've spent hours training with the product and I believe we will have the best product in the market for the value. We believe our authentic brand positioning, combined with the active backgrounds of our leadership team and company, will resonate with our target audience. Unlike our women's launch, which is in seed mode of distribution, we will be scaling much faster at sports performance during our late summer launch and heading into 2015. I expect sports performance would be present with several of our larger accounts during 2014, as well as new influencer distribution.

Turning to our gaming business. While the launch of new consoles for Microsoft and Sony has created some temporary headwinds for the entire industry, sell-through for Astro and Skullcandy gaming has been solid. In fact, they are the only 2 major brands showing year-over-year growth in retail sell-through in the last quarter according to NPD data. This was in the phase of the gaming headset market that was down by double digits from Q1 2013, providing a great indication of brand strength for both Skullcandy and Astro.

Looking forward, the strong initial sales of Xbox One and PlayStation 4 are a great sign of the health of the gaming market and speak to the medium- and longer-term opportunities for our gaming products. We're taking full advantage of our status as an officially licensed Xbox One headphone partner and expect to have new, fully compatible products for holiday. As the gaming headset market starts to rebound as NexGen products hit the shelves, we're very optimistic about this sector and our positioning within it.

At the same time, we continue to partner with some of the hottest gaming titles in the industry, such as the recently announced partnership with Watchdogs, in advance of that title's highly anticipated release later this month. This adds to our impressive portfolio of licenses which include some of the most popular video games in the world right now, including League of Legends, Assassin's Creed and Battlefield, to name just a few. We expect to announce even more exciting news on this front in the coming months.

In addition, our teams just got back from PAX East, one of the most significant consumer facing gaming events of the year, where the vibe in our booth was very strong. Astro continues to dominate the high-end of hardcore gamers, underscored by the brand's significant market share above $200. While consumer feedback at the show indicated that Skullcandy brand has earned permission to be part of the gaming community as well.

At PAX East, we also featured Astro's latest product line extension, the A38 Bluetooth noise canceling headphones. The reviews on the sleek-looking, extremely comfortable, innovative audio product had been fantastic. The A38 gives the consumer the flexibility to connect to their smartphone or tablet to enjoy music, streaming video or mobile gaming content outside the home, with the superior sound quality and design they've come to expect from Astro. And at approximately $225, it offers a compelling value proposition and is a great example of the remarkable products our teams are capable of developing.

Bluetooth is quickly becoming a bigger part of our product story as well. Air Raid has done really well since its limited introduction last holiday. During the first quarter, we partnered with RadioShack on a full-scale launch, and the sell-through have exceeded everyone's initial expectations. With its durable construction and powerful sound quality, it's a highly differentiated product, especially when a story is messaged correctly at retail and digitally, the loudest portable speaker and bomb proof with military-inspired specifications. Based on the early success we've seen with Air Raid, we are accelerating our expansion with a Bluetooth speaker line for the holidays.

Finally, we're excited to announce, we just signed a partnership with Spotify, one of the premier music streaming services in the world. The deal aligned Skullcandy and Spotify around driving additional subscriptions to Spotify through mutual promotions that elevate both brands. But more importantly, it opens the door to future collaborations between our companies. We're highly confident this combination will further strengthen our brand presence in the music world, a strategy that really just got underway in earnest this year, definitely more to come on this one over time.

On our fifth pillar, team in operational excellence. The foundation of our turnaround and future is our people, culture and values. This foundation is strengthening every day, and I believe it's proving a short- and long-term strategic advantage for us, as we turn revenue and profit positive for the year.

When this foundation is strong, we have an unbeatable and deeply vested team that then create remarkable and inspiring products and deep consumer connections. We continue to make important progress strengthening our organization through developing our current great talent and adding new best-in-class talent. We've implemented our holistic Skullcandy youth program to ensure our employees are receiving the necessary resources and support to excel at their jobs and overall lives. It's incredibly important to me that people work hard and are driving to be great, while also deeply enjoying and feeling committed to what we are doing.

This approach has also allowed us to attract some incredible people to the company over the past several months, and I'm confident this trend will continue as we work toward our goal of being the most desired employer with culture, talent and values at the core of our long-term strategies.

With that, I'll now turn the call over to Jason. Jason?

Jason Hodell

Thanks, Hoby. Hello, everyone, and thanks for joining us. In my section, we will start with a review of our first quarter 2014 income statement, then discuss our balance sheet as of March 31, and finally, we'll outline our guidance for the second quarter of 2014 and update our outlook for the full year.

First, our income statement. Sales. In Q1, we returned a positive revenue growth as first quarter net sales were $39.1 million as compared to $37.1 million a year ago, an increase of 6% and in line with our guidance on the last call.

Let's give you some details about these sales from a geographic standpoint. Historically, we have segmented North America versus international in our public reporting, and this transparency continues in our earnings release and forthcoming 10-Q. However, in order to better highlight our progress towards our turnaround pillar of growing international to 50% of sales, let's talk about domestic U.S. net sales versus non-U.S. net sales. That's moving our Canadian and Mexican customer sales into the international amounts to include international website sales.

Domestic U.S. net sales increased 1% to $26.1 million from $26.0 million a year ago. Non-U.S. net sales increased 17% from $12.9 million -- to $12.9 million from $11.1 million 1 year ago. The increase was primarily due to gains in Canada, Mexico, China, Japan, the U.K. and the Nordic region.

For the first quarter, these non-U.S. sales represented approximately 33% of our overall business, up from 30% a year ago. As a note, our domestic U.S. Q1 results did not include our initial test load-in with Walmart, which we expect in Q2.

In Q1, our gross revenue product mix move towards on- and over-ear headphones versus Q1 1 year ago. The share of on- and over-ear products advanced the 51% of sales from 47% 1 year ago, driven by the increases of the Astro portfolio and Crusher growth.

The share of in-ear products was approximately 42% of sales, down from 49% 1 year ago. And the remainder, speakers and accessories, was 6% of sales in Q1 this year versus 5% a year ago. As this was the launch of Air Raid, we note that speakers alone grew to 3% of sales from less than 1% in Q1 2013. These various percentages don't total to 100% due to rounding.

This shift is consistent with our strategic plan to expand known-for categories and partnerships, but not to be misinterpreted, we remain focused on winning the earbud market.

Gross margin. Our gross margin stabilized in Q1 versus a year ago. Gross margin for the first quarter finished at 46.5%, significantly higher than Q1 2013 at 44.5%, a year-over-year increase of 200 basis points. The increase in gross margin above our plan was driven by 4 key factors. First, increased invoice margins. As Q1 deals closed, our realized invoice and product margins were higher than those in the plan, in large part driven by a more favorable customer mix. Second, our improved ability to use returned product. This is the significant financial impact of returned product from our retailers now flowing back into inventory for resale and promotional use.

Third, lower supply-chain cost per unit of sale through increased efficiencies; and fourth, lower warranty expense from decreased warranty claim rates, a positive outcome in part, due to our shift away from being an outsourced product organization.

SG&A. With our SG&A spend, we are focused on continuing to drive down SG&A as a percentage of net revenue, while at the same time, driving demand creation and innovation spending higher. SG&A expenses for the quarter decreased 16% to $22.1 million or 57% of net sales, down from $26.3 million or 71% of net sales in Q1 2013.

This large year-over-year decrease in SG&A expenses is primarily due to: first, a significant reduction in write-downs of tooling, fixtures and furniture that occurred in Q1 2013; second, less severance expense; third, a lower performance-based compensation expense due to a change in our accounting methodology, which shifted the majority of that expense to later in the calendar year through revenue-weighted timing; and lastly, less bad debt expense.

Of note, demand creation spending was higher as a percentage of the SG&A total as compared to Q1 2013, with us spending slightly more dollars this quarter versus 1 year ago.

Comparing this SG&A result to our Q1 plan, we were under budget, primarily due to lower commissions expense, lower bad debt expense and the delay of some demand creation expenses to Q2, among other differences.

EBIT and net income. Our operating loss in the first quarter improved to a loss of $3.9 million compared to a loss of $9.8 million in Q1 2013.

Finally, our Q1 2014 GAAP net loss was $3.4 million or $0.12 per diluted share versus a net loss of $7 million or $0.25 per diluted share in Q1 2013 and compared to our guidance of a net loss between $0.16 to $0.18 per share. This upside was primarily driven by the higher-than-expected gross margin and lower SG&A than expected, which included the shift of certain demand creation expenses into Q2.

Balance sheet. Turning to our balance sheet on March 31, 2014, let's highlight a few items. Our cash and cash equivalents totaled $48.2 million as compared to $38.8 million as of December 31, and we have no bank debt similar to year end. The large increase since the end of the year was driven by the natural Q4 collection cycle and significant proceeds from the exercise of employee-granted options. Approximately 72% of our cash is held in domestic bank accounts.

Due to our high cash balance and projected free cash flow positive outlook, we are proactively reducing and improving the Wells Fargo line of credit. The line is being reduced from $15 million to $10 million, which significantly reduces line of credit fees, and the line is being improved by replacing the trailing 12-month GAAP net income requirement with a more flexible EBITDA interest coverage requirement.

Accounts receivable decreased 37% to $36.4 million from $57.5 million as of December 31, which is consistent with the seasonality of our business. Our allowance for doubtful accounts is currently $2 million, about the same as our $1.9 million allowance at year end.

Inventories were $42.7 million at the end of Q1, as compared to $40.3 million as of the end of 2013, which is consistent with seasonality. And our current inventory is down $9.4 million from $52.1 million 1 year ago.

Our inventory is currently offset by a $900,000 consolidated inventory reserve or 2% of gross inventory, which is down from 2.4% of gross inventory last quarter.

And the year-over-year decrease in inventory is a testament to the efforts of our supply chain team to generally run leaner on product stock and reduce the amount of close-out and end-of-life inventory through efforts that also maintain a healthy brand.

So in summary, the balance sheet has good liquidity, the line of credit is now more flexible and Skullcandy now has a net book value of equity of $140.5 million.

2014 guidance. Now I would like to share our thoughts on guidance. Let's focus first on Q2, and then we'll update our outlook for the full year. For the second quarter of 2014, we are currently forecasting net sales to increase year-over-year at the same rate we guided Q1, between 5% to 7% of net sales growth over 2013 levels. This is led by the expansion of our international businesses, while our U.S. results continue to be affected by the challenging domestic retail market. Q2 also includes our initial test loading with Walmart. We are targeting a Q2 gross margin of 44.5%. This is lower than our actual Q1 gross margin as some of those aforementioned gross margin benefits experienced in Q1 are challenging the forecast and may not be repeated.

We expect SG&A to be a similar total as Q2 2013, within a range of $23.5 million to $24.5 million for the quarter. This range includes SG&A spending pushed from Q1 to Q2, as well as anticipated demand creation audible spending, which I will discuss more below. This yields a Q2 GAAP diluted earnings per share of approximately breakeven.

For the full year 2014, we will review our guidance and update our EPS range to include a portion of our Q1 upside and a new annual tax rate estimate.

We still expect 2014 net sales to increase in the mid to high single-digit range over 2013, led by our international markets and new product categories, in line with our strategic plan. But as a reminder of our seasonality, the majority of our revenue will be generated in the second half of the year and is subject to many influences.

And with regard to the quarterly cadence of sales growth, we do expect that it will be somewhat variable as we enter new distribution and potentially see shifts with some accounts.

Our annual gross margin guidance remains unchanged at a target of approximately 44.5%. Again, this margin is lower than Q1 as some of the Q1 gross margin benefits we experienced are difficult to predict throughout the year after only 1 completed quarter.

Annual SG&A guidance remains unchanged at approximately 40% of net revenues, plus demand creation audible spending. We plan to continue unleashing this opportunistic demand creation audible spending that we approve and execute like we did in Q4, as long as we remain on or above our financial plan.

This audible expense is additional spending on demand creation, innovation, in-store training and in-store experience. It keeps Skullcandy on the attack, further driving brand and product awareness, and is generally variable in nature so that we can easily flex and ensure that it fits within our overall financial plan.

If we determine to proceed, these marketing audibles will increase over the rest of the year, and therefore be back-half-weighted with our launch of Skullcandy Sports Performance and the back-to-school and holiday seasons. We expect total 2014 audible spending to be in a range of $0.5 million to $1.5 million for the year, depending on our success and the opportunities that arise.

Our annual EPS guidance includes the impact of demand creation audible expense. More broadly, as you think about our planned quarterly total dollar SG&A spend, it should and will generally increase each quarter throughout the year with our largest SG&A dollar expense during Q4, which is, of course, also our largest quarter of revenue bookings.

The second major change to 2014 guidance comes from our forecasted annual tax rate. Given the blend of revenues, transfer prices and earnings across our portfolio of global entities, our expected tax rate is shifting. International growth is moving a larger amount of our modeled pretax earnings into is our Swiss GmbH entity, consistent with our strategy of driving international to 50% of the business. We intend to hold and reinvest these retained earnings in our GmbH entity and, therefore, we receive favorable tax treatment. Our newly forecasted annual global tax rate is approximately 18%.

With that said, please understand a few critical considerations. First, this effective tax rate is highly dependent on the level and mix of earnings from the various taxing jurisdictions, which are somewhat challenging to forecast and it is likely to fluctuate from quarter to quarter. Secondly, we are completing transfer pricing studies during Q2, which have the potential to change royalty and or cost-plus arrangements between our cross-border entities. As such, the tax rate can change as a result. We will provide an update on the rate and this work in our next quarterly call. With that said though, our new annual rate reflects our current forecast and best information at hand.

Finally, with respect to net income, based on our Q1 performance and this tax rate improvement, we are raising our outlook for 2014 GAAP net income EPS to be in the range of $0.16 to $0.20 per diluted share, up from our previous guidance of $0.10 to $0.14. $0.03 of this increase is due to the new tax rate, and the remaining increase is due to the Q1 upside after normalizing for SG&A spend we shifted to Q2.

In putting forth this new annual outlook, we want to remind everyone of the complexity of accurately assessing future earnings and revenue growth, given the competitive nature of the industry, the difficulty in predicting sales of our products to key retailers, changes in technology, sourcing cost trends and consumer preferences. Because of our consumer and innovation focus, brand strength, quality products, strong cash position and dedicated team of employees, athletes, sales reps and distributors, we are confident we can achieve our vision of being a global audio leader, deliver profitable growth and increase shareholder value.

Thanks, everyone. I will now turn it back to Hoby.

Seth Darling

Thanks, Jason. As you just heard, we've increased our earnings outlook for the year as our return to profitability has gained momentum. In addition, our Q1 gross margins stabilized and improved from a year ago, and we are driving improved expense leverage while continuing to invest in key long-term growth drivers such as demand creation, innovation and talent. They're both clearly budgeted initiatives as well as more flexible variable demand creation audibles.

The plan we laid out a year ago and have been refining over the past 12 months is working, and we are on plan. While we are only a year into our turnaround and overarching strategy to establish Skullcandy as a global audio and innovation leader and be the original performance in lifestyle audio brand, driven by the creativity and the reverence of youth culture, the pace of progress over the past 12 months has been tremendous and something I'm extremely proud for the team.

I want to thank everyone at Skullcandy, our partners and our teams for all their hard work and commitment to turning the business around and putting the company on a path towards exciting consumers and sustainable sales and earnings growth. I'm excited about the future, and we are on the attack.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Ed Yruma with KeyBanc Capital Markets.

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

I guess first, on the demand creation marketing activities that you have baked into the model, I think you said it was $0.5 million to $1.5 million. How should we think about -- and I think you indicated it will be more back-end-weighted, but do we use the midpoint in terms of what you baked in your guidance? How do we think about the puts and takes that would make you use that demand creation fund?

Seth Darling

Yes, I think -- first, this is Hoby -- and big picture when we think about that, really important to me that we're investing back in this company, both for the short and long term. And the way that we want to do that is instead of just putting fixed budgets into that demand creation pool, we want to make sure that we are on plan, we're doing the things that we say we're going to do, and that we have some variable expenses to really go drive the brand even more and accelerate and amplify even more. So it's a little bit tough to go, hey, here's exactly what to plug into the model because some of that is dependent on the opportunities that we see come up, and some of it is dependent on ensuring that we are on plan, right? And so when we designed that, we wanted to make sure, hey, if we're not on plan, we'll pull that back significantly or maybe not even do it. If we are on plan or accelerating or above plan, those are things that will amplify it to the high end of that $1.5 million number. So there's a little bit of flex in there. That's the way that it's really designed to be, just big picture. And Jason can probably give you a little more color, too.

Jason Hodell

And then Ed, in terms of the guidance itself, the Q2 SG&A estimate does include anticipated audibles in Q2, and then the EPS estimate for the year does include the full $1.5 million. So we're assuming success that way. But as Hoby said, we can flex it up or down as long as we stay on plan.

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

Got it. And I know that the sales growth forecast really does begin to account really the international growth. How do we think about the core U.S. growth x the Walmart shipment? What are you baking in for both 2Q and for the remainder of the year?

Seth Darling

Yes, on the Walmart side, we're not going to hop into the specific numbers on Walmart. It's an early test and partnership with those guys, so not specifically hopping into that. I mean, I think what you saw this quarter, right, was, hey, we are growing both internationally and domestically x Walmart. When we look forward as a business, what does success look like, we need to be growing both of those businesses and they're both important to us. So we're going to strive to grow both of them as far as exactly how Walmart fits in there for the year. That's really just the initial start of what's hopefully a really good partnership for a long time. So I don't want to jump in too much on that, Ed and cloudy those waters.

Operator

Our next question comes from the line of Dave King with Roth Capital.

David M. King - Roth Capital Partners, LLC, Research Division

So I guess, first, I appreciate all the color in the prepared remarks because it addressed a lot of my questions. But in terms of the guidance, maybe following up on Ed's, a little bit, question, which was the international versus U.S. So within it, it sounds like 5% to 7%, the bulk of that is still international, even though in the first quarter, you still had some domestic growth. I mean, should we be still thinking about domestic kind of being down in terms of that guidance? Or is it fair to kind of assume the same kind of pace that we saw in the first quarter in terms of U.S. kind of stuff? Or what are you guys thinking around that?

Jason Hodell

Right now we opted to leave the sales growth rate consistent with Q1, and we're watching the growth rates very carefully, international and domestically. We're super proud of the pickup in growth rates across the board in the countries that we mentioned. Domestically, it's a little tough to call right now, so I think it's fair to characterize us as being conservative right now with the domestic outlook, Dave.

Seth Darling

Yes, I mean, Dave, I think just [indiscernible] and just big picture a little bit. I mean, if you think about the strategic plan and those 5 key pillars, right, and the big part of that on marketplace transform, has to do with the U.S. and making sure that we're cleaning up this market. At the same time, we're amplifying. And the ad part is a small piece of that, so I just don't want people to get too overrun on -- or too over-revved on the U.S. and Walmart and so forth. There's a reason that we have 50% of the business wanting to go to international. Right now, that's a really strong business for us, where we have a super strong brand and the products are doing really well. The U.S. market, I think right now is in a little bit more of a turnaround both from just where audio is and where we go win. With that being said, as I said to Ed, our goal is we want to grow above those markets. They are both important markets. At the end of the day, the brand that we are, that has to emanate from Park City, that has to emanate domestically to be successful internationally. And so that's why we'll invest those demand creation dollars, make sure that we're accelerating there, and make sure that we're winning domestically as well as internationally.

David M. King - Roth Capital Partners, LLC, Research Division

Fantastic. And then in terms of the specific guidance around earnings, Jason, it sounds like some tax benefits included in the full year kind of guidance. There's an SG&A shift that's been moving, but obviously, you had the first quarter upside. Is there anything else there in terms of differences versus your plan that we should be aware of in terms of offsets? Or is that -- all of that is still kind of status quo versus what you we're thinking heading into the quarter?

Jason Hodell

Why don't we take a moment and just walk people through that math because we were in a loss position in Q1. It can get just a little bit confusing. So let's go through the puts and takes on guidance. So if you take the middle of the guidance range that we gave for Q1, it was $0.17. Of course, we beat that by $0.05. The issue is that our tax rate shifted as well. Whenever the tax rate moved from 31% to 18%, it actually made -- it actually created a $0.02 difference in our reported results. The lower tax rate made our loss worse. We would've been at a $0.10 loss with the 31% tax rate. What that means then is that from an operational perspective, we actually beat guidance by $0.07, okay? So now let's fast-forward to the end of the year. We shifted our end-of-year guidance by $0.06. $0.03 of that is the tax rate. So if you figure out how much the tax rate shift from 31% to 18% moved, EPS, it's $0.03. So of the $0.06 move, $0.03 is taxed and then the other $0.03 is operating our performance from Q1, which means the remaining $0.04 of the operational beat from Q1, that is the SG&A shift of demand creation dollars that I talked about in the prepared remarks.

David M. King - Roth Capital Partners, LLC, Research Division

Okay, so the SG&A shift is $0.04. There's nothing else in there in terms of gross margin or anything else that we need to be aware of?

Jason Hodell

It's almost -- that's right, it's almost all SG&A shift.

David M. King - Roth Capital Partners, LLC, Research Division

Okay, perfect. And then I guess, lastly, in terms of profitability longer term, as we look out, whether it's normalized 3 years out, and as you think about this company and you think about investing in demand creation, all those kind of things, looking back at what you did in 2012 in terms of earnings back then but you had some discount channel stuff you did $1 then, how should we be thinking about some of the different line items or just the profitability for this company as we look out a few years?

Seth Darling

Sure. Dave, I think big picture, from a CEO perspective on just what do I expect great companies to be able to do, right? I think, great companies grow at double digits. And kind of if you look in our industry, they're kind of in those mid-45s gross margins, and you can look at the SG&A leverage that most companies are getting the low 32s. So I think when you think about our long-term model of where we want to be, we want to be a great company. Now exactly how long does it take to get there, no, I don't think we're ready to start talking about that. What I do think is that there's definitely opportunity in the future above what we're doing and what I would kind of call this our return to profitability and return to revenue year. And long term, I'd be disappointed if we didn't exceed what we're delivering right now.

Operator

Our next question comes from the line of Ryan MacDonald from Northland Capital Markets.

Ryan MacDonald - Northland Capital Markets, Research Division

First off, so obviously, you saw some -- you put up some great numbers, international growth. Can you just discuss how's the landscape there different than what we're seeing in the U.S.? I mean, what do you think is attributing mostly to the success there? I mean, is it really a big shift in terms of competitive landscape? Or are there similar competitors in the U.S. and you're just performing better?

Seth Darling

Yes, I mean, overall, if you look internationally, number one, it's always interesting to try to break down international, right, when you think about what that means or even the direct areas that we're in and then try to take a global view on that. So a lot of different things going on, whether you're talking about the U.K. versus China versus Australia, et cetera. So a little bit hard to group that all into one place. I think that overall, though, when you look at as you think about the infancy that our overall international business is in, right? We've really only been an international company in a significant way for a couple years, when you talk about direct ownership and being there in a meaningful way. So it's still really early on for our international business. So that contributes to, in some ways on -- there's just more opportunity when you are a smaller business. You're out there from a global perspective and win market share. I think with that being said, what's important about that, though, is we are really committed internationally to doing the right things, being in the right doors, and so, much more strategic than I'd say, maybe when we were even in the U.S. historically in past times. So part of it's the infancy of the business there's going to be growth there. I think you also look at some of these geographies, and I'll use both China and Japan as examples. You look in Japan, and Crusher is the #1 selling headphone for us. That's like over $100 in Japan. That's a premium headset in Japan when you start to take what we sell it there for. Yes, we've done a great job, and in Japan, they get the product innovation. They understand the difference that we're bringing to the market, and they're adopting on that. And our brand is superhot there right now. They can sell our products. So you see that similarly in China. Crusher is our #1 over-ear headphone in China. And so in those territories, I think we're doing a great job teaching the consumer both the performance story, as well as the lifestyle story. I think internationally, our lifestyle American Heritage culture, I think that, that plays really well. And then I think to go on sort of the other end of that barbell from Crusher, if you look at that at the rest of the world, the buying power is just less than it is in the more developed markets. And so for us, when we look at our brand and we think about having a premium ethos, yet at some accessible price points, with that heritage, authentic lifestyle around action sports, music, art, film, that really resonates in a lot of those markets in a very strong way. So I think you combine those and that's a pretty interesting international growth story for a while to come.

Ryan MacDonald - Northland Capital Markets, Research Division

Okay. And in terms of you guys spoke about accelerating the rollout with the Sports Performance buds and also I think the Air Raid in your commentary. I mean, can you kind of define more or clarify more what that acceleration would mean? Does this mean shortly after your launch that you're going to be focusing on your largest distributors right away? Or I mean, can you give us a little more clarity or a little more sense of how that'll play out?

Seth Darling

Sure. I mean I think whenever we think about distribution moves, it goes back a lot to those 5 questions we talked about last time, and that applies to products as well. So if we think about where's our Sports Performance consumer shopping, that's what's going to lead us, and then we're going to look at, what are the doors that other active headphone-makers have had success. And I think you'll see us go there, and you'll see us go there with innovative and differentiated product. But it's just a whole lot -- the Sports Performance market is a whole lot more developed than, take the Women's market as an example. It's really a market that we're defining through innovation. Sports Performance, it's a market where people are running at it, people are seeing success. The consumer understands it. And so we can run much faster at that with our innovation stories and really look to take market share in that.

Operator

Our next question comes from the line of Andrew Burns of D.A. Davidson.

Andrew Burns - D.A. Davidson & Co., Research Division

I had a I guess, a sort of multifaceted question in terms of your in-store display strategy. So it sounds like, from the Crusher installations, you're getting really strong response. What's in the budget or the potential to add more of those installations? And then secondarily, you have these innovation stories with women's in the sport line. What's going to be the strategy to get you a widespread signage in-store to tell those stories?

Seth Darling

Sure, absolutely. So I think number one, as we've been very consistent over the last year when we talked about where we will put demand creation dollars, we are going to focus on digital and in-store and then, when the world is watching, and grassroot events. So when you think about all of our focus, one of the big ones in that is in-store. I mean, we will starve almost everything else to win at digital and win at in-store. We know with the innovation that we're bringing to market that we have to be able to tell a great story in-store. The great part of that now is from around the globe, we have some great examples of when we do a great job in-store, here is the ROI that we can achieve when done well. And so while I don't have a dollar amount to give you specifically or even a percentage of demand creation, I can tell you that when you think about where we have to win and where we will allocate dollars, in-store is a huge piece of that. So I think you have our commitment to we're going to go win in-store. From a perspective of Sports Performance and Women's and winning pegs, I think of a couple things. On the Sports Performance side, as I said, that's a market that is there. We're still in the early part of it, but I think the big piece is the way that we position the product in innovation. It really resonates with retailers. And so you go look at the pegs at most doors, ranging from a Best Buy or a Target down to a core mom-and-pop sports store, the buds that are there right now, they are much more positioned around that run slowly, bike slowly for long distances. And what we see when you look at what is our muse doing and what our consumers doing right now, there's a significant shift in the way that they're training and the way that they're exercising, what they're going out to do to be in shape. And that's way that we position this product. When you start to go through the growth rates around things like functional training, around things like CrossFit, obstacle runs, Spartan runs, Tough Mudders, those categories are growing at astronomical growth rates. For sort of the typical 10K, 5K going to the gym and pump it out a couple of sets, those growth rates are much slower. And so that really resonates with a retailer. You start talking about where is the world going? And our market or the way we've taken our product is positioned in that way and it's designed in that way -- for security, for durability, sweat-proof to make sure that we can help that athlete have more fun and enjoy their training. So that's resonating really well on our positioning. And on the Women's side, that's one where we have to teach the market a little bit more, and that's why we're seeding it much more than we are with Sports Performance. We need to be able to go out to the market and tell the story that men and women hear differently, and that's one's backed up by a university research, it's backed up by our internal research. But that's a new idea to most people. And so there's some training we need to do there. What I can tell you is when we take it into a retailer and you start to take them through the research and you start to take them through showing, guess what, men and women hear differently. As logical as that seems, people just haven't thought about that, but that's a teaching moment around innovation. And so when people hear it, they get really excited about it and they want to allocate peg space to it. But I think we need to win and show that from a customer demand perspective, we can tell that story well before we start to roll it out in the greater distribution.

Andrew Burns - D.A. Davidson & Co., Research Division

Another question on the international, there's a lot of opportunities, whether it's audio versus gaming, new markets versus greater penetration in existing, what are the real needle movers in '14, sort of the biggest in terms of dollars, growth areas that we should be focused on for the balance of the year?

Seth Darling

Yes. I mean I think the biggest opportunities when you look at them by dollars, Europe is the biggest territory there, and so the smaller percentage differences provide absolute dollar increases. But I think what you're talking about where the growth rates are great are when you look at Canada, which is a territory that we just took over last year in Q2, I believe. You look at the potential to grow in China, where the brand is resonating very strongly, and the same in Japan, where we have a great brand, great brand heat. I think there's a lot of growth in those territories. When you start to break it down a little more in Europe, the U.K. is a big part of that growth. That's where we penetrated the most. We talked about really that focus on the U.K., the Nordics, Germany, as focus areas in Europe. But like I said, when you're only a couple years into that project, I think keeping us focused is really important, because, to your point, there are of lot places that we can grow and a lot of places that we can go into. So we're going to focus on those territories that we own. We're going to focus on those territories that we think that we can see significant growth, but more importantly, where we think the brand can resonant and where we can tell a great innovation story.

Operator

Our next question comes from the line of Robbie Ohmes with Bank of America Merrill Lynch.

Rafe Jadrosich - BofA Merrill Lynch, Research Division

This is Rafe Jadrosich in for Robbie. Just in terms of international, can you just remind us where you're direct versus distributor? And then kind of what the margin profiles are of that business -- of those businesses? I mean, are there any -- is there any more opportunity to take any of those markets direct?

Seth Darling

Sure. So from a direct perspective, Europe is the territory that we've been in the longest, where we took over a distributor, then China, Canada, Japan. And then in Mexico, we have a joint venture. So those are the direct territories. We speak a little bit less on Mexico just because it's a joint venture, but it's actually a territory that's doing great for us as well. I think it really fits with, again, that premium ethos at an accessible price point. So those are kind of the big 5 when we think about direct.

Rafe Jadrosich - BofA Merrill Lynch, Research Division

Can you just talk about the margins in your international business versus the U.S.?

Seth Darling

Yes. I mean, it depends on territory a little bit in areas where we are completely direct from subsidiary to retailer. I mean, you have great international margins, right? I mean, I would say consistent with what you see with other companies that are direct to retail in international markets. That margin goes down a little bit in places where you have a subsidiary and then have a distributor who's then selling to retail. They come down a little bit, but overall, like most companies, our international margins are really solid from a gross margin perspective. And then every dollar that we have internationally, just because of the tax rate, it's a great sale for us, and that's part of the reason when we think about growing international to 50% of our business, part of it is because we think we can do a great job there, grow revenue and excite consumers. Part of it is also we make a lot of money when you sell internationally, and so that's an important focus for us.

Rafe Jadrosich - BofA Merrill Lynch, Research Division

And just on the gross margin outlook, can you -- I guess, after the 1Q upside, it sort of looks like the back half some of the quarters might be down year-over-year. Can you kind of talk about the puts and takes of that, just given the fact that your inventory is cleaner and you've had a big off-price reduction, kind of what are the drivers to that outlook?

Jason Hodell

Sure. So we mentioned the 4 major drivers in the prepared remarks, and those are roughly in order of magnitude. So the reason that we didn't shift the overall year gross margin expectation, frankly, is because so little of the year is determined by Q1 -- It's only about 1/6 of the sales -- so we have a long ways to go. And then the marginally impact of just the Q1 margin beat, at the end of the day on the whole year is fairly small. So Hoby and I want to take a wait-and-see attitude with what's affecting gross margin. A few of those things, as we model gross margin, are very difficult to predict, and I'll just take the second one because it's actually a very large driver of the gross margin beat this quarter. But the new program we have to return our product that has been returned by our retailers into our inventory to use it for resale or promotional or to refurb it and then sell it again online, that's a very powerful program. But it's just kicking off and it's difficult for us to figure out exactly how to forecast that in the model. So again, we're taking a wait-and-see approach. We opted to hold the year constant for now, and we'll update this in the next quarter.

Operator

We have no further questions in queue at this time. I'd like to turn the floor back over to management for closing remarks.

Seth Darling

I want to say thank you to our shareholders, our employees, our teams. I mean, the pace of recovery I think that we've had over the last year and the work that people have put in to this turnaround has been remarkable. So I just want to give a salute out to our entire team and thank everybody for their help and investment. Thank you.

Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.

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