Today I am highlighting two companies that I feel have a very high likelihood of being acquired by the end of 2014 for at least a 100% premium over today's stock prices. Both of these companies have gone through truly transformational changes over the last couple of years that have improved their competitive moat and make them increasingly attractive acquisition targets. Investors can buy these stocks and sleep well at night knowing that even if the premise of a buyout does not take place, that they own companies with attractive prospects for the future and high probability of stock price gains on improving fundamentals.
Takeout Target #1: Skullcandy
Skullcandy (SKUL) forever changed headphones when it burst onto the scene in 2003. Before Skullcandy, headphones where utilitarian. Skullcandy's founders started the company based on the idea that headphones should be more than just functional, they should be a fashion statement. The idea was brilliant and led to big growth for the company as their headphones, adorned with their catchy skull graphic found their way onto retailers' shelves and the heads of teenagers everywhere.
Fast forward to 2010 and the cracks were evident in the Skullcandy's dam, so to say. They had become a victim of their own success as new competition like Beats by Dr. Dre not only copied Skullcandy's idea of making headphones a fashion accessory but were successful in "one upping" Skullcandy with better marketing and higher-end and more expensive headphones. The new competitive landscape left Skullcandy competing mostly on the low-end, commoditized part of the market. It was becoming increasingly apparent that just placing a stylized skull graphic on a pair of headphones was not enough to create an enduring brand.
Even the best of companies face adversity and setbacks on the path to success. How a company reacts to adversity ultimately decides its fate. Will management become ostriches and bury their heads in the sand with their unwillingness to critically and objectively evaluate the problems the company faces? Will they claim that their company is perfect despite lots of statistics pointing toward problems? Or contrarily, will they properly evaluate the state that they are in and take the necessary corrective actions to improve their fate? One great example of a company diagnosing their problems and taking corrective action is Domino's. They asked themselves "what is wrong with our company?" and correctly answered that "our pizza sucks!" and they fixed the problem and the company and its stock price has since flourished.
So which response to adversity did Skullcandy choose? Did they keep playing the fiddle while Rome was burning or did they accurately diagnose the problems and take corrective action? They most definitely chose to be truthful with their assessment of the company and take corrective action. Here are some of the changes that they have made that, while in the short-term have caused lower sales and lower profits, in the long-term have dramatically improved the prospects for the company:
• New Management Team: Often times the founders of a company are not the right people to take the company to the next level. Skullcandy's founders recently came to this conclusion and turned over the reins to Hoby Darling. Hoby was General Manager of Nike+ Digital Sport, Nike, Inc. He is bringing in new talent to the company. You can read more about Hoby's and the rest of the senior management teams' background here.
• New and Improved Marketing: Skullcandy's marketing is, in my opinion, incredible. They are one of the few public companies that I have run across that really get marketing in today's interconnected world! They are leveraging social networking and Youtube with amazing campaigns, like this one, featuring Skullcandy sponsored skateboarding phenom, Sean Malto.
• Better Displays and Listening Stations in Retailer: This falls under catching up with the competition, like Beats, that "one upped" Skullcandy several years back. I have tried out the new listening stations at Target and have been impressed with the sound and the experience. They are also building out the stations at Best Buy. This will drive demand.
• Higher Quality Products: Skullcandy admitted to a quality problem and have been making progress in improving quality judging from my own due diligence and the improvement in reviews on Amazon over the last year. I suspect that previously they had been outsourcing too much of the design and engineering to China and that they have taken more control over this internally to improve quality.
• Product Innovation: The new Crusher headphones are a great example of how the company is innovating. They have a patent pending mechanism that allows you to truly feel the bass. Try them out for yourself at your local Target. I have and I was quite impressed!
• Continued Investment in Gaming Headphones: Skullcandy acquired gaming headset maker Astro Gaming in 2011. Astro Gaming makes very high-end gaming headsets, many of them are wireless. The products have outstanding reviews on amazon.com. The division should benefit nicely from the XBox One and Sony PS4 gaming systems that were just launched as some of their headsets are compatible with the systems.
• Defending Pricing: Skullcandy has been punishing retailers that do not adhere to their Minimum Advertised Pricing strategy by ceasing shipments of new products. In the short-term this has hurt sales and earnings, but in the longer-term this will help maintain a premium brand and keep retailers happier by giving them consistent margins.
Reasons an Acquisition is Likely:
• Cheap valuation.
• Return to more normalized earnings power.
• Incredible distribution.
• Big and improving brand equity.
• Customer demographic is highly sought after.
Potential Acquirer and Likely Takeout Price: Nike's (NKE) name has recently been lobbed around as a potential acquirer of Skullcandy. I just don't see that happening. Nike has been more focused on divesting companies that they acquired rather than acquiring new ones. They are already selling Nike branded headphones and I don't anticipate them being interested in acquiring Skullcandy. The company that I believe will acquire Skull is Sony (SNE). Sony has had a much publicized struggle with re-inventing themselves. The brand "Sony" doesn't have much meaning to consumers. In their heyday, the name was synonymous with high quality audio and video, and innovation. In the last 10 years, Samsung (GM:SSNLF) has stolen much of Sony's brand thunder. Sony, in the perception of consumers, has moved down a peg or two on the quality and desirability spectrum. As an example of the perceived brand superiority of Samsung over Sony in consumer electronics one has to look no further than a comparison of Android phones sold by the two companies. Samsung sales absolutely crush Sony, with over 30% of smartphone sales for Samsung compared to a paltry 7% for Sony.
Conventional wisdom is that Sony's problems stem from a lack of innovation. I would argue that much of the problem is that the brand has no relevancy to consumers, as smartphones from Sony do not differ that much from those made by Samsung. Acquiring Skullcandy could help give some edge back to the Sony brand. The demographic of Playstation 4 customers also overlaps nicely with that of Skullcandy's customers. Sony could do some clever cross promotions, bundling Skullcandy gaming headphones with Playstation 4s. Winning the hearts of consumers in their teens and twenties will earn years and years of goodwill for Sony. The acquisition would also make sense because Sony will be able to use their manufacturing and distribution leverage to increase the margins for Skullcandy products. The deal would make sense on so many different fronts that it should happen, but if Sony does not move fast enough I see a private equity fund buying Skullcandy and later turning around and selling it to Sony for a much higher sticker price.
I have looked at valuations for a takeout and feel that the price will be at least a 100% premium to current stock prices, or at least $11 per share. This is based on a multiple of normalized sales of just over 1, or a multiple of normalized earnings of under 20. I expect Skullcandy to return to growth in 2014, which will make an acquisition at those multiples very attractive to Sony or a private equity player.
Takeout Target #2: AudioCodes
AudioCodes (AUDC) makes products that enable IP Telephony and Unified Communication (Worthless Pennies first highlighted AudioCodes as a buy on May 30, 2013 at a price $4.00). The company hit a few year rough patch that started with the financial collapse in 2008. Sales dropped from $174 million in 2008 to $127 million in 2012. They have now returned to growth, profitability and free cash flow, growing revenues at 11% in the recently reported third quarter. They raised estimates for the 2013 slightly implying a Q4 growth of between 7 to 13% growth year over year. AudioCodes is obviously benefiting from the recovery in the economy, but they have also been benefiting from a boom in unified communication for enterprises that is highlighted by their strong partnership with Microsoft (MSFT) Lync.
Lync has gone from nothing to over a billion dollars a year in sales in short order and continues to grow at over 30%. Enterprises need hardware solutions to enable reliable, high quality, and secure Lync unified communications and AudioCodes has a great product suite. A recent event that validates the quality and importance of AudioCodes' Lync offering was the announcement of a partnership with Dell Services, whereby AudioCodes will be the provider of networking solutions for the company's Accelerate Program for Microsoft Lync. This is a very exciting development and bodes well for AudioCodes growth prospects in 2014 and beyond.
Reasons an Acquisition is Likely: :
• Big Beneficiary of Microsoft Lync growth: As I mentioned above, Microsoft Lync sales are booming and should continue to do so for the foreseeable future. This makes AudioCodes a desirable target for an acquisition.
• Established Services Organization: This is a desirable asset as the services business is critical and extremely difficult for competition to replicate.
• Unified Communication of Enterprise Hitting Critical Mass: Enterprise networks are not prepared for the boom in Unified Communications and need to be upgraded to insure high quality and security. One can look at public company 8x8 (EGHT) for validation that the sector has hit critical mass. The stock has rallied more than 200% over the last couple of years off of accelerating sales and earnings. They were able to raise over $100 million dollars through a secondary offering.
• High Percentage of Insider Ownership: From my discussions with management, I believe that they would be willing to sell the company for the right price. Given that they own roughly 20% of the company they have big input on whether or not a deal gets done. In my opinion, they will look to sell during this upswing in business as they can demand a higher valuation.
• Accelerating and Sustainable Growth: Given the growth in Lync and Unified Communication in general I see growth accelerating in 2014.
Potential Acquirer and Likely Takeout Price: There are several companies that I believe would be interested in acquiring AudioCodes. Hewlett-Packard (HPQ), Polycom (PLCM), Dell and Sonus Networks (SONS) all come to mind as potential acquirers, but I think that HP is the most likely. The price is likely to be around $12.50 per share. This would represent about 3 times 2015 sales. This looks cheap compared to the 5 times sales that Oracle (ORCL) paid for Acme Packet early this year. HP would significantly cut back on SG&A expenses by leveraging their own sales teams. They would also get access to a group of highly skilled engineers in Israel. The deal would be small for HP but would help them move away from a dependence on the hyper-competitive and low margin PC space.
Bottom Line: Skullcandy and AudioCodes offer investors a great opportunity with a high probability of a big payout on an acquisition in 2014. If buyouts do not occur, I believe that both companies will have impressive growth in 2014 which should lead to some gains or at the very least a good safety net protecting the downside.