Skullcandy's Earnings Are Not As Rosy As They Appear

May. 2.14 | About: Skullcandy (SKUL)

Summary

Skullcandy's earning beat was achieved by cost-cutting, rather than stronger-than-expected sales.

International sales, the main growth driver, were driven by lower gross margins.

Strong domestic gross margin was helped by one-time benefits.

Wal-Mart's contribution to domestic sales was not satisfactory.

The 2014 EPS outlook raise was mostly caused by favorable tax rate.

On April 30, 2014, Skullcandy (NASDAQ:SKUL) announced its Q1 2014 earnings. While it beat EPS estimates by 5 cents, it missed revenue estimates by $0.13 million. The immediate market response after-hours and pre-market was a jump of share price with relatively thin volume. As a stock mostly owned by retail investors (institutional ownership is only 37%, according to Google Finance), Skullcandy can easily get positive reaction from less sophisticated traders/retail investors with headlines such as "earning beat" and "raised guidance." As sophisticated investors, however, we need to examine how Skullcandy achieved such headlines.

First, the earning beat was achieved by cost-cutting, rather than stronger-than-expected sales. In his prepared remarks, CFO Jason Hodell said: "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." These factors offer little indication of Skullcandy's long-term turnaround. Hodell even added that "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." Therefore, part of the SG&A beat is just a timing difference.

Second, on the gross margin side, I find something really interesting. Even though the headline gross margin percentage strengthened to 46.5% from 44.5% a year ago, the contribution of this strength was diverged. Using the segment information section of the earnings release, I did a gross margin percentage calculation by geographic segments. North American gross margin increased to 47.0% from 43.5%, while international gross margin decreased to 44.9% from 48.1%. Although international sales growth of 19.7% helped Skullcandy avoid missing revenue estimates by too much, the double-digit growth bore a high cost by lowering gross margin percentage by more than 300 bps.

In the Q&A session of the earnings conference call, CEO Hoby Darling initially avoided a question from analyst Rafe Jadrosich of Merrill Lynch regarding the international gross margin outlook. Jadrosich asked again when the question was not answered at first. Darling reluctantly gave a vague answer by mentioning the weak international gross margin was due to joint ventures that cut the gross margin. I do not buy that answer in that Skullcandy always uses joint ventures with these international markets. The fact is that the company has to sacrifice more than 300 bps gross margin to satisfy its joint venture partners in order to meet its sales goal.

Furthermore, Hodell reminded us that the high gross margin experienced in Q1 is not sustainable. It was helped by many one-time benefits. Investors should not expect the same high level margin in Q2, and certainly not the rest of the year. When asked about the long-term margin goals of Skullcandy, Darling said that a great company in the industry should have gross margin of 45%. Obviously, Skullcandy is still far from great, so in the near and median term, the company will not see sustainable gross margin above 45%.

One exciting thing Darling mentioned in the Q4 2013 conference call was the addition of Wal-Mart (NYSE:WMT) as its retailer. There was hype built for that news. However, in the recent conference call, Darling only used vague words like "Wal-Mart has been a great partner," to appreciate the partnership. When asked about the specific numbers from Wal-Mart, Darling mentioned that "on the Wal-Mart side, we're not going to hop into the specific numbers on Wal-Mart. It's an early test and partnership with those guys, so not specifically hopping into that." Thus, the language from Darling really implied that Wal-Mart was not doing great with Skullcandy's products.

Last, regarding the 2014 full-year EPS update, Hodell mentioned a few times that 3 cents of the 6 cents EPS guidance raise was a result of tax rate differences. Given that Skullcandy already beat EPS estimate by 5 cents in Q1, we should not consider the 6 cents full-year EPS upgrade an indication of a brighter future.

Long-term Implications

My philosophy toward earnings is always about breaking out the facts from underneath the surface and evaluating their long-term implications. Skullcandy is known as a turnaround story. That is the goal that many investors are hoping for. However, weak domestic sales growth, combined with lower-margin international expansion shows that Skullcandy's brand has not gained traction yet. Otherwise, we would have seen stronger domestic growth, which is the main battlefront where Skullcandy has pushed to build its brand strength.

It is also alarming that Skullcandy has to sacrifice gross margin by so much to push for international growth. I understand that international growth is a main pillar in Skullcandy's growth strategy, but rushing it by lowering gross margins is not sustainable. In the end, sustainable growth in the international markets should come from brand strength, rather than repeated distribution expansion/stuffing.

Conclusion

The pre-market action after earnings were announced was mostly built by nice-looking headlines. Once we break the surface, we can see the outlook underneath is not as rosy as the outside appears. There is little evidence from the earnings release and conference call indicating positive progress with regard to the turnaround. Investors should not consider the jump in share price in the pre-market to be an indication of a successful turnaround.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.