Skullcandy's (SKUL) CEO Hoby Darling on Q4 2015 Results - Earnings Call Transcript

| About: Skullcandy (SKUL)

Skullcandy, Inc. (NASDAQ:SKUL)

Q4 2015 Earnings Conference Call

March 02, 2016 04:30 PM ET


Brendon Frey - IR, ICR

Hoby Darling - CEO

Jason Hodell - CFO


Andrew Burns - D.A. Davidson

Nick Meyers - ROTH Capital


Good day ladies and gentlemen. Thank you for standing by. And welcome to Skullcandy's Fourth Quarter Fiscal 2015 Earnings Conference Call. Presenting on today's call will be Hoby Darling, President, and Chief Executive Officer and Jason Hodell, Chief Financial Officer. As a reminder, today's call is being recorded. At this time, all participants are in listen-only mode, following the presentation we will conduct a question-and-answer session.

At this time, I would like to turn the conference over to Brendon Frey of ICR. Please proceed, sir.

Brendon Frey

Good afternoon and welcome to Skullcandy's fourth quarter of fiscal 2015 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 statements. 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 on Form 10-Q and 10-K. Investors should not assume that statements made during the teleconference today will remain operative at a later time and Skullcandy undertakes no obligation to update any of the information discussed on this call.

With that, I would like to turn the call over to Hoby Darling, Skullcandy's President and Chief Executive Officer. Hoby?

Hoby Darling

Thanks, Brendon, and thank you to everyone on the call for joining us today. During 2015 we achieved double digit top line growth on a currency neutral basis as both our Skullcandy and Astro Gaming brands increased revenue and gained market share. For the year we continue to generate positive cash flow while investing in our brands by adding talent and increasing our demand creation and innovation spending.

While 2015 fell short of our original expectations due to both external and internal factors during Q4 I believe we are a much stronger company today and on a better path than at any point over the last several years. Heading into the holiday season we believe that our products innovation, demand creation and distribution strategies which drove nearly 13% sales growth year-over-year through the first nine months of the year had us well positioned for another quarter of solid growth. We had also increased our product placements in key accounts for Skullcandy brand wireless products which led to our belief that our projected growth for the quarter looks solid. This was further bolstered when we saw Black Friday sell through in our largest accounts up significantly year-over-year.

Unfortunately overall consumer demand for audio headphones during late November and the months of December and particularly during the important selling weeks leading up to Christmas was significantly weaker than both industry expectations and our expectations. While sell through of Skullcandy branded products was well above industry average for NPD reporting retailers and Astro brand sales were exceptionally strong, it wasn’t enough to overcome some market headwinds which I'll discuss in more detail shortly.

Looking at our Q4 performance there were a number of positive takeaways that underscores the strength of our brands and reinforce our confidence in the company's direction. There were also key learnings from our results and competitor actions that we are using to refine our go forward strategy. As I discuss the results I think it's helpful to separate our two brands. So let's start with our largest brand Skullcandy.

First I'm happy to announce that Skullcandy was again the most chosen audio headphone brand in the U.S. by consumers for the second year in a row according to NPD. To be the number one choice for the consumer remains an incredible honor for our brand and shows the results of our dedication to consumer centric innovation.

Now let's talk about Q4. During the critical fourth quarter when approximately 40% of headphones sales occur in the U.S. Our performance at retail was markedly better than the rest of the industry and retailers covered by NPD, and very strong at several of our largest accounts such as BestBuy, Walmart, Amazon and Target. In NPD covered retailers Skullcandy brands sell through increased mid-teens on a percentage basis year-over-year compared with a mid-single digit decline for the rest of the industry. So overall we feel very good about how we did versus the competition and the market overall. We took significant market share that is a win. Our strong results were driven by the performance of our new product introductions as consumer responded positively to our expanded wireless offering.

Growth was led by Hesh 2 Wireless the number one selling wireless Over-the-Ear Headphone in out killzone between $20 and $100 for 2015. Retail sales of our wireless portfolio, which also includes Uproar, Smokin' Buds 2 Wireless and XTFree, our wireless sports performance Ear bud, increased 400% in the fourth quarter compared with the same period last year. This growth elevated Skullcandy to the number four dollar position in the wireless category in Q4, up from number 12 a year ago as measured in NPD retailers. And from a unit perspective Skullcandy was the number three wireless player up from number 13 last year. So I believe we are looking good on the question of whether we will be a top player in wireless audio after many years of strong performance in wired audio.

As expected the growing consumer shift toward wireless negatively impacted demand for our wired headphones, especially at the higher end of the market. According to NPD the wired market for all price bands was down approximately 24% in retail dollars in Q4. However I think it is important to note that the opening price point market was not nearly as effected as evidenced by total unit sales being down a much more reasonable 4%. And even in the down markets Skullcandy once again had two of the top three selling styles in terms of unit.

The Q4 numbers tend to validate our assumption that the high end of the wired market will be significantly impacted by the rise in wireless, but that the opening price point wired market may be less impacted. We’ll continue to monitor the rate at which the wired markets slows down and adapt accordingly.

What was especially encouraging about our overall performance at retail was the fact that consumers continue to choose Skullcandy more than any other brand despite the fact that several competitors were significantly more promotional in Q4 then they were in the prior year. While we ran planned strategic promotions on specific products over the Black Friday weekend and the week before Christmas, we choose not to follow the actions of several other brands that discounted popular in line styles 40% off MSRP much of the holiday season and closer to 60% off MSRP during key sales windows. We thought it was in the best long-term interest of the brand to maintain our strategy on discounting and deliver our premium yet accessible positioning without further discounts even though the competitors discounting brought several of their styles into our product killzone pricing.

To summarize our holiday performance at the majority of our domestic distributions Skullcandy products sold through at a very solid pace. This has resulted in very lean Skullcandy inventory in the channel for most retailers at yearend compared to that of the overall market.

I think it is important to explain the disconnect between our sales results, which we recorded on a sale in basis and were lower than our projections, and the sell-through data published by NPD, which was very strong. The difference is driven primarily by two factors. First the decline in sell-through for the rest of the industry and significant promotions offered by our competitors negatively affected our replenishment sell in business. Especially for our new wireless products late in the quarter. We just did not get the sell-in reorders we expected to match the strong sell through in consumer adoption.

Secondly, our performance at retailers not covered by NPD which consists primarily of discount retailers and specialty doors was below plan for Q4. In the discount channel we chose to minimize off price sales significantly below our guard rails to further protect the Skullcandy brand and our full price retailers. Late in Q4, we decided to hold back approximately $3 million in planned shipments to the discount channel that would have been detrimental to the brand, gross margin and our long-term business. That was a difficult decision because it was a change from the earlier plan but we believe it was important for our long-term success. We will continue to use this channel sparingly in the future which does effect year-over-year revenue comparisons and profitability this year. But it's simply the right thing to do to ensure a strong Skullcandy brand.

Our specialty channel performance was more of a disappointment. This channel is where Skullcandy first established its gritty authentic positioning. Unfortunately as a result of shift in consumer purchasing behavior and the rapidly changing specialty retail landscape many of these doors have seen traffic decline. This accounts continue to play a strategic role in the brand’s positioning, but we do believe this part of our business will continue to be challenging from a sales and profitability perspective. We remain committed to this channel and these retailers but are also being realistic about the business at the same time.

Turning to our international Skullcandy audio business fourth quarter revenue was down 17% from last year on a reported basis, but flat on a currency neutral basis in line with our most recent expectations. Excluding the impact from FX, our performance outside the U.S. was marked by pockets of strength in several countries. Offset by headwinds from certain distributor markets that are in transition, especially China where we continue to have some challenges around payment and maximizing the territory.

Let’s start with performance in our EMEA territory. In the influential UK market, we experienced solid sell through of our new wireless audio styles at several of our large key accounts. Sell-through was also up solidly in other major markets like Germany and the Nordics as consumers responded positively to our product and marketing strategies during the fourth quarter. This bodes well for 2016 and beyond when the transition to direct distribution in Germany and a new distributor for the Skullcandy brand in the Nordics is complete and the pressure of liquidating our former partner’s products is behind us.

While slightly behind the pace in the U.S., European consumers are migrating to wireless audio, which is impacting elements of our wired legacy business. However, we believe that we’ll be able to replace these loss sales as our higher price wireless offering adds new points of distribution and gains broader awareness with our target audience across the region.

In Canada, the combination of successful demand creation programs, new fixtures including listening stations at key retailers and merchandising teams in stores on the busiest shopping days translated into audio sell through growth rate 25 times the rest of the industry during the fourth quarter. Our retail performance helped Skullcandy in 2015 as a top five stereo headphone brand in Canada. For the first time since we went direct in 2013.

Turning to Mexico where we announced in Germany we acquired the minority interest in our joint venture. We executed this transaction because we felt that the brand and business was at an inflection point and it was the right time to assume complete control over the future direction of this market. A partner did a terrific job generating brand heat through innovative marketing program such as our association with Formula One Racing as well as more localized grass root sponsorships that connected Skullcandy with the creative culture of Mexico.

We now need work with the team in Mexico on how to accelerate this business .on the other hand as we discussed on the Q3 call. Our wholesale business in China declined during the fourth quarter and we withheld shipments to Times Runner, our distributors that sells under the brick and motor CE channel. We needed to address their current inventory overhang and respond to payment challenges. Our work to improve the situation is ongoing, but we expect to return to a more normalized state in the back half of 2016. But the situation remains somewhat fluid as we work towards a positive solution.

In Q4, we also increased our bad debt reserve by $1.6 million at year-end, which had a significant impact on our Q4 EPS. The good news in China is that are direct-to-consumer business led by e-commerce continue to grow double-digit. All-in-all, I’m pleased with how our Skullcandy products performed at retail during the holidays in-light of the significant drop off for the headphone industry in total.

Remember we’ve seen double digit U.S. market growth rate for the first nine months and then U.S. headphone market was actually down year-over-year in Q4. Our strong performance compared to the market has led to good discussions with our retailers about their commitment for 2016 and how we can expand with them in 2016 and beyond.

Looking ahead at the opportunities to drive growth pursuant to our five pillar strategic plan that I have discussed with investors at length. So how do I feel about 2016 from a Skullcandy brand perspective? Good overall, we’re winning compared to the competition, taking market share and producing some of our best products ever as evidence by the announcement just this week by PC Magazine that our new Grind wireless headphone was selected Editors’ Choice and also the team behind Run just won an international forum design product award for Grind’s aesthetics, execution, usability and economics.

Congratulations team. With that said, I believe the Skullcandy brand business faces some marketplace challenges in 2016. First from a retail distribution perspective, just in the last few week several of our largest retailers across multiple channels have announced closing doors and restructuring. While others have publically guided to overall flat or decreasing revenues for 2016. There is a change we have really just begin to quantify during Q1 and has led us to be a bit more conservative on growth than we earlier felt. Second, I feel that the market inventory across the majority of our audio brand competitors is probably a bit higher than retailers might like right now. Due to Q4 sell through been well below retailer expectations.

Third, the potential news from apple around discontinuing the 3.5 jack in the next iPhone will also provide both opportunities and challenges. With all of that said, I do believe the Skullcandy brand will grow in 2016 led by strong growth in the wireless category for headphones, earbuds and speakers. We had significant new wireless offerings coming to market in the back half of the year, which I believe will drive growth despite continued pressure on our traditional wired Skullcandy business. Significant focus, you can expect to see from a Skullcandy brand in 2016 includes the following.

First, innovation in three key areas. Starting with wireless, which is where the world is moving and so we want to make sure we lead across all categories. We have a strategy that we believe will accelerate our position in wireless by providing the consumer everything they love about Skullcandy. Great styling innovation and unbeatable value. We are taking several of our best-selling most comfortable and heralded products and recreating and improving them for a wireless world, styles like the best-selling wired earphone in the United States improved and made wireless, screams [ph] wireless. Proven products that retailers and consumers trust to be winners. Then our virtual reality audio crusher products which were very well received at CES.

We believe that VRA helps us bring a new consumers to the brand and positions Skullcandy as a brand that is leading a new technology while further driving our immersive crusher platform. Finally, our Sports and Human Potential Lab, where we work with the best athletes in the world to unlock their full potential. The lab provides us a very unique position to drive our product creation and also our innovation point of view for sports performance and music making people better.

Second, we’re focusing on how we spark our international business where growth was relatively flat year-over-year excluding currency effects, but where we expect significant growth overtime. Third we’ll be looking to bring new consumers to the brand and appealing to a broader group of fans overtime. This will be achieved by evolving our brands look and feel to make sure we’re hitting on all elements of our heritage including music, sports, technology and creative culture. It will also be achieved by expanding our affinity marketing to make sure we are closely tied with our influence to consumer. These will supplement our existing rollout of the in store and digital presentation that can be our brand message of, life at full volume.

And fourth winning with our opening and midrange price point business which historically have generated significant earnings. We even make sure that we are the trusted choice of consumers and retailers where we have traditionally been a big player with styles like Jib, Ink’d, Uproar and Hesh. While there is certainly more going on this is where we’ll be focusing and spending our time and dollars.

Shifting now to our Astro Gaming brand. I believe Astro has the potential to grow into a dominant gaming company. Gaming is such a strong trend and Astro is at the top of the most desired performance products in gaming audio. Astro had a phenomenal fourth quarter sell in and sell through were both up strong double digit helping Astro grow it's already dominant share of the premium segment of the gaming headset market and increase its overall share by almost four whole points to 13.5% versus Q4 last year. This is driven primarily on the strength of two products and meaningful games on both major platforms Xbox One and Playstation 4.

The major highlight from the quarter was the launch of Astro's new A40 tournament ready Headset. Excluding the A40 TR with pre influencers and the media around the globe coupled with digital and social marketing campaigns explain the product’s innovative features showed strong sales right out of the gate. In fact we sold out of our inventory during the fourth quarter and could not fill demand despite producing the levels above our optimistic projections.

At the same time sell through of our top of the line wireless A50 gaming headset easily outpaced the rest of the industry. The fourth quarter performance of our two product families to A50 and the A40 reinforced Astro's position as the undisputed king of premium gaming audio and set it up for even bigger things overtime.

This is a dynamic period for the gaming industry participation rates are growing rapidly as the new consoles continue to sell well. Now that we are in the third year of the life cycle for Xbox One and Playstation 4, the pace of new AAA rated multiplayer gaming titles is accelerating, which is the big driver of gaming headsets sales. And through licensing agreements Astro's associated with Halo and Call of Duty arguably two of the best-selling franchises of all time.

Both launched the latest iterations of their award winning series in November and were two of the top performing games over the holidays. We believe Astro represents a significant opportunity for our company. The brands authentic position with elite gamers provides great foundation to expand market share of gaming headsets and develop a true lifestyle brand within gaming. We plan to invest resources in taking the brands to the next level.

With that said we will protect profitability with Astro and our overall company, but I also think that we need to make sure that we are investing in such a strong brand that is in infancy of its growth cycle. It is a time to grow the brand and secure the full potential for the future.

Significant focus you can expect to see from the Astro brand in 2016 includes the following. First take Astro global through our Inc platform, so that we replicate the successes of the Astro brand in U.S. abroad. Astro currently generates a third of its revenue internationally and we believe has the potential to be significantly higher.

Second, expand our ecosystem through new products and price point overtime. We believe the canvas where we can play, are the need today. 2016 will be about setting us up for the future. Third, improve our in store experience with listening stations with several of our most important partners. As a company we have a lot of experience here and believe this will provide us solid lift.

Fourth, improve long-term gross margins, this is not an overnight lever but one that becomes more relevant as we continue to scale. I do want to make clear however that as a premium brand we will not ever settle for creating product that is not the best at the price points we play. Astro already has the most profitable gaming headset business in the industry as far as we can tell from publicly available data, but we believe there is opportunity to make the best-selling gaming products in the world while also increasing profitability.

There is a lot to be excited about with Astro. One challenge we will have on the Astro brand side in 2016 will be around fulfilling demand for products. Astro product have long manufacturing lead times and so forecasting is more challenging, we’ll continue to be unable to meet full demand for our newest and most successful product during the first half of the year. We will catch up towards the end of the year, but it is always hard to see such high demand and be unable to match it with supply.

To bring it to a conclusion while there are always challenges, I believe they just make us stronger. I remain excited for the future and what our two brands, teams, ambassadors and partners can do. I will now turn the call over to Jason. Jason?

Jason Hodell

Thanks, Hoby. Hello, everyone and thanks for joining us. In my section, we will start with review of our fourth quarter income statements, discuss our balance sheet as of December 31st and then provide an outlook for the year and Q1. First our fourth quarter income statement.

Sales, in Q4, our net revenue declined 0.8% year-over-year to $96.1 million from $96.8 million one year ago though it grew 2% year-over-year on a constant currency basis. From a geographic standpoint, domestic net sales increased 3% to $72.7 million from $70.6 million one year ago. Driven by a strong performance in gaming and the sell in of our expanded wireless offering, partially offset by the decline in wired Skullcandy products.

International net sales decrease 11% to $23.3 million from $26.3 million one year ago. However on a constant currency basis our international sales were flat year-over-year, primarily due to decreased sales in Australia and China was offset by strong growth of gaming sales in Europe. Foreign currencies depreciating against the dollar over the last 12 months has continued to put pressure on our average selling prices. Using average monthly rates, over the past year the euro is down 8%; the British pound down 2%; the Canadian dollar down 17%, and the Mexican peso down 17%.

For the fourth quarter international sales felt as a percentage of our business due to the changes we've made in the Nordic region and in China. International represented approximately 24% of our business in Q4 versus 27% one year ago and down from 30% in Q3.

Product mix, during Q4, our gross revenue product mix changed considerably from both Q3 and one year ago. First, let's look at the year-over-year changes. On and over ear headphones increased 4 percentage points to 58% of gross sales versus 54% one year ago. Products driving the increase included the A40TR, wireless Hesh 2, and both wireless and wired Uproar. In ear products decreased 2 percentage points year-over-year to 38% of sales versus 40% one year ago. Products with the largest decreases were our older models like Ink, Titan, Spoke and 50-50. These declines were partially offset by sales of Bluetooth Smokin’ Buds 2, Bluetooth XTFree and XTplyo.

The remainder speakers and accessories decreased to 3% of sales versus 6% at one year ago due to decrease sales of our Bluetooth speakers. Comparing Q4 mix to Q3 also showed the shift towards on and over ear headphones. Our on and over year share is up 8 percentage points to 58% from 50% in Q3 and our in-ear share is down 6 percentage points to 38% from 44%.

Gross margins, in Q4, our gross margin was 40.3% down 300 basis points from 43.3% one year ago. The year-over-year decline was driven in part by 120 basis points of negative foreign currency effects. On a constant currency basis gross margin would have been approximately 41.5%.

As for the remaining 180 basis points change in our gross margin year-over-year, there are three primary and overlapping drivers. Here are the approximate measurements. First, a 50 basis points decrease in product margin to capture the shifts in our business away from in ear products and the introduction of wireless products. Second, a 30 basis points decrease for the overall mix shift of our business towards gaming and lastly the remaining 100 basis points is driven by the impact of increased product returns and promotional trailing credits.

Comparing our gross margin to plan the 170 basis points difference from our realized gross margin had three approximate drivers. First 100 basis points through higher product returns in China and Mexico during Q4. Second 50 basis points through higher volumes of promotional pricing programs in the quarter particularly with the domestic Skullcandy brand as we competed in the promotional environment and lastly 20 basis points for the increase in gaming as a percentage of our total revenue.

SG&A. Turning to SG&A spend. We are continuing to drive down SG&A as a percentage of net revenue while still funding demand creation for revenue growth and investing in innovation to build our future. As a percentage of net sales, SG&A decreased 31% from 32% in Q4 2014. SG&A absolute dollar expenses for the quarter decreased 3% to $30.2 million from $31.1 million one year ago. The-year-over-year decrease in SG&A dollars can be attributed to decreases in personal related expenses, offset by increased demand creation and research and innovation expenses as well as the $1.6 million bad debt expense related to our Chinese distributor.

Generally, aside from demand creation and R&D, we will continue to leverage the rest of our SG&A spending. Operating income, our operating income in the fourth quarter decreased $2.3 million to $8.5 million from $10.8 million in Q4 last year. The decrease in operating income can mostly be attributed to lower gross margins partially offset by decreased SG&A spend. Taxes with the relative under performance of our domestic segment to plan in Q4, our effective tax rate fell with the larger international share of earnings. Thus our Q4 tax rate was 27.5%.

Net income, net income for the quarter was $6.1 million or $0.21 per share, versus $7.4 million or $0.26 per share in Q4, 2014. After eliminating the benefits and losses of foreign currency changes, Q4 constant currency net income per diluted share decreased by about $0.015 or decrease of 7% year-over-year.

Balance sheet, turning to our balance sheet on December 31, 2015, lets highlight a few items. Our cash, cash equivalents and short-term investments totaled $23.6 million as compared to $13.9 million last quarter and $36.6 million as of December 31, 2014. Approximately 48% of our cash is held in domestic bank accounts and we have no bank debt similar to last quarter.

The year-over-year decrease in total cash, cash equivalents and short-term investments is mostly driven by our factory early payment discount program. We have put roughly $15 million to work with our factories in the form of these early payments. Though this amount is constantly changing based on factory orders and timing. Since Q4 last year cash, cash equivalents and short-term investments are down $13 million, while at the same time our accounts payable balance is down $14 million, despite the growth of the business during this time.

As an important note our current plan is to phase out of our early payment program with the factories by the end of June. So this a forth mentioned cash approximately $15 million will be recaptured on the corporate balance sheet by the end of Q2. As a measure of the liquidity improvement of the business working capital as defined by current assets minus current liabilities is up $8.6 million from one year ago. Inventories decreased $20.8 million or 33% since Q3. And more importantly compared to one year ago our inventory has decreased 24% to $41.7 million from $55 million. The large reduction in inventory levels can been seen as the end of efforts to manage down inventories now that the 2014-2015 port stoppage effects on mostly over combined with efficient balance sheet management.

So, in summary, the balance sheet has good liquidity, and we now have a net book value of equity of $150 million, an increase of $6 million since Q3.

Now I will outline our full year 2016 and first quarter guidance. Before we give our guidance we want to carefully point out certain risks that are not fully in our annual nor first quarter guidance. Potential legal cost related to litigation and retailer bankruptcy proceedings are not factored into guidance because they are unknown. Also we are not assuming any extraordinary bad debt amounts with retailers or distributors.

Full year guidance. For annual revenue driven by Astro Skullcandy brand wireless products and 2016 new model releases we expect net revenue to growth of mid to high single digits. In particular we are expecting strong results from Bluetooth Ink’d and our successful A40 and A50 product lines as manufacturing catches up to demand and releasing two new A50 skews for holiday. Our guidance assumes constant currencies in 2016. As an important note our total unit volumes are planned to be down in our 2016 forecast while increases in ASP drive revenue growth. In this plan we are significantly reducing our projection of volumes into the EOL and close out channel to booster our brand strength and due to generally lower inventory volumes.

Our current plan projects of 4 million decrease year-over-year. In a change that occurred during Q1 please note that we have excluded revenue with the sports authority due to store closures and reports of the bankruptcy filing. This has reduced the annual plan by approximately 1% as we also discounted other changing customer financial situations that have been publicly disclosed. There are other headwinds to our revenue plan to include financial risks with the number of our domestic retailers and international distributors while we account for some risk in our financial outlook there are of course unknown risks.

Gross margin. We are targeting our annual gross margin to be generally stable with 2015 on a constant currency basis. Offsetting the natural headwinds of increasing gaming and increasing wireless mix are several gross margin tailwinds of note. Number one, the U.S. dollar to Chinese yuan foreign currency exchange rate effect is lowering factory cost. Number two, Astro gross margin improving, license cost in gross margin are falling as a percentage of revenue. And number three, sales returns and promotional trailing credits are expected to fall year-over-year with generally better customer terms and less product returns. Assuming a 29% tax rate for EPS we are targeting and EPS range of $0.24 to $0.28 for the year as we now take into account the recent retailer and consumer factors effecting on marketplace. As Hoby mentioned in January our outlook is being balanced by the challenging retail audio market in the U.S.

Q1 guidance. We are expecting Q1 net revenue to change in a range of minus 4% to flat versus the prior year due to a few key issues. Number one, the recent marketplace forces noted above. Number two, we believe we had approximately $2 million in additional Astro revenue that we could not captured due to product shortages as the A40 Tournament Ready Edition has been sold out combined with the effect of longer Astro manufacturing lead times. And number three, lastly China revenue in the Q1 plan is $1.3 million less than Q1 2015. Assuming a 29% tax rate we are expecting Q1 GAAP diluted EPS of minus $0.15 to minus $0.17.

Looking forward we want to provide context on the cadence of our revenues and earnings during 2016. As Hoby mentioned earlier we are expecting to return to revenue year-over-year growth in the back half of the year. In 2015, Q2 benefitted from both the Walmart Planogram expansions that we are not experiencing now and the initial customer product set at Kohl's. In 2016, China is down $0.9 million year-over-year in our Q2 plan. And in 2016 benefits from new product releases and potential distribution additions are in Q3 and Q4. On cost we expect SG&A to be higher than 2015 in both Q1 and Q2. As a result, we expect Q2 to swing to a modest loss on a GAAP basis with a number of onetime cost items effecting our profitability.

In putting forward our first quarter and annual outlook we again want to remind everyone of the complexity of accurately assessing our future earnings and revenue growth given the competitive nature of the industry competitive pricing and promotion shifts, potential manufacturing delays with difficulties in predicting sales of our products into key retailers especially with new products and new technologies, changes in market technology, operations in international market, unforeseen legal matters, retailer and distributor operational challenges, sourcing cost, foreign currency impacts and shifts in consumer preferences.

Because of our consumer and innovation focus, brands strength, quality products, strong working capital position and dedicated team of employees, athletes, sales reps and distributors we are confident we can achieve our vision of being a global audio leader, deliver profitable growth and increase shareholder value.

Thanks everyone, now back to Hoby.

Hoby Darling

Thanks Jason. Our think it is clear from the performance at retail over the holiday season that our company owns two of the strongest brands in audio and gaming. We feel confident that people will only be listening to more music, engaging more with devices for media experiences and doing more gaming. We've built world class audio engineering and product development teams, added season sales leadership of global CE experience and enhanced our supply chain systems. We are in a place where we are excited for the future. Even despite some early headwinds this year we are confident that we will continue to grow our businesses top and bottom line in 2016. While investing in the future ensure that our brands can reach the full potential and we have some exciting brands with big potential.

We have a strong balance sheet to operate from and continue to add cash to it we also have the ability to protect profitability and intend to do so we have work to do but I believe we have the right foundation for a strong future.

Operator we are now ready to take some questions.

Question-and-Answer Session


Thank you, gentlemen. [Operator Instructions]. And now our first question comes from line of Andrew Burns with D.A. Davidson. Please proceed with your question.

Andrew Burns

Couple of quick ones for you. In terms of the commentary in the fourth quarter about holding back 3 million in sales that could have gone into the discount channel I know you guys have been working down the size of that discount channel. How big is it as we look at the business today and then also how big is the specialty channel for you? It’s seemingly shrunk as a percentage of the mix.

Hoby Darling

Sure. Hey, Andrew. This is Hoby. Maybe let me start with that and then I can hand it to Jay. On the Q4 piece around size of the off price channel and you are absolutely right on that has been a big emphasis over the last three years specially I think when I came in as CEO what that business was, it essentially chopping it in half, doing about the same to where we sat last year. So it is a small part of our business overall, we generally look at it as when we have products that are going EOL, a place to put it, we don’t have the big outlet channel and so forth. So that's really what we use it for going forward into small number going forward, smaller than it's ever been and that's what we want to do with the Skullcandy brand, that's a big part of brand strength that is, where are you, how does the consumer perceive you and so it will continue to be a small a part of the go forward.

On the specialty side, as we've grown we certainly came from being a brand that dominate in specialty born from those independent skate, snow shops and we love that business. It's a big part of who we are, it has certainly become a much smaller part of our business when you look at the size of where consumers shop for headphones today from BestBuy and Amazon, Target, et cetera, of a percentage of business. So we don’t break them out specifically, but I can tell you that the off price one is very small right now and getting smaller and the specialty ones been a little bit of a challenge, but it's not a huge number from a sales or profitability perspective, it's much more all about brand and how we make sure we stay relevant with our influencers there.

Jason Hodell

Andrew, on the EOL performance in Q4 we publicly talked about using 7% as an internal guardrail that we won't go above for the closeout EOL channel and that's been a hard and fast rule here. As you might suspect after Q4 not shipping into that EOL channel significantly we came in well under that guardrail for the year, it rounds to about 5%. So much better than expected as we try to minimize the EOL and closeout. And then for 2016 again we’re looking to decrease that and as I disclosed that difference is $4 million of revenue year-over-year that’s out of the plan.

Andrew Burns

Thanks for that color. And then in terms of the iPhone 7 dropping the headphone jack, I think if you just spent a little more time on that. It seems that that has the potential to impact the entry price point wired business over time pretty substantially. Any thoughts there?

Hoby Darling

Sure, on iPhone 7 part we are certainly planning for Apple not having a 3.5 jack on that phone that's where our strategic priority is as we look at product and we look at what we bring to market, that’s the assumption that we are making. And I think it’s a big opportunity and it also creates a challenge, big opportunity from a perspective of I think it pushes people to wireless faster for us that's overall actually a great thing because it pushes our ASP up so significantly and our gross margin dollars up so significantly when you start to talk a $20 to $30 up charge from wired to wireless. So very good on that piece. From a perspective on the opening price point if wired, what does it do to Jib wired, what does it does to Ink'd wired. The way we're thinking about is, the latest numbers that I've seen are if you look at the U.S. iPhone is about 40% of the market, international it's much smaller, it's about 15% of the market. When you look at our target consumer it actually skews a little bit less iPhone than even that 40%, I think it's one data point, and then the second data point, for our general Skullcandy brand consumer, they're not quite as early adopter as some other consumers and so I don't think you’d see an immediate drop off in that opening price point business.

But we are thinking about it, over time how are we balancing some of that business I think it will go away as you see the 3.5 jack go away and then at the same time I think there's some really big up sides as a move to wireless is accelerated on that as well.

Andrew Burns

One last one, at a few points during the call you mentioned higher return and it feels like Mexico and China were highlighted, I didn't know that the causes of that elevated return was directly tied to the distributor changes, is there anything else worth mentioning there?

Jason Hodell

Andrew you’re hitting the nail on the head, for the most part these are tied to distribution changes we're making. Clearly we've publically disclosed the distributor situation in China and taken the allowances there both for future returns and for bad debt, that is the bigger story there, but those were the two geographies that had the highest abnormal amounts of product returns during Q4.


Our next question comes from the line of Dave King from ROTH Capital. Please proceed with your question.

Nick Meyers

Hello guys, this is Nick Meyers, I'm on for Dave king today. Yes, so anyways just wanted to first start off your outlook for the year. Can you guys talk about what the outlook assumes for the gaming business versus the traditional audio business? And then on the traditional side what are you assuming in terms of industry growth versus market share gains?

Jason Hodell

Sure, from a segmental perspective the biggest growth category for us as you look at 2016 versus 2015 it's definitely our suite of Bluetooth products, it's approximately doubling in the plan year-over-year and that is in accordance with the strong wireless growth we're seeing macro wise in the industry and of course we're still launching our new products in Season C of this year which will add to the portfolio, which kinds of underpins that growth. Gaming had such a strong end to the year in Q4, it is up slightly in 2016 but by no means anywhere near the growth of our Bluetooth category in Skullcandy. We're launching a new speaker suite, that's up slightly and then all of those growth areas Nick are essentially offsetting the general decline of our corded businesses both in-ear and, on and over ear.

Nick Meyers

Perfect, I appreciate the color. Moving on to the next one, so it's obviously a tough holiday, how are you guys thinking about the retail backdrop currently and has the competition and/or discounting abated at all? And how is your sell-in and retail open to buy tracking versus sell through?

Hoby Darling

So, Nick let me hit on those maybe one at a time, I think the first question was just around retail and what are we seeing at retail, and I think you can read the headlines pretty much like I can, it's a tough spot at retail coming out of Q4 with a lot of big box retailers, a lot of specialty retailers. I don't think anyone has come out of Q4 from a retail perspective and gone, gosh, best days I've ever seen. At the same time you see some bright spots, clearly within Amazon some of the online dealers that we have both in audio and in gaming. But I think that those retailers that we do business with they're big, they have good scale, I think they'll be okay but I don't think anybody's gone gosh, really bang up Q4s and we’re certainly not feeling that as we talk to them either. From a perspective of the competition, we always have competition, clearly in Q4 as we talk about on the call, I think the competition was more promotional than we were.

At the end of the day how I look at it is I go, what did consumers choose? And if you look at NPD consumers we're up 16% year-over-year with a market that was down. So, even despite heavy promotional environment we still did pretty darn well when it came to what were consumers choosing. So, I feel pretty good on that.

I think the part that goes to that open-to-buy channel health is what we mentioned around when you have a disconnect and what retailers expected and I think most retailers expected the audio market to be up double digits and it was actually down. You do have a bit of an inventory issue, we feel good on it from a Skullcandy perspective, but we do hear that from retailers of, gosh, we were probably a little more inventoried on other brands and we'd like to be -- and some of those are pretty big brands.

With that being said, haven't seen tons of promotions in Q1, hasn’t been a huge promotional period, cadences actually been fairly normal at the big retailers. From an open-to-buy perspective, I think one of the concerns we expressed on our pre-release was around, okay, as we go into Q1 how much inventory will be in channel and will there even be open to buy. I mean the good answer to that has been, or the positive answer for us, has been we are seeing open to buy orders, we are seeing re-plans, they are not quite as big as we would love to see them based upon our performance. But we’re definitely seeing them and I think that’s a lot more than other brands are feeling right now. So we feel pretty good from that perspective.

Nick Meyers

Perfect. I appreciate it. That great color. One more then I’ll be move back. So you guys are quite successful in working down inventories, it was quite a bit actually despite the difficult holiday. And it seemed to have generated a good amount of cash flow after you adjusted for the accelerated payment programs. Can you talk about -- you said you’re going to have a lot of growth in cash in 2016, can you talk about the drivers there and further progress on inventory. And then last but not least, just remind us when you’ll anniversary the accelerated payment program related to the declines in payables?

Jason Hodell

Sure you got it. So as you look at our balance sheet are really proud of where it stands right now. The best measure that we look at internally I think is just looking at our working capital at hand and that’s current assets minus current liabilities and that’s a $125 million right now and that’s up $9 million year-over-year. But then whenever you drill into that a little bit Nick these are really high quality, net current asset, because the vast majority comprises of accounts receivable cash itself, cash equivalent short-term investments and inventory, all very high quality. As long as you’re managing your inventory well and I think one of the nice story that popped out of the year and its hats off to a lot of people at Skullcandy sales obviously supply chain and the planners, but having inventories fall by $13 million in growing environment, it’s hard to do.

And we’re at 67 days of inventory right now, which is the lowest in recent history Skullcandy and what that speaks to them is whenever you’re looking at the quality of the net current assets on the balance sheet, that of course increases the quality whenever inventories have been relatively minimize. And then whenever you look at just that inventory balance, because of course in Q4, we did not meet our internal forecasting, a lot of that inventory is basically in line inventory, that we just haven’t worked through yet.

So not a lot of risks of that as we carried into the year and continued to work through it. So all of that sets a stage for a really nice kind of cash flow generation year in 2016, if you take the $0.26 of EPS guidance and you back into what that means in terms of operating income, it’s about 11.4 million and operating income which then is about 27 million in EBITDA, which leads to about $11 million in operating cash flow after you subtract off a run rate for CapEx and taxes. So $11 million of operating cash flow for the business and like I mentioned in the scripts, we’re going to end that early payment program. We have about $15 million tight up in it right now, we put that to work with factory earn discounts. Our goal is to end that plan by the end of Q2.

So to recapture that cash that being used in that plan. And in addition to the natural operating cash flow the business which I just talk about we’ll be able to recapture that cash as well and you’ll see the early payment programs completed by the end of Q2, which ironically is the same quarter where we started it a year ago because you asked me when we anniversary it.

Nick Meyers

Okay. Perfect, I appreciated all and wish you guys good luck. Thank you.


[Operator Instructions] Alright. There are no further questions at this time. I’d now like to turn the conference back over to management for any closing remarks.

Hoby Darling

Thank you to all the members of the Skullcandy Inc. Skullcandy brand and Astro broad teams including our employee, ambassadors, retailers and investors around the world. We look forward to updating you post our Q1 results in just around a month. Thank you and we’ll talk you soon.


Ladies and gentlemen this does conclude today’s teleconference. Thank you for your participation. You may discontinue your lines at this time and have a wonderful rest of the day.

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