Finding Value in The Most Shorted Stock
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
"Young and Rebellious"
That's how the Skullcandy Inc. (NASDAQ: SKUL) annual report describes the Skullcandy brand. It's also a bit how the market is viewing the company as a whole right now. The company is in full growth mode, with revenue almost having doubled in the last two years. This Graph from Google Finance says it all:
Even so, Wall Street is of the opinion that this rebellious streak will be put to a swift and decisive end by the forces of competition and ruthless capitalism. Business professionals seem to think that the biggest problem with Skullcandy is that its brand is flimsy. While it's growing now, Skullcandy will only create shareholder value if it can hold on to those profits when other opportunists join the party.
According to Yahoo Finance, along with 35% insider holdings, Skullcandy has 11.56 million shares sold short. With a float of 15 million shares, that's more than 70% of the float that's being shorted, making it the most shorted stock on the NASDAQ. Clearly Wall Street really means to teach Skullcandy some discipline.
Of course, in any situation like this, contrarians swarm.
The Contrarian Case
1. Short Squeeze
With 70% of float shorted, the worst of bad expectations are priced into SkullCandy's shares. Bad news that's not as bad as expected could trigger a small squeeze. Good news would catapult the stock price. The presence of such an obvious catalyst makes for a great opportunity. All Skullcandy has to do to cause the shorts to go away is keep raking in the profits.
2. The Profits Ring Loud and Clear
As Kyle Farrah mentions here, Skullcandy may have the brand to protect its profits. Farrah says, "Skullcandy has managed to transform something that was once sold like a commodity into a product that is able to demand a premium from the market. By adding bright colors, creative logos, and celebrity flare into their products, Skullcandy was able to differentiate their products and make them special." The contrarian opinion is that while there isn't an obvious competitive advantage for Skullcandy in its business, the brand puts competitors at a competitive disadvantage in attracting customers. While the advantage isn't necessarily as tangible as one would hope, if it's enough to protect profits, it should be good enough to cause a short squeeze.
As this article by Rick Munarriz shows, Skullcandy has managed to top analyst estimates for all 3 quarters it has had as a public company. If Skullcandy is able to continue growing even in the face of increased competition, shareholders will definitely see value reflected in the stock price.
As the use of Apple Inc(NASDAQ: AAPL)'s iPhones and iPods increases, headphones and the quality of audio should naturally grow more important, but I would ask how easy it is to compete in this market. Even Apple, whose main product is the iPod or iPhone, has its own brand of headphones competing against Skullcandy's headphones. Even so, Skullcandy's brand advantage is in its innovation and excitement. Competitors like Sony(NYSE: SNE) and Bose make headphones for quality and elegance rather than design innovation, as the target markets for these companies have generally been older. At least for the time being, Skullcandy should have an edge simply in that it has products with a bit of pazazz.
The Final Word
I'm not convinced that Skullcandy represents a true value at these prices. While things look great now, competition is on the rise as well. Beats Audio, for example, is partnered with Hewlett Packard(NYSE: HPQ) and make formidable competition. As competition increases, I expect Skullcandy's returns to diminish. Even if returns don't go to die as the 70% short float implies, I don't see a lot of upside. In his article less than a month ago, Kyle Farrah used PEG ratios and EPS estimates to value the stock between $16.50 and $23.25. With shares currently at $15.98 that represents 0% to 45% upside. A maximum of 45% upside isn't nearly enough potential reward to cover the risk implied by jumping into a stock where everyone is so convinced of the company's long term downside. I think at these prices an investment in Skullcandy would be speculative at best and imply a lot more risk than it's worth.
Even so, do your own research and feel free to give your thoughts in the comments below.
shamapant owns shares of Apple. The Motley Fool owns shares of Apple and SKULLCANDY INC and is short Sony (ADR) and has the following options: long JAN 2013 $22.00 calls on Sony (ADR). 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.