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Skullcandy (NASDAQ:SKUL) has had a rough ride, having lost around three quarters of its value since its IPO. In more recent times, it was hit drastically upon revealing guidance for the first fiscal quarter of this year. Following a series of swift analyst revisions and downgrades, the company plummeted to new lows, and has since rebounded modestly.

In this article I will try to detail one of my favorite distressed asset picks, and detail a strategy that I think will appeal to most readers, though many probably already know what I am referring to when I use the term dollar-cost averaging. In any case, let's discuss SKUL first and the main investment hypothesis.

The Fear Play

The market is nothing more than a bunch of people gambling their money in various tickers, though strategic and due diligence exists, at the core there is a gamble involved, and so in this sense the market behaves no different than a herd of sheep at the approach of a wolf; when fear kicks in it kicks in one at a time and it accelerates rapidly. After the wolf has had his pick of the litter fear slowly levels off as we approach a return to normalcy. Excess fear has arisen around SKUL and the vultures have been circling the stock for quite some time, it is one of the most heavily shorted stocks on the market. For most, the criticism has come of the business model and lack of differentiation, after all, anyone can make headphones right? But time and time again SKUL has, in my opinion, justified its existence as a public company, and it has a tremendous following with strong branding. Needless to say, the fear has been there, and it has had a material effect on the stock price. After the IPO, SKUL dropped 25% in less than six months!

The worst part to come out of all this is that because this is not an institutional stock, with institutional ownership at 33% - based on Google Finance - it is extremely susceptible to the effects of both fear on the downside and greed on the upside. Retail investors often lack the gut to stick it out through a storm as rough as this has been, the company has lost three-quarters of its IPO market cap.

However, at these levels, I believe there is real anchoring book value, that fear has been fully priced in, and that there is a quality way for the right distressed asset investor to step in for the long run, banking on a turnaround by newly reinvigorated management. In addition you have the opportunity to lower your cost basis if you so choose by writing some covered calls through January 2014, currently offering a 10% annualized hedge at the $8 strike. Options aside, the real strategy here in the coming year is to dollar cost average to build a moderate long position.

SKUL's finances as of the most recent quarter show a modest picture of financial decline; the company has had mixed results, with the most recent quarter resulting in its first loss, though it should be noted that the recent loss was in significant part due to the loss of one major customer - HMV - and that the first fiscal quarter is normally the worst for SKUL, where the fourth quarter historically has generated half of all annual EPS. Needless to say, SKUL is not currently a profitability machine, it is a company in the midst of a restructuring; management is being ousted and the company is bringing in new talent! More on that later. More compelling than the bleak earnings, for the sake of our trade, is the balance sheet. We can see on the balance sheet that SKUL right now has zero long term debt and approximately $1 per share in cash on hand. In addition, the company has around five dollars and a quarter in book value. I think that these simple statistics offer a compelling picture into the downside, most importantly that you are looking at a minimal premium to book value on a company that could very easily be a takeover target at the current valuation. On to bigger and more exciting things.

The Turnaround Story

While this article's main focus is the distressed asset play, and while I would hesitate to consider myself a raging bull on SKUL - as we are all acknowledging the fundamental weaknesses of the company's income figures - there is light on the horizon. It appears that SKUL's management has taken the recent issues seriously, and this year the previous CEO was ousted and replaced by the significantly more experienced Darling. I was involved in SKUL in a passive options capacity earlier on in the year, and I despised then-CEO Jeremy Andrus. He was a young kid who left the company to work for Solamere Capital in the midst of crisis, and perhaps the worst part is the material difference his departure package makes on the stock, but let's not get down. What's lost is lost and Hoby Darling offers a fresh perspective and experience to boot. Since his arrival the company has already announced a fundamental shift in strategy. I think that the new, more experienced leadership and strategic shifts could provide a cushion to the potential downside in riding out SKUL for this trade between now and the winter season, particularly if management can provide decent guidance for the holiday quarter, as it has historically been a cash cow for the company and solid guidance could provide a price boost. Other articles will claim the issue lies in the business model, and that SKUL represents a fad, but I believe those are the same people that would have said that Pokemon was a fad when it first came out. I come from the target demographic, and I assure you headphones will be needed in years to come, and like Aero, American Eagle and the clothing retailers, SKUL simply has to accomplish what it already has done in crafting a brand, and bringing up the next generation in a consistent manner to turn them into future clients. The issue that SKUL has had is one of mismanagement by a CEO who gave horrible conference calls, lacked the experience necessary to care for a growing company, and was more concerned with his own pocket than the welfare of shareholders; did I mention his exit package? It cost the company 3 cents a share in the most recent quarter, and he is on board as a "consultant" for the remainder of the year.

The Gaming Hope

Undoubtebly the biggest ray of hope for SKUL is the acquisition of a small video game headphone development firm called Astro Gaming. SKUL acquired the company for a measly $10.8m. Why is video gaming the key to success? Because until this point, SKUL had absolutely no foothold in the market, and oh is this a market to be taken over. There is one company right now that practically owns the segment, and that company, Turtle Beach, recently announced their dominance with over 50% market share. Given that Astro has high quality products and that their products were previously only offered online, this is a big deal.

Astro gaming has had an unprecedented surge in growth facilitated by the in store presence SKUL has in Best Buy. Perhaps what is most interesting though is the coming next generation of consoles, hyped up more than any launch in history, and with Microsoft announcing their intention to force you to buy a headset, this can only mean terrific news for SKUL. Licensing deals in the gaming department as we enter the launch of the next gen of consoles will have a material effect on the future of this company, especially if something of a package can be arranged with Best Buy.

Dollar Cost Averaging

Lastly, the wonderful, underappreciated mechanism for entering this trade that too little people understand, is the principle of dollar-cost averaging. At the core, this is a long position, and we are long on SKUL. DCA simply means that we invest a fixed amount of money in SKUL, several times in succession, irrespective of price changes. The effect of this is that when the price declines, you will receive more shares, and over the course of time your cost basis of the position benefits tremendously. If the company stock price goes up over several years, you make money. If the company stock price goes down, you lose money initially, but on a recovery, in many cases lower than your initial entry point, you will pull positive. The key to this as well, is that by regimenting yourself to a strict schedule, you avoid guesswork in timing your trades. It is a simple and effective way to get involved in this position, as SKUL could very well slide in stock price before it fully recovers as a company. Here is a graphic that I use when I introduce people to the concept, it is of money invested in the great depression. If that doesn't convince you, I don't know what will. Be patient, remember the value story, and look at the downswings as two things: an opportunity to get more at lower prices, and an increase in the likelihood that a company like Apple swallows SKUL at $7-10/share.

Recap

In this article I hope I have provided a simple, yet effective explanation of a long term investment that one can take over the course of time by using DCA effectively. Backed by a solid balance sheet, zero long term debt and an exceptional revitalization via the management team as well as a new hope in gaming, SKUL's income woes have created an excellent entry point for a value-oriented investor with a DCA strategy. When others run from fear, find the value and go against the herd.

Source: Skullcandy: Ride Out The Storm With Dollar-Cost Averaging