Headphones You Should Hate to Love

Austin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

What I like most about Skullcandy is how far from Wall Street the whole company feels. Its product is targeted towards everything a typical stock analyst isn't, its most Googled sponsor dances in a bikini on Youtube, and it's also the most betted against stock on the Nasdaq. If I've already sold you on Skullycandy you can stop reading and buy your shares, the rest is just filler anyways.

Skullcandy is a growing headphone and audio accessory company that targets the younger marketplace with its bold and edgy audio equipment. Colors are vibrant and styles are loud, turning a pair of headphones into a fashion statement. These aren't your daddy's headphones, and they probably aren't even your headphones, but there is a good chance those skateboarding punks disgracing your cul-de-sac are wearing them. While it may be tough to invest in such hooliganism, I think the company and the irrational market make a compelling reason to do so.

In the five quarters since Skullcandy went public, it has beaten consensus earning estimates each of the five quarters. Its total revenue is expected to grow 52% by 2013, up to $354 million from 2011 earnings of $232 million. Its 5-year expected PEG hovers around .6 due to an inexplicable forward P/E of about 9 as well as a mid $12 stock price. By comparison, the S&P as a whole has a forward PEG of 1.7, and somehow I doubt they are expecting similar growth.The recent end of second quarter press release announced that quarterly sales increased 34% domestically and 59% internationally from the same quarter of last year. Meanwhile, long term debt clocks in at zero, a rarity for a company this young. Those are the general financials to consider when I tell you that 60% of its shares are sold short, making the possibility of an explosive short-squeeze look more like a certainty.

Skullcandy's management is consistently proving it knows its market. As sponsors for its product it has chosen a wide range of young and fashionable stars that are highly idolized and followed by today’s younger generation, for reasons that may befuddle those on Wall Street. They range from skiers (Tanner Hall) and skateboarders (Eric Coston), to the more well-known NBA stars (Kevin Durant) and models (Kate Upton). Whether they shoot hoops, ski off cliffs, or dance on YouTube, these are ideal sponsors for the fast and loud youngsters that Skullcandy is reaching out to. If you are too old and crusty to believe fashionable headphones have a place in the market, then you should watch a minute of the X-Games, or the pre-game footage of the NBA finals, and then realize that tens of millions are also watching.

Recently, Skullcandy named Kyle Wescoat it's new CFO, effective October 1st (the departing CFO, by the way, picked up $250,000 worth of shares as he made his way out the door). Wescoat spent six years with VANS, a now popular shoe subsidiary that targets virtually the same market, before joining LCD television's top set maker Vizio. With Wescoat coming aboard and current management demonstrating a strong connection with its market, I think investors should like who is captaining this ship.

In the last two weeks, Skullcandy's stock price has dropped nearly 14 percent. Most of that damage is due to the announcement of new 'earpods' included with Apple products, as well as Morgan Stanley's downgrade of the stock to equal-weight. In regard to the upcoming 'earpods', I am confident they will have much less of an impact on sales than most investors seem to believe. For starters, I don't see why Apple (NASDAQ: AAPL) would improve their ear buds any more than the bare minimum. iPhone and iPad sales will be largely unaffected, so I view higher quality earbuds as just a dent in their margins. Secondly, assuming that a slight upgrade to the world’s most generic earbuds will steal considerable business from Skullcandy shows a significant misunderstanding of their target market. Skullcandy customers don't want generic, they want the very opposite. A headphone maker such as Koss Corp (NASDAQ: KOSS), a brand focusing on low price points with generic styling, has a lot more to worry about.

The analyst responsible for the Morgan Stanley downgrade thought that Beats by Dre, a line of stylish and quality headphones by privately held Monster Cable, was starting to creep on Skullcandy's shelf space. While both audio lines target the younger hip generation, a product and market comparison between the two suggests Skullcandy's niche market of loud self-anointed 'rebels' is still largely intact, while the Beats headphones sell at higher price points with a generally more clean cut image. Also of note, Monster and Beats Electronics ended their partnership in January, with manufacturing rights ending with the current year. Scratching Dr. Dre's name of Monster headphones will hurt their competitive edge while it remains to be seen how much of a splash Beats Electronics can make on its own. While the market remains flush with dozens of other notable companies, I don't believe any are too well positioned to encroach on the Mountain Dew-drinking X-Games-watching marketplace that Skullcandy oversees. Like Peter Lynch says, its all about finding that niche.

Eventually, whether its the 6th, 7th, or 15th time the company beats earning estimates, the market will realize how absurd Skullcandy's valuation is. I mean, I don't like the name either, but I doubt the kids who smashed my mailbox mind.

Fool blogger Austin Brown is long SKUL. The Motley Fool owns shares of Apple and SKULLCANDY INC. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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