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Skullcandy (NASDAQ:SKUL)

Q2 2014 Earnings Call

July 31, 2014 4:30 pm ET

Executives

Patrick D. Grosso - Chief Legal Officer, Vice President of Strategic Initiatives & Corporate Affairs and Corporate Secretary

Seth Darling - Chief Executive Officer, President and Director

Jason Hodell - Chief Financial Officer and Principal Accounting Officer

Analysts

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

Lee J. Giordano - CRT Capital Group LLC, Research Division

Daniel R. Wewer - Raymond James & Associates, Inc., Research Division

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

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

Jay Sole - Morgan Stanley, Research Division

Randal J. Konik - Jefferies LLC, Research Division

Ryan MacDonald - Northland Capital Markets, 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 Second Quarter Fiscal 2014 Earnings Conference Call. Presenting on today's call will be Mr. Hoby Darling, President and Chief Executive Officer; and Mr. 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 call over to Mr. Patrick Grosso, Vice President, Strategic Initiatives and Corporate Affairs. Please go ahead.

Patrick D. Grosso

Good afternoon, everyone, and welcome to Skullcandy's Second Quarter Fiscal 2014 Earnings Call. Before we begin, I want to 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 the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

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

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

Seth Darling

Thanks, Patrick, and thank you for joining us this afternoon. We are pleased with the progress our team made in Q2 against both our short-term goals and our long-term vision. While we have much work to do, our positive momentum is increasing.

Revenue was up as planned and profitability exceeded forecast on an operational basis as gross margin was up slightly from last year. Each piece of our organization played an important role in our Q2 results. Revenue growth came from both domestic and international channels; new innovative products like Crusher continue to sell well and excite consumers; while expansion of new categories, such as gaming, women's and wireless, all contributed to our growth.

We're mixing in-house talent with new talent from outside like the addition of proven veteran Dave Raffone as our new Chief Sales and Revenue Officer. We are also continuing to invest in the future of the company overall with increases in spending for demand creation and innovation planned for the coming quarters, while also demonstrating our desire to be disciplined and gritty by decreasing other areas of SG&A. I'm really proud of the team for the success we've achieved so far in 2014 and what we are building. It has the entire organization excited about what this company is capable of in the months and the years ahead.

Now let's discuss the progress we made against our 5-pillar strategy during the quarter. As a reminder, our pillars are: one, marketplace transform; two, create innovation in the future; three, grow international to 50% of the business; four, expand and amplify known-for categories and partnerships; and five, team and operational excellence.

Beginning with marketplace transform. Editing of low-margin and brand-dilutive accounts continues to elevate Skullcandy's premium yet accessible brand position. Sales to the off-price channel were once again in line with our internal guidepost as we continued to adhere to the strict guidelines we've put in place. At the same time, we are having success enforcing MAP on new styles like Crusher, Air Raid and Knockout. This is a constant battle for any brand in today's global marketplace, but we are now in a much stronger position to monitor our channels and regions and take necessary actions to protect the brand.

Just in the past few weeks, we again cut multiple accounts for breaking our MAP guidelines. We have to be vigilant maintaining the value of our products and look and feel in our global marketplace in order to be a great brand long term. The brand and protecting price have to be above short-term revenue gains.

In terms of amplifying, our efforts have been concentrated on enhancing our in-store presence so that the consumer experience is on the same level with the strength and premium ethos of the brand. The main focus of our retail marketing team right now is to improve the look and feel in-store and ensure that our listening stations are working properly. It is critical that consumers are able to experience differentiated technologies like Crusher in order to fully appreciate its immersive qualities and how different the product is from everything else on the market.

The initial in-store work is focused on our largest accounts and also the most influential smaller, independent accounts that drive brand strength. While it is early in the process, we've already seen a positive impact on the sell-through in the doors that have been touched thus far. We still have work to do with some of our key specialty and middle-tier accounts, but I believe the trend of performing well with our largest accounts, and seeing upside with some of our most influential accounts, shows that we have the ability to improve our business across our distribution pyramid. Another good sign on brand strength and relevance with our 20-year-old influencer Muse is that our college accounts were up for the quarter. While early, these are positive signs of brand strength improving, and the hard work of the team's showing progress.

Efforts to amplify our distribution extend beyond our retail partners to also include our own e-commerce websites. Under new leadership, our digital team has made great strides improving the pivotal area of our business by stabilizing revenue and better connecting with our consumer via digital.

It's Skullcandy's projected premium ethos that it needs to be conveyed across every touch point, beginning with our direct-to-consumer channel and digital and social media. The recent upgrades we've made in digital and social media, such as the creation of our new Skullcandy women-specific Instagram account, the rollout of more creative banner, email campaigns aligned with our consumers' life and times and new landing pages for our new products are driving positive full-price selling.

In addition, we are on schedule to introduce entirely new sites for Astro and Skullcandy ahead of the holidays. They will enable us to further amplify our digital channel. We will invest heavily in digital internally and with our retail partners. Our consumers are researching and purchasing online, and we need to ensure we have great digital experiences and are with the right partners with strong digital presences.

Now to the add portion of marketplace transform. As we've said before, we are taking a measured and cautious approach to increasing our distribution footprint in the U.S. We want to make sure any incremental accounts are right for the long-term health of the brand and the business. We also want to make sure our brand -- we are a brand that grows through great service to our current accounts versus a brand that simply chases new accounts.

For the second quarter, the highlight of marketplace transform add was the start of our relationship with Walmart. We have a "crawl, walk and then run" strategy with Walmart, and I anticipate crawling throughout '14. Walmart is much more of a '15-and-beyond story. '14 is about ensuring that we can succeed in Walmart and testing. The initial crawl phase was a Q2 shipper where we were able to control the merchandising and creative. On this test, we exceeded our expectations and we are pleased with the results.

We also recently launched the small segmented in-line section in roughly half of Walmart's domestic doors where we are currently at or above our internal projections as well. To date, we are pleased with how we have performed in Walmart and excited to further partner with them in ways similar to much of our competition, which has been in Walmart for multiple seasons and years.

We are also taking more control of how our brand looks and feels to our consumers at retail. We have to be able to show the Skullcandy brand and products in a pinnacle form to tell a great consumer story and excite the consumer about our brand and products, which I believe will help sales throughout our distribution channels. To that end, we'll be partnering with Sound Lion, one of our leading premium music and audio retailers that also has experience with licensed retail, to test shop-in-shops and select high-traffic areas where our consumer frequently visits.

In addition, we have signed a license agreement with an experienced retailer to launch our outlet stores. The shop-in-shop and outlet stores will enable us to enhance our brand through careful assortments and enhance Skullcandy retail experiences, and also control the sale of discounted and end-of-life products. This is good for the consumer, our retail partners and our brand.

As you'll recall, we tested an outlet here in Park City during the holiday season and the results were encouraging from a brand, experience and profitability perspective.

At this point, we believe partnering on these retail opportunities makes the best strategic and financial sense for Skullcandy because our partners have shown they know how to build great consumer experiences at retail, while we can focus on our core capabilities. We plan to open our first shop-in-shop and outlet stores in the coming months. The numbers will be small at first and we'll test before any larger rollout, but we're very excited about the future.

On the last piece of marketplace transform drive, we focused on our 4 marketing imperatives of: one, "when the world is watching" events, media and activations to bring awareness to the brand; two, grassroots events in media to create emotional ties to the consumer; three, digital; and four, in-store experiences.

On "the world is watching" side, in Q2, we generated buzz with our digital and PR campaigns during the World Cup, featuring Brazilian captain and Skullcandy athlete, Thiago Silva. On the digital front, we launched a Facebook and mobile app with Silva that allowed users to compete to win a limited edition of Silva-edition Crushers. The brand engagement from app is incredible, with an average playing time per user of nearly 16 minutes and significant increases in fan base and social media and email opt-ins.

In-store centered around Skullcandy's national teams series of headphones as we were the official headphone partner for the German, French, English and Mexican national teams. Retail activations across the globe focused on these teams and expanding our football message that Skullcandy is where the music of football plays, highlighting the strong link between football culture and the music around these teams and this sport. The creative collateral around these campaigns was used as part of regional media buys and in-store signage and displays. As part of the connection with our national teams, Skullcandy also seeded limited edition Crushers to each of the teams, and again, received extensive organic coverage of our products associated with some of the best footballers in the world.

The final piece of guerilla grassroots marketing focused on watching parties in key cities in each of the partnership countries with street teams, promo flow and product activations at the hottest venues in Paris, London and Berlin. These activations, while hand-to-hand and difficult to scale, got back to Skullcandy's roots as an authentic and connected youth culture brand.

On the athletes front, we had some amazing highlights this quarter. Kevin Durant won the NBA MVP award. To celebrate and as a nod to his historic MVP speech, we installed a billboard in his hometown of Seat Pleasant, Maryland, to further connect this amazing accomplishment to his hometown roots. And just a few weeks ago, Kevin was named best male athlete at the ESPY Awards.

Meanwhile, Stevie Johnson was traded from Buffalo to San Francisco, which should signal amazing things for the coming season for him and his new team. Mick Fanning won 2 major events on the ASP pro surf tour, the first being in the early quarter at Rip Curl Pro and the second one being just a few weeks ago at the J-Bay Open, putting him in a great position to defend his third world title.

Ryan Dungey has had several wins in the Pro Motocross championships and is currently in second place in the point standings with 4 races left to go.

The roster of amazing athletes and ambassadors for Skullcandy is killing it right now and a huge part of the success that the brand has seen at retail with our consumers.

And just last week, we officially kicked off our Sports Performance campaign with an announcement that Chris Spealler, one of the most influential CrossFit athletes and a long-time friend of the company has officially joined the team to officially launch us into CrossFit.

We also did a limited-edition athlete-seeded Nike Skullcandy Crusher headphone for top competitors at the CrossFit Games in L.A. last week.

During the quarter, we also received strong media attention from Men's Journal, which named Crusher as a Summer 2014 essential. The Red Bull bulletin named Crusher a best for Summer around the pool and tech publication iPhone Life Magazine called Crusher an awesome pair of travel headphones.

Air Raid and our new Women's line also got positive reviews from publications such as Astman [ph], GrindTV and ELLE.

Driving our brand and brand heat is important for our long-term success. To this end, we will continue to spend and drive demand creation. We will look for opportunities in the year to further invest in those areas that will drive our company long-term demand creation, brand and innovation. Audio is a strong consumer category right now and there are variable cost opportunities to invest in with positive short- and long-term returns.

Jason will talk a bit more about how we're thinking about this financially, but we want to make sure Skullcandy has the brand heat to be a great company, successfully launch our new product categories and achieve our long-term vision. We are on the attack.

Under our second pillar, create the innovation future. We brought to market 2 new earbuds and one on-ear headphone engineered specifically for women. The features of our first Women's line includes fine-tuned ergonomics and fit, as well as an industry-first and enhanced-sound profile engineered around the fundamental differences in how women hear as compared to men.

During the second quarter, we put the finishing touches on our new Sports Performance line, which officially launches at retail tomorrow with several key partners. At the end of the day, what athletes want more than anything from their earbuds is that they stay in, they work and they are simple. We have those solutions for the athletes.

From an innovation standpoint, we are really excited about the benefits our proprietary Sticky Gel technology provide today's active consumer and believe our entrance into this segment of the market can be disruptive.

I'll have more to share on both Women's and Sports Performance when I discuss our fourth pillar, expand known-for categories and partnerships.

Moving to our third pillar, growing international to 50% of the business. Our focus on cleaning up markets, building brand heat and accelerating sales momentum in our key focus countries continues with good success as net sales increased 6% year-over-year. We have a lot of opportunity in growing our International business from 27% in Q2 to our goal of 50%, where I believe it's fairly customary for global consumer brands.

Cleaning up our international markets has been a large initiative in 2014. An early example of our focus making an impact is that excluding off-price sales for Q2 in both 2013 and 2014, we are up over 10% year-over-year in our International segment. This shows we are winning with full-price selling and doing it with the right accounts. It is great to once again see positive growth internationally.

It is also important to remember, though, that all of our international businesses are in their infancy. I believe they will generally grow faster than our domestic rates, but we'll also have some growing pains and can be a bit less predictable and more difficult to forecast and leverage the businesses where we have more operating history.

So let's talk about those countries. In Canada, the strong full-price selling of Crusher that began following the installation of new listening stations at Best Buy in January carried into the second quarter. Our recent performance led to new distribution beginning in Q3 with Future Shop, Best Buy's sister chain and the largest CE retailer in Canada. I'm proud of the progress we've made driving the business in Canada since we set up direct distribution there approximately a year ago. It always takes time to clean up the market post the distributor, and we took further steps to clean up the market in Q2 and still have some work to do until this operation is moving at 100%. But the team is strong and Canada has a lot of potential.

In China, we strengthened our brand equity and connection to fashion through a great partnership with H&M. We reached over 700,000 people through digital activations on H&M's website and social network platforms in addition to having listening stations at their top 20 doors in China. Our demand creation efforts are yielding positive results with sales through our China website gaining pace on a year-over-year and sequential basis. We're slowed down a bit in Q2 in China due to transitioning with one of our primary channel distributors, but we believe this will be positive for the long run. The work we have done has us well positioned for the back half of the year when we'll be launching Air Raid, Women's and Sports Performance in China.

Our brand heat in Japan continues to build, driven in part by the success of Crusher, our #1 selling style in Japan. Our ability to quickly establish Skullcandy as a premium brand in Japan is a great sign of our long-term potential in this large and important audio market and has recently led to additional shelf space at several top CE retailers. While this territory is still small, it is important in the long term for trend and overall global presence.

In Mexico, we continue to build our brand identity through a strong push around the World Cup. After seeding the Mexican national team with products in Q1, we cosponsored and organized viewing parties in several major cities throughout the country where we had Crusher demo stations and gave away prices during half times. Over 250,000 people watched games at these events during the World Cup, so we're able to generate tremendous brand awareness in a 1-month period.

Mexico is also a territory where we look to do some very significant testing of our 2XL brand throughout the remainder of the year, as we believe this brand and price are a great fit for the Latin American market.

Turning to Europe, the second quarter was highlighted by increased shelf space at HMV and Dixon, 2 of the largest CE retailers in Europe, and the initial rollout of our new interactive Crusher displays to several of their top doors. As discussed earlier, we ran some great activations around the World Cup that furthered Skullcandy's connection to global football and the sound of football. We see continued opportunity in Europe as the economy is generally rebuilding and our brand is still very young.

Europe was off plan in Q2 due to some product shortages and packaging compliance issues, which I anticipate will be rectified later in the year. Business in Russia and its neighboring countries was also severely affected by the current political situation.

Moving to our fourth pillar, expand known-for categories and partnerships. It was another very productive quarter. Beginning with our gaming business, Astro continues to post strong results with double-digit year-over-year growth despite the continued softness in the gaming headphone category. To grow sales in a down market for headsets is a great sign of the brand's strength, particularly at the high end where Astro dominates above-$200 with almost 95% market share.

In June, we exhibited at E3, the largest gaming trade show in the country where, we showcased our newest Astro product, the active noise-canceling Bluetooth A38, taking home several awards including best technology, best gaming accessory, and runner-up for best of show from various industry publications. We've incorporated much of the consumer feedback from our A38 beta launch last quarter, and we will be launching that product in its final consumer-improved form this coming Q3.

Our gaming business, especially Astro, is on fire right now, and we intend to continue pouring gas on that flame. Our Xbox One SKUs are still on schedule for a launch this holiday, although timing is very tight and there are a lot of hurdles to leap between here and launch. But we're confident. At a bare minimum, we'll have Xbox One product for sale online , but our plan is to have it on shelf throughout our retail network in time for the holiday. While important to us, this is just the first holiday of a 6- to 10-year console cycle. And with our brand positioning and global distribution network, we're very well positioned to take full advantage of the upswing in demand as these next-generation consoles continue to take root.

With regards to Skullcandy gaming, through the first half of the year, we have gained market share in a down market, but it is not yet performing as well as our lead horse, Astro. We need to do a better job showing our consumer the benefit of combining Astro engineering and design at great price points under the Skullcandy brand, and some upcoming product introductions will start to showcase this more fully.

Coming back to Women's, as we outlined on our last call, we successfully kicked off this new product line with a great launch party in New York that generated a significant amount of positive buzz and media attention for the brand. Initial demand for our Women's line has been very encouraging on our own website as well as the key accounts we selected to partner with out of the gate. These include nordstrom.com and birchbox.com on the digital side.

While for brick-and-mortar locations, we limited distribution to our current lifestyle doors that we thought were a great fit for the line, along with a handful of leading women's boutiques across the country.

While it's too early to measure the long-term potential of the Women's line, we did receive a great endorsement by being selected to exhibit at the ENK trade show. Following the show, which kicks off next week in New York City, our plan is to gradually build distribution over the remainder of the year with the addition of more women's specialty-influencer doors. We'll do this before assessing the speed in which we may want to scale distribution in the next few years.

Tomorrow marks the official launch of our Sports Performance line, which we are bringing to market with key partners, such as Dick's Sporting Goods, the Sports Authority, City Sports and Olympia Sports, to name a few. The response to our new line of earbuds featuring our proprietary Sticky Gel technology has been extremely positive. We are confident that our unique point of view on today's performance athlete, a lot of which comes from the varied active backgrounds of our athlete ambassadors, our management team and our company overall, dovetails perfectly with the current trends in training that now include much more high-intensity interval training like CrossFit, kettle bells [ph] and obstacle races, as well as how our lead athletes are actually training for their sports. This area of sports and training are also the fastest growing.

NBA All-Star Kyrie Irving and 3-time ASP surfing world champion Mick Fanning are going to be the key launch athletes for our marketing campaign and our new Method earbud, which utilizes our off-axis and Sticky Gel technologies. We are also excited about the potential of this new product line.

Another category that we are making important inroads penetration is wireless. We are really excited about the introduction of a wireless version of our popular Hesh headphone for holiday. At $99, it's a tremendous value proposition, thanks to premium fit and comfort upgrades, massive volume potential with 60-millimeter drivers and industry-leading battery life. This entrant for Skullcandy at a disruptive price point brings elements of color, graphic and on-trend design to a growing section of the wireless market. Wireless Hesh will be available in several pinnacle accounts in CE accounts this holiday.

Building off the success of Air Raid, our first Bluetooth speaker that we launched late last year, we're expanding our product offering for the holiday. With an MSRP of a $149, Air Raid has sold through at a very solid pace, which bodes well for our new equally impressive products that carry more accessible price points. Bluetooth speakers are a rapidly growing category, and we are well positioned to capitalize on this trend due to our advanced in-house engineering and R&D capabilities that allow us to bring to market new products that our consumers want much faster than we have historically.

Our consumers are loving the increased durability of these products and that they are louder than similarly sized portable wireless speakers. They are the ultimate speakers for heading to the beach, the pool, the impromptu summer barbecue or creating the ultimate garage gym. They are tough and loud with a great value proposition.

A year ago, we were behind in wireless. Come holiday, I will -- I believe we'll have as many, if not more, wireless styles than any of our significant competitors. Hats off to our product teams. They are able to do this as part of our quick strike program, which is a new weapon in our arsenal. On the partnership side, we're seeing good early success with our Toshiba audio licensing agreement for their laptops. Moving forward, we'll look to continue to activate more with Toshiba to elevate both of our brand and demonstrate the power of Supreme Sound audio and providing a competitive advantage to companies looking to gain greater influence with youth culture and our Muse consumer. We are also continuing to develop compelling programs and alignment with Spotify's streaming music service that will be critical to providing enhanced user experiences to our consumers in the future.

Lastly, and perhaps most importantly, our fifth pillar, operational and team excellence. Our people, culture and values are the foundation of this organization and what I believe will separate Skullcandy in the long term from the competition, and a critical reason why I'm so excited about the future. We have an unwavering commitment to be a great company where the best and brightest come together to create innovation that excites our consumer in ways never thought of to help people have more fun, perform better and even use the power of music to unlock human potential.

In addition to creating the innovation future, we want to advance Skullcandy's position as the leading employer where team members enjoy great quality of life and have the tools to be the best in the world. To do this, we are expanding our internal Skullcandy university to include several new programs that we believe will further strengthen the foundation we've established and amplify our team and culture. This includes our commitment to our scholarship program that helps participants complete their undergraduate and graduate degrees. To be the best, we have to invest in the best. And that we will do.

I'll now turn it over to Jason for a review of the numbers and guidance.

Jason Hodell

Thanks, Hoby. Hello, everyone, and thanks for joining us. In my section, we will start with a review of our second quarter income statement, discuss cash flow, our balance sheet as of June 30, and finally, we'll outline our guidance for third quarter and update our outlook for the full year.

First, our income statement. Second quarter net sales were $53.9 million as compared to $50.8 million a year ago, an increase of 6% and in line with our guidance on the last call. Let's provide details about these sales from a geographic standpoint.

Beginning this quarter, in order to better highlight our progress towards our turnaround pillar of growing international to 50% of sales, we are shifting our segmental reporting to a consistent U.S. versus non-U.S., or international, segmentation on calls, in our earnings release, our 10-Q or our 10-K. In short, we've formally moved Canada and Mexico sales into the international amounts for our segmental reporting.

U.S. net sales increased 6% to $39.5 million from $37.2 million a year ago. International net sales increased 6% to $14.4 million from $13.6 million 1 year ago. The increase was primarily due to gains in Canada, Mexico and China.

For the second quarter, these international sales represented approximately 27% of our overall business, up from 24% a year ago.

Let's provide details about these sales from a product standpoint. In Q2, our gross revenue product mix moved towards in-ear headphones versus Q2 1 year ago. It reflects our commitment to winning in the bud market and our initial launch with Walmart, which focused heavily on in-ear styles. Our success with Ink'd, Jib and Smokin Buds lines drove the uptick in our earbud share, with Jib and Ink'd both being in the top 5 earbuds sold in the U.S. according to recent NPD market share data.

The share of in-ear products was approximately 56% of our sales, up from 53% 1 year ago. As a result, on- or over-ear headphones fell to 40% from 47% in Q2 last year. And the remainder, Bluetooth speakers and accessories, was 4% of sales in Q2 this year versus only 1% a year ago. This shift towards Bluetooth speakers is consistent with our strategic plan to expand known-for categories and partnerships.

Gross margin. Gross margin for the second quarter increased 10 basis points to 45% from 44.9% in Q2 of last year and was better than guidance by 50 basis points. Generally speaking, realized product and customer margins were as expected in our plan. The increased share of earbuds, which carry a higher margin, led the increased margin, though this was offset by the emerging share of our Bluetooth speaker, the Air Raid, which carries a margin lower than our company average. As a note, though, as additional Bluetooth speakers are launched, we do expect product margins to improve for the Bluetooth speaker category.

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. SG&A expenses for the quarter decreased 4% to $22.9 million or 43% of net sales from $24 million or 47% of net sales in Q2 2013. This year-over-year decrease in SG&A expenses is primarily driven by lower personnel expenses, licensing royalties, co-op retailer spending versus one year ago. We also delayed some demand creation expenses that we expect to spend later in the year. As a note on the quarter, though, the share of SG&A spent on demand creation grew year-over-year.

Operating income, taxes and net income. GAAP operating income in the second quarter improved to income of $1.3 million compared to a loss of $1.2 million in Q2 2013. Other income or expense was $0.4 million of income versus $0.3 million of income in Q2 2013, driven by foreign currency balance sheet translation income. In a moment, we will update our view on the total annual effects of nonoperating income, both other income and interest income, since they are material to earnings.

On taxes. Our current quarter tax benefit was $0.1 million versus a benefit of $0.3 million a year ago. Of note, in this quarter, we created positive taxable income versus last year's loss. So typically, this would have created a tax expense not a tax benefit. Importantly, Skullcandy benefited from a onetime tax benefit of $0.36 million from the impairment of the 2011 acquisition of our Swedish entity by our Swiss operating company. The onetime benefit was recognized this quarter and will be monetized against our taxable earnings in the Swiss subsidiary as we file our returns for 2013 and 2014.

Without this onetime tax benefit, our resulting Q2 tax expense would have been in line with our year-to-date taxable income and modeled annual tax rate. We will touch on the annual tax rate more in just a moment. After the Q2 tax benefit, our Q2 GAAP net income was $1.6 million or $0.06 per diluted share versus a loss of $0.6 million or minus $0.02 per share in Q2 2013 and versus our guidance of breakeven net earnings per share.

So summarizing, the GAAP EPS beat of $0.06 versus guidance into approximate drivers: number one, gross margin exceeded guidance by 50 basis points or about $0.01 of EPS; two, SG&A finished under the midpoint of guidance by approximately $1 million or about $0.03 of EPS; and three, approximately $0.02 was driven by the onetime tax benefit and tax-rate change.

Operating cash flow. Let's give an update on our operating cash flow. Our total GAAP depreciation and amortization was $3.1 million in Q2, and this includes CapEx depreciation, amortization of intangibles and the amortization of stock compensation expense. Our formal GAAP cash flow statement has added detail on this. With GAAP reported operating income of $1.3 million, this produces a non-GAAP measure of operating cash flow of $4.4 million in Q2 when adding GAAP operating income and GAAP depreciation and amortization together. Importantly, as guidance, we expect total depreciation and amortization for the year of approximately $13 million.

Balance sheet. Turning to our balance sheet on June 30, 2014, let's highlight a few items. Our cash and cash equivalents totaled $44.1 million as compared to $48.2 million as of March 31 of this year and up from $29.7 million at the end of Q2 1 year ago. We have no bank debts, similar to last year. Changes in our cash account are consistent with the seasonality of our business and cash working capital needs during Q2. Due to our high cash balance and projected free cash flow-positive outlook, we completed the amendment of our Wells Fargo line of credit during Q2. The line was reduced from $50 million to $10 million, which significantly reduces line-of-credit fees and the line was improved by replacing the trailing 12-month GAAP net income requirement with an EBITDA interest coverage requirement, which is more flexible and appropriate for our business operations.

The accelerated recognition of amortized financing fees appeared in interest expense this quarter due to the onetime reduction of the line of credit.

Accounts receivable increased 20% to $43.8 million from $36.4 million as of March 31, consistent with the seasonality of our business. Our allowance for doubtful accounts is currently $2.5 million, up from $2.0 million as of March 31.

Inventories were $50.8 million at the end of Q2 as compared to $42.7 million as of March 31, which is consistent with seasonality, and compares to $51.1 million as of June 30, 2013. Our inventory is currently offset by a $1.5 million consolidated inventory reserve, or 3% of gross inventory. The year-over-year decrease in gross inventory despite higher forecasted sales is a testament to the efforts of our supply chain team to increase our efficiencies.

So in summary, the balance sheet has good liquidity, the line of credit is now more flexible and Skullcandy has a net book value of equity of $142.3 million.

Forward-looking guidance. Based on our second quarter performance, we are raising our gross margin, tax rate, other income and EPS projections for the year. Let me first walk you through our updated annual guidance and then we'll talk about Q3.

Full year net sales. We still expect 2014 net sales to increase in the mid- to high-single-digit range over 2013, led by our international markets, new product categories and recently opened additional distribution. As a reminder of our seasonality, the majority of our revenue will be generated in the second half of the year, over 1/3 in Q4, and is therefore 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.

Gross margin. Our annual gross margin guidance is rising by 20 basis points to approximately 44.7%. This reflects generally outperforming gross margins thus far in the year and continued expectations around the previous gross margin effects and product trends that have driven our improvement like product mix, warranty expense, freight and warehousing efficiency and customer-returns benefit.

SG&A. On SG&A, our annual guidance is remaining the same. Importantly, the expense savings from Q2 are mostly being reinvested during the back half of the year to support growth. Annual SG&A is targeted at approximately 40% of net revenues plus $1.5 million. The previously announced potential demand creation and innovation spending. Of note, $1.1 million of this spending is planned for the back half of the year. Our aim is to stay on the offense by increasing our demand creation and innovation. We have successful market platforms like Crusher, Hesh with Bluetooth coming, and Bluetooth speakers that give Skullcandy the opportunity to amplify our market message and support holiday brand heat around these special products.

As a reminder, though, we only unleash this potential spending if we feel it will create incremental sell-through that creates shareholder value and we are on plan from a profitability perspective.

Again, our annual EPS guidance, in a moment, includes the full impact of all $1.5 million of this potential demand creation expense for the full year.

Operating income. To provide more commentary on the operating performance of the business and the things we can control, we will begin providing guidance for annual GAAP operating income. We currently expect 2014 operating income for the year in a range of $8.3 million to $9.7 million. This includes the full-potential demand creation and innovation spending in SG&A.

Now let's walk through nonoperating items and update annual EPS guidance. Other income and interest income. After the Q2 onetime benefit to other income, we now model other income/expense and interest income/expense to be a combined expense of approximately $0.6 million for the year between both line items. Other income is difficult to predict but we want everyone to understand exactly what we've modeled into our annual EPS guidance.

Annual tax rate. Given our latest blend of revenues, transfer prices and earnings across our portfolio of global entities, our expected tax rate has increased. As our ratio of U.S. to international sales has increased, our expectation of the ratio of U.S. to international earnings has also increased. Our newly forecasted annual tax rate is approximately 24.7%, which compares to our previous forecast of 18% and includes the latest information from our annual model and transfer-pricing studies. As we've mentioned before, this effective tax rate is likely to fluctuate from quarter-to-quarter and could increase further if our U.S.-to-international earnings ratio further increases as the year progresses. Importantly, from a guidance standpoint, understand that our full year 2014 taxable income will be taxed at the new forecasted rate of 24.7%. And then, this tax expense is offset with our onetime Q2 $355,000 tax benefit to derive the total annual tax expense.

EPS. Finally, with respect to EPS, based on our Q2 out-performance, tax rate shift and onetime items, we are raising our outlook for 2014 GAAP net income EPS to be in a range of $0.22 to $0.26 per diluted share, up from our previous guidance of $0.16 to $0.20. 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, the financial situation of those key retailers, changes in technology, sourcing cost trends and consumer preferences.

Third quarter guidance. For the third quarter of 2014, we are currently forecasting net sales to increase year-over-year in a range of 7% to 9% of net sales growth over Q3 2013 levels. This will continue to be led by the expansion of our international businesses, additional categories and selectively adding distribution. We are targeting a Q3 gross margin of approximately 45.0%, consistent with our actual Q2 and slightly higher than our Q3 2013 gross margins.

SG&A. We expect our base level of Q3 SG&A to be within the range of $22.5 million to $23 million, which includes Q2 SG&A funds now shifted into Q3. Our base level of SG&A does not include previously discussed opportunistic marketing audible spending, our potential demand creation and innovation spend that we may unleash to drive growth if we are on plan to get earnings guidance. This is optional marketing spend that is above and beyond our base SG&A run rate and is meant to drive brand heat around new product launches and key halo product stories as we go into holiday in 2015. Importantly, including this potential demand creation and innovation spend, we expect SG&A in Q3 to be within the range of $22.8 million to $23.3 million for the third quarter, and this spend will be included in all earnings guidance.

As a comparison, last year's Q3 have reported SG&A of $21.9 million. So this is a material increase year-over-year that is mostly driven by 2 discrete differences: one, last Q3 had a bad debt benefit as opposed to an expense, which is, in total, $0.7 million different from this quarter's plan; and two, we are projecting $0.5 million in increased commissions over last year.

Including the potential onetime demand creation and innovation spend and the shift in SG&A out of Q2 into Q3, our guidance for Q3 GAAP diluted earnings per share is a range of $0.02 to $0.05. 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.

Thank you, everyone. I will now turn it back to Hoby.

Seth Darling

Thanks, Jason. It's been a solid all-around start to the year as we achieved or exceeded in some cases our main financial and strategic objectives. The combination of our current momentum and the product and marketing plans we have in place for the holiday season have us well positioned for continued success in the back half of 2014 and beyond. I'm confident in our balanced approach to profitably driving the brand and the business forward in the near term while deploying capital to high-return investments that will set the company up for sustainable growth over the long term.

Before I turn the call over to the operator for questions, I've been asked on a number of occasions about the Apple Beats acquisition, and so I want to address it briefly. While it doesn't change our focus, I do think there are some important aspects worth highlighting as it relates to our industry. We certainly view the deal as positive for Skullcandy as it further validates the audio category and the importance of audio, particularly with today's younger consumer. We have been saying for some time that audio and headphones are what we call part of the uniform of youth. With Apple now focusing more attention on audio, this will no doubt accelerate innovation within the category. With our advanced in-house R&D capabilities, Skullcandy is well positioned to benefit from this trend as we further differentiate ourselves from the majority of the competition who don't have the capabilities to keep pace, and it may also create a material upgrade cycle for audio products.

In terms of competing directly with Beats, nothing has really changed on that front. Our brands have been going head-to-head since their inception, but they play at price points generally $100 and $200 and up, while our kill zone is between $20 and $100. Then we have our key halo and most innovative products above $100, which offer consumers a value proposition and excitement level unmatched by most any other brand in the market. So that equation really remains the same. If anything, we feel like the acquisition strengthens our market positioning as it puts us as the most influential, independent youth culture audio brand, which we think is an attractive spot to begin. It's the same story with Apple. They've been a competitor in the earbuds for several years, and I don't see this dynamic changing going forward. I feel very good about how our products stack up to theirs in terms of sound quality and connection. And while Apple stores are a point of distribution for our brand, it was never that material, and we've been proactively reducing our presence with them in order to focus on other strategic partnerships since they started pushing their own earbuds in store over competitor earbuds.

With Beats and Apple now aligned on headphones and streaming music, I think you'll see an acceleration of strategic alliances in the hardware streaming music and the audio peripheral space, which provides us a lot of opportunities, being the leading independent youth culture audio brand. Bottom line, this industry trends are shifting in our favor, and we are on the attack. There are 7 billion plus people on the planet, and almost all of them listen to music and increasingly through their smartphones and tablets. So this is a great market for us, and we feel we have a sound plan in place to take advantage of the many growth opportunities that lie ahead.

To close, I want to thank the entire Skull team for their continued hard work and dedication to the job. Your efforts day in and day out are tremendous. Let's stay on the attack.

Operator, we're now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Dave King of Roth Capital Partners.

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

I guess first off on the gross margin, it looks like in terms of sequentially that you had a fair amount of improvement domestically, while the international cutout was down a bit. It seems to me that maybe the domestic stuff was in part due to the in-ear addition of Walmart. So the better growth you had there. Is that indeed the case? And then on the international side, it sounds like the growth decelerate is a little bit because of getting out some of the off-price channels. I guess what affect did that have on the margins? And how should we be thinking about what happened there in terms of some of those margin changes? Or maybe I had it backwards a little bit, but I'm just trying to see what happened in terms of the 2 different channels.

Seth Darling

Sure, Dave. This is Hoby. I think first just on the international piece, on the deceleration piece, I mean, you look at those businesses overall, and I think that those will be great drivers again when we go from that 27% to our goal of 50%. So I think long term, still very sound on those. So something is going on there. I mean, as we talked about, those business is really still in their infancy, a little bit harder to predict when they're 1 year old. We don't have some of the historical trend. They might be 2 years old. So some of that is just a little bit more of a business we'll get better and better at over time so -- on that piece. On what happened a little bit there, I think on that deceleration piece, you look at Canada, you see that, that's going to be a strong territory for us. Across the board, some really strong results. I think probably where we felt it more than anything else was in Europe and in Western Europe where I think everybody felt a little bit of softness over the quarter. But I think that's one when we look at product and when we look at the countries where we have some strong presence that we'll come back solid in those areas. And then I'll let Jason add [ph] a little bit more on the margin.

Jason Hodell

Dave, so in the U.S., you hit it on the head where the in-ear share and the Walmart piece were the drivers domestically. Internationally, a couple of things that Hoby mentioned in his prepared remarks around the product labeling issues and whatnot. From an accounting perspective, some of those issues have been reserved for, and that results in an expense which is above the line. It's a difference between gross revenues and net revenues. And we talked about it a couple of quarters ago. It's called our SR&A expense. So whenever you have issues like that, we do reserve for those and create a liability on the balance sheet and reduce the in-peered [ph] revenue. Well, COGS stays the same, and so that can be a depressant on gross margin. And indeed, that was part of the story, especially in the international segment.

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

Okay. That helps. And then in terms of -- Hoby, we talked about some of the things you're doing on the brand side, especially internationally and some of the things you're doing to drive brand. And it sounds like you're having a lot of initial success there. And domestically, I think we're probably still maybe in some of the early innings in terms of where the brand is versus kind of your turnaround, et cetera. I guess how would you characterize where you're at versus kind of where you want to be, understanding that, obviously, you can always -- any company can always improve? But then along those lines, maybe can you talk to us about where the listening station stuff now stands. Are those issues now addressed? And then how are product return rates in terms of build quality and that kind of stuff? How have those trended?

Seth Darling

Sure. So I think first just on the brand piece, Dave, and I think a big piece of that you answered even in the question, which is I don't think we'll ever be satisfied with the strength of our brand. I think you look at our management team and where we're all from and it's a push on brand as our most important asset that we have, and we'll always had to push it to be stronger. So you'll continue to see us amplify there every occasion that we can and take every opportunity to amplify around brand, number one. I think from a perspective of where does the brand sit right now, I think you look at some of the things in the channels like the college bookstores as an example where our muse consumer is buying. When we talk about who is that pinnacle consumer for us, it's the 20-year-old, constantly connected influencer that came from music art film. And that's a kid that's in college. So when you see that business up, that's a positive sign from a brand perspective. So I like what I see there. I think we still have some work to do. There's no doubt about it. Can we always make it stronger? For sure. I think one of the things that you'll see, and Jason mentioned it even with some of the SG&A pieces, we reserved a little bit of ammo for the back half make sure that they could go after that. So I think you'll continue to see some big demand creation in the back half so that we can drive new categories and products that will continue to drive the brand as well. So again, I feel good about where we're heading on that, and I think some exciting things to come. From a listening station perspective, that's not something that turns around immediately. I think as we've talked about, the great thing that we have is we probably have better location in store than any brand, whether you go to CE, whether you go to our core action sports consumer specialty. We have great real estate. The thing that historically we didn't do a great job of is making sure that we took that great real estate and made sure that it told the right story worded properly, et cetera, and I think that hurt the brand a little bit. So making big investments a lot that you'll see in Q3, a lot that you'll see in Q4. Focus will be on those largest accounts initially and on our really key influential smaller accounts because those are the ones that one, drag revenue on the top piece and then from the brand influence side are really important on that mark 4 [ph] piece. So I think you'll see those get considerably better over Q3 and as we head into the holiday, and I think that will have positive financial impact for us. And then on the -- we certainly have other accounts than those. We'll continue to push those hard, and I think we'll start to see that as we get into kind of Q4, Q1 and start drive more revenue through their -- through a better brand presence on the listening station side. And then on the product side, this was one that I think we've talked about a lot, which is I think there's a historical -- a little bit of a feeling on when you go ask a kid, "Hey, tell me what you think about Skullcandy?" They say, "Man, that brand is awesome. The product is super cool. I love the color. Love what's going on. It's loud. It's fun." And then kind of the part that you hear at the end of it is, "But man, the quality is not quite where we'd love to have it be." And I think that's one that we've acknowledged as a team and as a management team and are making sure that we resource against it. Again, you go back a couple of years and in our compliance and in our product development teams, those were very, very small skeleton teams. And you look at it now and those are significant teams with mechanical engineers, acoustic engineers, electrical engineers and compliance teams to make sure that we do the right things on that. So it doesn't mean that everything always goes perfect because you have those teams, but it means we're going to get a lot better on it. And so we're continuing to see from a breakage rate perspective and so forth to be below industry averages on that. And we'll continue to drive that, that compliance piece. I think it's an important part going forward on where we need to take the brand. And again, I mean, does it turn perfect over night? No. Are we below industry average and I think is that a consumer perception we need to change? Absolutely. I think a big way we've thought about that is our consumer doesn't really resonate to walk in with them and tell a story on we now have 40-odd electrical and mechanical engineers in our product development team. It works much better to tell that story through product. And so even with the wireless speaker product, that is a reason we went, hey, let's have the key story on Air Raid, on the new wireless pieces, have it be. Those things are bombproof. Those things are durable. You can throw them off the top of the building and they keep rocking because they connotates that piece that we are durable, we're a quality product. And so we'll keep telling those stories to make sure that the consumer understands where we're taking the company.

Operator

The next question is from Lee Giordano of CRT Capital.

Lee J. Giordano - CRT Capital Group LLC, Research Division

Can you talk a little more about the outlet strategy, how the economics might work for that? And then do you think you'll have your whole product assortment in those stores? Will there be any made-for-outlet product? And then how many stores do you think you'll open?

Seth Darling

Sure. So on the outlet side, I mean, we're really just rolling those out right now. As we talked about, we tested one outlet last year for holiday. It performed well. So when we think about rolling that out, I mean, it's a piece where we went, hey, who's the best possible partner that we could find to go do it with? They wanted to do it with us. They love the brand. So we're really just rolling that out. I mean, from an economics perspective, we think that it's certainly a better channel than if -- a similar product was going into some of the off-price channel, and we can tell a much better brand story around some of that products. So the economics on it are positive compared to the opportunity cost on it. I think the brand experience are going to be great. From a product and merchandising assortment piece, there definitely will be a piece that is end of life, and that's where we will clear through some of that product and keep our channel clean. I think at the same time, we want to make sure that we do tell a compelling story in there. And so we'll make sure that we have some product in there as well. It is some pretty cool stuff as well in that end of life piece. And then like I say on the scale side of it, we're going to go slow on it. We're excited by the partner. We think it has a ton of potential both profit-wise and brand-wise. But we're not going to get out in front of ourselves. I mean, I think this year we'll look at 1 or 2, and we'll see where those go and make sure that it resonates with the consumer and make sure that it tells the right brand story and make sure we learn how to work with the retailers that are around those outlet centers as well.

Operator

The next question is from Dan Wewer of Raymond James.

Daniel R. Wewer - Raymond James & Associates, Inc., Research Division

Hoby, I wanted to ask you about the inventories entering the third quarter. I believe it was 27% higher than a year ago, and yet you're looking for revenues to grow at about a 5% to 9% rate during the second half of the year. So if you could maybe talk about why it's necessary for inventories to run at so much faster than revenues and where you think the inventory growth will finish the year?

Jason Hodell

Dan, it's Jason. I'll take that one. So our inventories are clearly up compared to the end of Q1, from the $43 million now at about $51 million. But that's absolutely a function of the coming back-to-school season and we're even getting ready for holiday. So it's normal. And a good comparison there is 1 year ago, as of June 30, 2013, we were actually a little bit higher. We're at $51.1 million on inventories. But for the rest of this year, certainly, our forecasted sales are better than what was expected last year. So it's a testament to kind of running lean and mean. You know what I mean?

Seth Darling

Yes. And I think, Dan, maybe the only thing I'd add to that one is from an inventory perspective, I mean, I feel really good on our inventory. As we've been really transparent about them and I think the only 2 styles that I have even any concerns are around Navigator and Aviator that were some of those high-priced prior styles before the new management team was in. And those are ones we need to continue to work through, but everything outside of that, I feel really good about it. I think we're getting it in at better times and earlier than we have historically, and that's just because of our product organization is getting better and better at lining that up. So from an inventory perspective, I feel really good on that.

Daniel R. Wewer - Raymond James & Associates, Inc., Research Division

Further question I had was exposure to RadioShack receivables and if you're adding to accruals because of their situation?

Seth Darling

Sure. Let me get that one first, this is Hoby, and I know Jason had a lot of contact with that team and he can add on to it. And I think the first part is RadioShack is an important partner for us. I think Joe definitely has work that he has to do around RadioShack, but we want to make sure that we're a good partner to them. Whatever happens to them financially, I think they'll come out of it at some point, and we want to make sure that we've done the right things around them. I think at the same time, we're going to make sure that we protect ourselves and we don't have our head in the sand around potential future outlook. But we talk to Joe. We talk to their CFO very frequently. I think we have a pretty good pulse of what's going on and have acted accordingly. So Jay can tell you a little bit more about where we sit on that and what we've done.

Jason Hodell

Yes. In terms of managing our credit exposure, it's kind been a day-to-day thing. John, their CFO, has been terrific about constant communication. And their buyer team has been on top of the payment cycle. So we're very comfortable with where we sit right now from a net credit perspective. It's decreased significantly over time recently. And there's nothing public to announce in terms of the relationship, but we're working carefully on planning for the future as well.

Daniel R. Wewer - Raymond James & Associates, Inc., Research Division

Okay. And then final question. Hoby, following your comments on Apple and Beats, in the past, Skullcandy product would often be exclusive to the Apple stores as far as 3 to 6 months. There was a thought that it created a halo benefit for the Skullcandy brand, recognize you could generate a lot of revenues through the Apple. But nevertheless, isn't there some concern that, that halo benefit from Apple will no longer exist?

Seth Darling

Yes, Dan. I'm not sure about some of the stuff that happened prior to my arrival on how we looked at Apple. More or less since I've been here, really the way we've looked at Apple is very solid retailer, innovative company, do really cool things. But we also look at them as a competitor, and I've gone, you know what, when a consumer walks into an Apple store and goes, “I want to buy a product that would be in our kill zone," they'd get recommended to Apple. And so we've made a concerted effort to go, hey, is it potentially important to be in Apple? Maybe, but we want to make sure that we're limiting that exposure, and we have better relationships with other partners that aren't competitors. That's much more what we've looked at.

Operator

The next question is from Ed Yruma of KeyBanc.

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

I guess just first from a bigger picture -- from a bigger picture perspective. You indicated that you're going to be judicious as you add new doors. I know that you've gone at great length to talk about Walmart. Can you talk about kind of the types of doors you're targeting? Are they national chains, small chains, given that in the past, you've talked about your already expansive distribution?

Seth Darling

Yes, good question, Ed, and I think it's an important one. I mean, when we look at that ad piece, there's a reason that it's the third piece of marketplace transform and not the first or the second piece. The 2 most important pieces to me are, number one, that we get out of accounts that either don't take the brand and put it in the best light possible, don't have the right creative, they can't -- we can't work as well with on pricing. That's the first piece. And we've got to make sure we do that, and we're always going to be vigilant on that piece. The second piece is always going to be, hey, in those accounts that we currently are, those are our most important doors that we have, and we need to make sure that we grow with them. And so that's why we're spending a lot of dollars on listening stations, a lot of time with those accounts, to make sure that we grow those accounts. And that's really where the focus is as well as we've just opened up Walmart, and that's a massive account, and it can have a lot of positive things for this brand. And so that's really where our focus is. I mean, we will always ask ourselves kind of those 5 questions we talked about on the prior call around where do our consumers shop and expect us to be. Where can we tell our brand story in a great way? Where do our competitors sell product? And where can we bring things from a diversification perspective and in a way that segments our product? I mean, we'll always ask that piece on, you know what, consumers are going to change where they shop. Our consumers are going to change where they get information. And that's part of why we need to be so close to our consumer. And we'll always ask that question. But our focus is really, really on making sure that we're great in the doors that we're in. And as our consumer potentially changes where they shop and how they look at information, we'll make sure that we're looking at that same information. But the focus is let's be great in the accounts that we are and then make sure that we track our consumer with where they're shopping.

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

Got it. I know that the company has changed over the years. Certainly, management has changed. But when you look back to strong handset upgrade cycles, if we are in the cusp of one, what does that do for your business? Do you see consumers kind of make that handset -- or make the bud purchase with the handset? Is there a delayed impact? And kind of how do you think about that for the back half of this year?

Seth Darling

Yes, that's an interesting question, Ed. I mean, I think historically -- and I was just talking with our sales team about this just the other day to get their thoughts on it. And I think what we see is, I mean, definitely, when you have an upgrade cycle or new phones coming in, it drives new people into the mobile channel specifically. And so you see stuff in mobile start to accelerate. And I think where you have very differentiated products from what comes in the box, you have potential of people get that at the time of purchase. So things that I think about like that are consumers more and more are going, "Hey, you know what, if there's something differentiated around a sports performance bud, I might buy that at the same time. If I use my new tablet, new phone to watch movies, if there's something interesting that's maybe over-ear and not in-ear, I might look at that." So I think there are some upside in that. I think it crossed the channel outside of mobile though. You don't see it quite as much, and for us, we're placed much more in the audio category than we are in the mobile category of places like a Best Buy or places like a Target. So I think there's some potential upside there. I don't think it's one that we're looking at as this is going to be a huge run-up as you have a handset cycle changeover, but I think in the channels that especially deal with mobile, it certainly puts more people in the door. There's no doubt about that.

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

Got it. And one final question. On the tax rate, I know that you've seen some benefits as you've employed the GmbH structure. And obviously, international ebbs and flows, that changes the effective tax rate. But kind of how do you think about tax rate longer term? And is this step-up to kind of 24.7% kind of the go-forward tax rate for the foreseeable future x any kind mix shift?

Jason Hodell

Sure. Good question. So we try to be very careful about the way we've talked about tax rate because as that earnings shift in the model every quarter occurs, it naturally shifts the tax rate. So our aim on this is every quarter give you -- give everybody the update with the best information we have for the year, 18%, which was the tax rate model last quarter. More of the earnings were flowing through our Swiss tax entity than domestic, and now it's roughly half-and-half. So that's basically been the shift. As you think about the business going forward, however, Hoby has been clear. Our goal is to grow international to half of our business. This quarter was only 27%. So by definition, as the international size of -- slice of the pie grows, the earnings naturally is going to grow as well. And we'll be able to have more of our earnings tax to that 10% incremental tax rate in Switzerland, and that'll be favorable for the business, which would drive the tax rate down from 24.7% to lower amounts again.

Operator

The next question is from Andrew Burns of D.A. Davidson.

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

A question on the off-price sales. Is that still a significant headwind? It's been reducing exposure of that channel for several quarters, and I just didn't know the magnitude of the headwind that's still presented there in the second quarter.

Seth Darling

Yes, good question, Andrew. I mean, as I think about that, let's take a [ph] quick historical journey with me here and then I think hop to where we are today. A big part of last year was that had crept up above what I think great brands do in off-price. And I think it was negative for our full-price selling, and it was negative for our long-term profitability. And so last year, we took that and ripped the BAND-AID off and said, "We're just going to cut this in half." And are we going to feel pain around it? Yes. But is it the right thing to do if we want to be a great brand, long term? Yes. So let's do it. As we go into this year, it's much more when we took that lack, it brought us down to where I think we generally need to be. I would actually say it's taken us below what I think the competitive set does when I just look at other places that I've worked. I think you'll always have some product in that channel, right, just from a perspective of you're going to have some overages, et cetera. So will there always be some product in there? Yes. When we target it, we go we had too much in there before. We need to pull it back the other way and have less in there than I think the yin kind of other similarly situated youth culture companies do. And so we pulled that back really dramatically. So for us, I think as we go forward on that off-price piece, though, it's much more staying within our guidepost than it is, oh, we're going to cut this again in half. There's not that much more to cut on it, and I think we feel good about where those guideposts are.

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

Got you. And then could you provide some more detail on the shop-in-shop potential? And the focus in terms of U.S. versus national -- international types of accounts, will they be new stores or existing? I'm just trying to better understand the opportunity there.

Seth Darling

Sure. On the shop-in-shop side, I mean, I think the first part that gets me excited is I think Sound Lion is a great partner. I think if there are some great premium audio partners out there, they are at the very top of that list and have just done a great job. So I think being partnered up with them, number one, is going to tell us a lot of about our consumer, how they shop and what we can do with our other retailers moving forward to be the best partner possible. So that piece is right off the bat I'm excited about. From a U.S. versus the international perspective, first, it's going to be U.S. because we can control that, the tightest [ph see how it works, make sure that, again, we can have a great brand experience and we're learning what we think we can learn. But I think there's opportunity to do that internationally as well. And I think at Sound Lion folks are interested in looking at that internationally as well. So I think there's a lot of opportunity there. From a number of doors perspective, again, I think we want to test it, see how it does. But when you look at what has Sound Lion done with some of their prior retail, things that they've done, they definitely like to roll out some high-quality stores. And so where we see opportunity that we can have strong shop-in-shops in there that are profitable and tell a great brand story, we'll make sure that we partner up with those.

Operator

The next question is from Jay Sole of Morgan Stanley.

Jay Sole - Morgan Stanley, Research Division

So Hoby, you know what, I wanted to ask you a question. You guys gave some really great detailed guidance for this year and for 3Q. Can you talk about how your vision for maybe the long-term earnings augment [ph] the companies coming together, what you see kind of 2, 3, 5 years out?

Seth Darling

Sure. I mean, I think, overall, we're not ready to go certainly on any guidance perspective and talk about what we see in '15 and what we see in '16. But I still feel very comfortable and very strong on what I said on prior calls, which I think is, number one, we want to be a great company. And when I look at other great companies in consumer and I look at what they do, I think we need to be growing in that low double digits to mid-double digits and making sure that we have a strong gross margin and are leveraging SG&A. So that's the model we're chasing after, I think, with where the category is and the brand strength upside that we have as we go forward as well as the new products that we have coming in. I think we can drive this business in the long term, and there's a lot of opportunity out there for it.

Operator

The next question is from Randy Konik from Jefferies.

Randal J. Konik - Jefferies LLC, Research Division

I guess my question is with the return to sales growth. How do you think about that as a function of additional sell-in to more doors versus improved sell-through with inventory turns improving in existing accounts? So I'm just curious, how do you see that? And how do you see that differential between domestic and international markets? And then I guess the last question kind of ask about the long term, but asked differently, when you're trying to march back towards like $300 million in revenue before the decline in the revenue stream of the company, how would the company look different in your eyes from either a product standpoint and/or a margin standpoint versus where the company was when it was at $300 million in sales and 15% operating margins?

Seth Darling

Yes, sure. So I mean, I think on the sales growth perspective, the sell-in versus sell-through piece, clearly much more concerned on the sell-through piece than I am on the sell-in piece. Doesn't do anything if we get it on shelf if it doesn't sell through. So that is certainly the biggest focus for the company overall. I think what we've seen over the last year is we're continuing to see sell-through get better and better overall, and it's why you see revenue up. And I think our inventory in-channel is really good right now, if not even actually a little bit low at some of our bigger retailers. So I think the sell-through piece, we're looking strong on that one. That's primarily domestic where I talk on that. International, it's a little bit more complicated. Only out of a lot of that business is through distributors, and so we don't quite have as much transparency on it. From everything that I understand, though, across the board is selling is strong as well as sell-through at the majority of those accounts. So I think we're doing the right thing. I mean, one of the things I've talked with the sales team all the time about is it's not about just taking product and getting it and pushing it in there. We've got to have great plans to make sure that it sells through the channel, and we've got to make sure that it's the right product in there. We're not winning just by getting it in the door. We're winning it by getting it back out the door. And I think the company is really focused on that right now. And I think that's a little bit of a difference even from some of the place we've been historically, which was a little bit more, hey, make sure we get that sell-in and make sure we get that sell-in. And it's a lot more focus on sell-through right now. So I think that's the sell-in, sell-through piece. On the $300 million versus where we sit today, I mean, I think the biggest ones are we look at that distribution piece, and I think we're in a really clean distribution place, both with the accounts that we're in, the inventory that we have in channel. From a product side, I think the products that we're coming up with now on wireless, on sports performance, on women's, those are all categories we never played in before. And so we have a lot of runway from a product side on that. And then I think you look at that from international, and we're going to be able to grow that international business significantly and have cleaned up those channels as well and have put in, I would argue, some great teams in all those places. So our revenue is down. As we talked about last year, a big portion of that planned because we didn't want to be a good company and kind of just keeping doing what we're doing. We wanted to be a great company, and that took cleaning things up and doing the right thing. I've been focusing on brand and innovation. And I really like where we sit right now when I think about the future. I definitely wouldn't want to sit in the place we were a 1.5 years ago compared to where we are today and what I think the future holds.

Randal J. Konik - Jefferies LLC, Research Division

So I guess my follow-up would be if you think about where that $300 million was on a 15% margin -- operating margin, do you think that when you -- if and when you get to that $300 million kind of revenue mark again, do you think the margin structure of the company look markedly different from that 15%? Would it look lighter? Would it look better? I mean, how do -- how should we be thinking about that business and just how it would look differently from, like I said, from a margin and product structure?

Seth Darling

Sure, yes. I -- yes, absolutely, Randy. I mean, I think the big piece of that goes back to the question that Jay had, right? Sort of, hey, what do we foresee in the future? And I don't think we're on a spot where we're going to go, hey, can we return the 15% operating margin, et cetera? I can tell you, where my mind focuses is not where this company has been. It's where a great company is that are in similar sectors, what did they have the ability to do. And so when I look at that, again, I look at it as we should be growing double-digits. I look at it as we should have strong, high, 44%, 45% gross margin. And if you look at what great companies that are branded companies do from SG&A, we should be able to drive that down into the low 30s. So you can do the math on where that ends you generally. But again, I mean, I think where the company was is not where we're taking it. We're taking it to be a great company.

Operator

The next question is from Ryan MacDonald of Northland Capital Markets.

Ryan MacDonald - Northland Capital Markets, Research Division

Just with the launch of the fitness line happening tomorrow, I mean, what are your thoughts in terms of how quickly this can grow and how large of an opportunity this is? I mean, is this something that will start in all of the -- your biggest customers? Or is this also going with the gradual approach on that?

Seth Darling

Yes. So I think unlike Women's where you go -- you have to teach a consumer, there's a difference on how a man hears compared to how a woman hears. There isn't a market out there, so there's a lot of education, and there's a lot of influence that have to happen. People are starting to find out very quickly that it's important to have a sports performance line, and there are already brands that are in it and paving the way on it. So what you're going to see from us is we're going to absolutely lead on innovation to differentiate from the rest of the market. We're going to have a very different positioning than other things that are in the market around how do true athletes actually train for their sports, what's going on in high-intensity, those areas that are really growing in the sports performance area. And we're -- it's the one that we're going to scale much faster than we are from a Women's perspective. So are you going to see it everywhere at holiday? No, we're not going to walk it into every single door. I think it's still really important to have great launch partners and build brand strength. So we're going to take it and we're going to scale it a lot faster than we're going to scale Women's as an example.

Ryan MacDonald - Northland Capital Markets, Research Division

Would you say that it would -- like in order for it to be, say, ramp to the level of an Ink'd or a Jib, would that be something that is possible in fiscal '14? Or is that more of a 2015 event?

Seth Darling

Well, I mean, I think from an Ink'd or a Jig, I mean, Ink'd you're talking about from an NPD perspective was the #1 selling bud in the U.S. this last quarter, and Ink'd was the #3 selling bud in the U.S. So I don't think you're going to see something that's more of a specialty bud jumped to being the #1 in the U.S. Do I think that it can be in that line of 3 buds? Do I think that they can be really successful? And as we continue to take consumers and take them from that bud that they got with their phone when they bought it and transfer them and upgrade them into a sports performance bud? I think that trend will continue and continue. I mean, one thing I heard and read the other day was something like 85% of consumers still use the headphones that came in their -- in the box with a phone to exercise. And you go -- the buds that came in the phone to exercise is -- it's just -- it is far less than desirable when you talk about they fall out, they burn out because they're not sweat proof. And so I think when you take -- you go, hey, only 15% of the population is actually using a sports performance bud for a fitness activity, there's a big market there to go, one, if we can come out with the right product to be disruptive and teach people. Again, throw away what came in your box from an exercise perspective, wear it when you're in the car or whatever. But man, it's not what you want to exercise in. There's a lot of upside to that bud. I wouldn't expect this to run to an Ink'd or a Jib.

Operator

And our final question comes from Rafe Jadrosich of Bank of America Merrill Lynch.

Rafe Jadrosich - BofA Merrill Lynch, Research Division

Just one quick question. Can you guys just talk about the competitive environment? Have you seen any consolidation of brands at retail and just the promotional levels? And then maybe talk a little bit about -- I know you said your inventory is better, but how about kind of at retail with maybe some of your competitors. Have you seen any promotional uptake?

Seth Darling

Sure. I mean, I think on the competitive and consolidation side, I think we're definitely seeing that happening. We've been talking about that for the last couple of calls. I think we're continuing to see it happen. As I talk to buyers, and we're doing our free lines [ph] now, I think that it will only happen more and more. So definitely seeing it. I think that, that happens first in the U.S. If you go abroad, internationally, I've been in international a couple of times lately, and I think you still see a much wider assortment than you do domestically. So I think the U.S. will lead that. Then places like Canada will follow, the U.K. and then go through. But we're definitely seeing that. From a promotional perspective, I think for the top brands, and I kind of think of kind of those top 4 brands that are pretty solidly in that consolidating group, I think overall, not a ton more promotion, maybe a little bit here and there. I think you've seen with one of our big competitors kind of might be like a semipermanent price drop in one of their key styles. But I don't see it super driven by promotion on those 4 brands. What I see a little bit more is those brands that are on the outer edge of the consolidation that there's a decent chance they won't be here a year from now, 2 years from now if they're not a little bit more aggressive. I think you are seeing some more promotion out of those brands, and I think that's to be expected in a consolidated environment. We've known that, that's coming. I think for us, the biggest piece is we want to make sure that we build that premium ethos of the brand. We make sure that we sell through at the full price. And of course, we'll be competitive from a promotional perspective, but we're going to concentrate on making sure that we get full value for new products and innovations that we're bringing to the market. And then I think the last piece on that, Rafe, I think you just had was do I see a lot of inventory from any of the brands. And it's not something I've heard a ton of from retailers. I'm certainly not in the backroom of any of our biggest retailers, but it's not one of the first things that comes up in conversations.

Operator

We have no further questions at this time. I'd like to turn the floor back over to Mr. Darling for any closing remarks.

Seth Darling

Great. Thank you. I think just first, I'd like to say thank you to our team, this is a team that has worked so hard and is jelling together. So thank you to that team. And to all our investors, we appreciate the patience and being an investor. I believe that we have Analyst Day coming up in September. So hopefully, we'll see some of you then. Thanks.

Operator

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.

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Source: Skullcandy's (SKUL) CEO Seth Darling on Q2 2014 Results - Earnings Call Transcript
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