Skullcandy Q1 Report Proves The Core Brand Growth Story Is Dead

| About: Skullcandy (SKUL)


Skullcandy loses less than expected in Q1 but misses on revenues.

Company increases EPS guidance for the year by $0.06, sparking a rally.

Deteriorating US sales picture offset by temporary margin expansion.

Piper Jaffray analyst reiterates Underweight rating on the stock.

Financial engineering is the real cause of the higher margins, not performance.

After reporting results on Thursday, Skullcandy (NASDAQ:SKUL) stock shot up after hours as high as 15% on low volume and reached nearly $9 on Friday morning on relatively moderate to heavy volume. My initial reaction to the report was that it would be viewed as negative. The company reported a loss of $0.12 per share compared to estimates of a loss of $0.17. The big takeaway for me is that top line sales missed estimates by $130,000. This is not a significant amount to miss by but recalling the prior 2013 Q4 earnings where a tiny revenue beat sparked a rally as high as 50% intraday my initial thoughts were that sentiment would be negative and the stock would sell off based on this.

However, as I read through the report I noticed that the company upped EPS guidance for the year by $0.06. The increased EPS guidance clearly clicked with investors. They caught the bait and the stock traded up considerably. Momentum players who bought the hype will likely be mourning the loss of their money shortly as the move is not sustainable. It will be interesting to see how many insiders dumped shares Friday morning like they did following the Q4 report. There are only a couple days a year that it is possible to sell a significant amount of Skullcandy stock and not tank the stock price and these guys seem to take advantage of every opportunity to do so. I still continue to be pessimistic of the turnaround despite the well received report.

Before I discuss my updated thoughts based on this new information, I'd like to explicitly state that despite my bearishness on the business, I do not find any compelling reason to be short the Skullcandy stock. Not a day goes by when somebody questions my motives on Twitter or by private message saying that I must be short Skullcandy. Fact is, there are much better shorts out there and I already disclosed the stocks that I felt made good short candidates at the time I became bearish on Skullcandy in early March.

These shorts that I noted having a position in and mentioned in that controversial article are down collectively by about 30% in 2 months. So I was right. These were compelling risk/reward short trades, but Skullcandy is not. However, I think the stock is overpriced by a significant margin because of deteriorating US sales. For all intensive purposes the growth story is dead. But due to the consistently strong balance sheet and cash position, coupled with the superb growth of Astro Gaming, being short this stock makes no sense. If it gets to the teens, that is a different story but for now the play in my opinion is on the sidelines. There still remains a chance that the company could be acquired. The story is very similar to True Religion and the company is attractive to private equity for a number of reasons that I have outlined in past research.

I'm pretty sure that the company reads my articles as the first thing that Hoby Darling addressed on the call is something that I have hammered them on repeatedly in the past. That is online channel stuffing and maintaining MAP. So now a concentrated effort has been made to enforce minimum pricing in digital channels and this is great. It cleaned up the Crusher undercutting on (NASDAQ:AMZN) that I referenced in March and is able to maintain the price of the Air Raid. I do note that one of Hoby's key objectives during 2013 was to maintain MAP on the new Smokin Buds 2. This has failed and the product has now been conveniently discontinued.

Now for those who don't understand how retail works, allow me to explain. It is a bit of a shell game for these companies. To make the numbers they need to channel stuff and stick unsophisticated resellers with as much inventory as they can with impeccable timing. They create demand on a product and then take as many orders as they can and dump them on retailers. This occurs in a fashion similar to the promotion and then selling of company stock from insider to retail investor. It is nearly impossible to regain trust with retailers using this strategy and while you can fool smaller retailers it's only going to get you less than favorable terms with larger retailers in the future. Regardless, any way you want to slice it, this approach has been perfected by Skullcandy. Remember that the Smoking Buds 2 was a "Halo" product last time we heard from Hoby - now it is discontinued and the channel is infinitely stuffed with inventory nobody will be able to sell near MAP. Gaming retailers is a cat and mouse game and not an entirely sustainable long-term business model.

Skullcandy has hundreds of SKUs and have only been able to maintain MAP on the Crusher (and only after recent efforts following my critique of this) and the Air Raid. Overall this doesn't impress me. With Smokin Buds 2 gone, what will be the next shoe to drop to make the numbers next quarter and the quarter after? Ex-CEO Jeremy Andrus led one of the most prolific channel stuffing campaigns that I have ever witnessed and consequently destroyed the value of every product while consistently beating the numbers quarter after quarter until it inevitably caught up to the company in Q1 2013. Accordingly, as of today there is no value to manufacturing almost all of the current Skullcandy products as the millions and millions of dollars of inventory still exist in the hands of retailers that cannot give it away. All of the evidence of this is on and is no secret. So if products are not worth the cost of manufacturing, the value of the brand quickly becomes worthless and it becomes a commodity business. Out of all the Skullcandy core brand products, it is hard to argue that any have significant brand equity apart from the Crusher and to a much lesser extent, the Air Raid.

The question remains, can Hoby wipe the slate clean and reinvigorate growth with Crusher and Air Raid as really the only compelling products in the core brand? Although he is very optimistic about the women's line, I explained why that will likely fail in a Seeking Alpha PRO article that I wrote on April 19. I find it interesting though that he described the women's Knockout as a "Halo" product - one of the top 3 products that will define the company going forward. That sounds great on a call but he cannot be serious. Being that it is just a dressed up Navigator, my opinion is that this line will be the next Smokin Buds 2 and discontinued and channel stuffed by this time next year. Clearly this game can be played over and over. Andrus and company founder Rick Alden did it for years, very successfully. I think it's an incredibly ingenious way to work through the unsellable Navigator inventory that was previously channel stuffed beyond recognition.

The Q1 report confirmed my thesis that the core brand sales are eroding, perhaps quicker than even I anticipated. US sales are up only 1% from Q1 2013, and that includes Astro Gaming which I estimated in my last report to have significant gains year over year. So given that Astro Gaming sales are likely up quarter over quarter (again the company will not break these numbers down formally), it is only logical to conclude that Skullcandy core brand sales are in significant domestic decline. Hoby can talk about "innovation" and "pillars" and "amplify" all he wants but it is hard to ignore this fact. The fundamental business model has shifted. So now they are growing internationally, and rapidly. I don't see this shift as sustainable long-term without strong US growth. It is very easy to stuff channels overseas and companies always have strong initial international sales when breaking into new markets but the pace normally slows down following initial demand creation efforts and retailer orders.

Sean Naughton, an analyst with Piper Jaffray, reiterated his Underperform rating on Friday. He noted:

Skullcandy reported Q1 EPS of ($0.12), exceeding guidance and consensus expectations due to gross margin upside and expenses shifting to Q2, partially offset by an unfavorable tax rate. Based on the Q1 results, the company raised its full year EPS guidance by $0.06. Positive news included strong sell-throughs of the Air Raid Bluetooth speaker, more speakers being introduced for the holiday season and entering the first Wal-Mart (NYSE:WMT) stores during Q2. While there are signs of a turnaround at Skullcandy, we remain concerned about the lack of growth at existing accounts in the U.S., specifically for headphones. We are raising our price target slightly to $7.50, but are maintaining our Underweight rating at this time as we want to see growth in existing U.S. doors before becoming more constructive on SKUL shares.

I share this sentiment. The margin growth in the quarter to 46.5% is likely temporary as it is a result of cost cutting. Long term that is not sustainable. You can only cut costs so much and much of it was addressed in the recent 10-K filing as savings from the office closures and executive departures. None of this really impresses me long term as a trend to watch. CFO Jason Hodell, while making a prominent point of the Q1 margin expansion in the earnings news release, stated on the call that Q2 margins will contract to 44.5%. It does not appear that there will be a positive trend of margin expansion and this was likely more of a one-time event. Just like the positive EPS guidance increase, which half of it was due to favorable tax benefits. In fact, entry in to Wal-Mart will likely pressure margins going forward. Investors should watch this metric carefully. SA Contributor Stan Ackman makes some very interesting points. He reiterates many of my own suspicions with regard to the financial engineering of the margins:

According to SKUL's geographic segment data, gross margin of international sales decreased to 44.9% from 48.1% year over year. So, we know the 19% international growth bears a price. It is so easy to stuff the channels in the international market... North America segment, where the gross margin is stronger, only show a sales increase of 1.3%. As many have noticed, this is where SKUL has shown declining popularity. I am sure SKUL may find more doors to reach in the international market, but the weakened margin means the real demand of SKUL abroad is not there.

Overall, despite the bullish sentiment of the earnings release and Hoby's killer delivery, I remain bearish on Skullcandy's future prospects. I do confirm however that this is not a good short target and a fair valuation of the company in a strong market is about $6 per share. I base this on projected 2014 profits of $0.20 per share, which implies a PE of 30. That is a very generous assessment but I give credit to the company for a strong balance sheet, plenty of cash, no debt and a red hot Astro Gaming division that is firing on all cylinders. I see the potential of a takeover as moderate to high down the road, but would expect the stock to sell off first to the $5 level and then be taken out at a premium close to today's share price. Given the tepid growth it is unnecessary for any acquirer to overpay for Skullcandy so no trade should be based upon this but it may be worth revisiting when the stock trades considerably lower.

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.