Skullcandy is Sounding Sweet
John is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Skullcandy (NASDAQ: SKUL), the innovative and colorful audio accessories company, reported its first quarter earnings on May 2nd after the market close. Investors were underwhelmed, and since closing at $16.65 minutes before the earnings conference call, shares have lost nearly 20% of their value, and the stock closed the week on May 4th at $13.30. Shares currently trade at around $13.70.
Did SKUL post a loss? Reveal an accounting scandal? Throw a sandal at an unsuspecting civilian? No, actually the company reported a 48% increase in sales, and met the consensus EPS estimates of 4 cents. The company also noted it was expecting $1.10 to $1.20 in EPS for the 2012 FY, which means SKUL stock is trading at around 11-12 times projected 2012 earnings.
Skullcandy is a growth story, and not the fantasy type of story. It’s quite real. The continued success of its business model relies upon its brand and image, which it’s carefully cultivated since it began back in 2003. It embraces action, youthfulness, sports, and the integration of sports and music. Its attractive and lively design and packaging reflects the spirit of the rebellious young culture it targets—it is truly a lifestyle brand.
SKUL has built up a team of all-star endorsement deals across some relevant areas of culture that the youth market engages in and interacts with. Supermodels, NBA stars, musicians, and prominent action sports figures alike pepper the list of celebrities that endorse Skullcandy products and help to make the brand cool. Sports Illustrated Swimsuit covergirl Kate Upton, 3 time NBA scoring champ Kevin Durant, defending NBA MVP Derrick Rose, music icons Slightly Stoopid and Snoop Dogg, and skateboarder Eric Koston are just a few of the celebs signed to the Skullcandy team.
Aside from its attractive valuation and compelling brand image and positioning, there is also the more speculative—but still altogether legitimate—reason to believe that SKUL could make sense as a takeover target in the future. In the summer of 2011, mobile phone manufacturer HTC purchased a majority ownership in Beats Electronics, a Skullcandy competitor and the producer of the trendy line of headphones, Beats by Dre. As growth in mobile technology continues, it may make sense for another mobile manufacturer to purchase SKUL as a complement to its own business. In reiterating its “overweight” rating on SKUL shares on April 30th, Morgan Stanley noted that consumers were “increasingly buying headphones when purchasing smartphones.” Considering the growing ubiquity of mobile devices, this bodes well for SKUL’s outlook no matter how you view the prospects of a takeover bid.
Let’s be clear: Skullcandy faces significant competition in its industry. The headphones market has relatively low barriers to entry; there are many players in the game already, and new offerings and lines pop up frequently.
Because Skullcandy’s niche audience is the young and vibrant crowd, SKUL’s competitors are considered in that light: Sony, Bose, and other bland behemoths of sound are certainly competition, but not in the sense that they are trendy or cater explicitly to the youth market because they aren’t, and they don’t. It’s unlikely that anyone would find themselves debating: “Hmm…do I buy these rasta-colored Skullcandy headphones or this pair of dull, monochromatic Sonys?”
Having said that, the Beats by Dre line is Skullcandy’s major competition—its products are extremely popular, it has its own impressive portfolio of celebrity endorsements, and benefits from its own colorful, unique design. Beats, however, is almost exclusively a high-end headphones company, with pairs retailing for as much as $500 a pop. Compare that to SKUL, which has offerings ranging from $15 earbuds to $300 headphones, and a wide offering in between that has been the company’s bread and butter. The Beats line is also intricately associated with hip-hop music and culture, a niche genre of music that Skullcandy has been wise not to confine itself within. Seeing the success of Dr. Dre’s Beats, other successful and established rappers with wide followings like Ludacris and 50 Cent have recently launched their own audio lines. Insofar as Skullcandy is focused on the “action sports and youth lifestyle,” and not a particular style of music, these market newcomers do not threaten to capture Skullcandy’s consumer base, and in fact pose a much larger threat to fracturing Beats’ grip as the signature hip-hop audio brand.
Bottom Line: SKUL is Attractive After Post-Earnings Selloff
In recently reiterating its “overweight” rating on the stock, Morgan Stanley maintained a price target of $21 for SKUL shares. Citing store checks of major retailers carrying their line, Morgan Stanley said SKUL appears to be “taking share at Best Buy (NYSE: BBY) and at least maintaining share elsewhere.” A target price of $21 implies more than a 50% upside to the stock from its recent price of $13.70. To be fair, investors may be thinking that Morgan Stanley’s compliment rings hollow; BBY has hit a rough patch of its own recently and will be closing 50 of its stores this year. This can be attributed to more customers shopping around online for the best price and for increased convenience. As a brick-and-mortar retailer, Best Buy and others in its industry will have to embrace the online marketplace, cut their overhead, and close stores if they want to stay competitive. Because Best Buy accounts for more than 10% of SKUL’s net sales, the fate of BBY is not irrelevant to future SKUL growth, and in fact will play an important role in the fate of SKUL moving forward.
This troubling concentration of sales (Target also accounts for more than 10% of net sales for the company) is something to be wary of as an investor, but it doesn’t account for the post-earnings nosedive, because this was already a known issue. The company owns its European distributer, has amped up its online sales presence, and is taking efforts to diversify its distribution partners. The real story from the 10-Q that may have gotten Skullcandy investors spooked is in its inventory numbers. Inventories were up nearly 80% in the first quarter from their levels just a year ago. This too is legitimate cause for some concern—popular styles and looks can fade quickly, and getting stuck with tons of inventory that isn’t cool anymore and can’t be sold or must be severely discounted is bad for business. With SKUL, this is doubly true because, after all, it is not only selling a style but a product. Headphones, like almost any other electronics, change and improve rapidly, and as time moves along, the specs of the older models can become obsolete quickly. But although the inventory numbers may sound daunting and clear-cut, it helps to look at them through the right lens. Yes, inventories skyrocketed this year, but so did the company’s assets, and inventories as a percent of assets actually decreased from the year-ago quarter, from 35.9% to 34.6%.
Then again, perhaps SKUL has taken a beating recently because it’s a victim of its own success. The company beat earnings estimates in its first 3 quarters as a public company, so it’s possible the Street expected another earnings blowout. Whatever the case may be, the recent selloff is way overblown, which has SKUL shares looking almost as attractive as Kate Upton in a swimsuit (...almost).
Fool blogger John Divine owns Skullcandy common stock. The Motley Fool owns shares of Best Buy and SKULLCANDY INC and is short Sony (ADR) and has the following options: long JAN 2013 $22.00 calls on Sony (ADR). 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.