Skullcandy - Slightly Optimistic On Relative Cheap Valuation

Jan. 2.14 | About: Skullcandy (SKUL)

Investors in Skullcandy (NASDAQ:SKUL) are seeing a strong end to a difficult 2013, partially fueled by a bullish research report being released by analysts at Roth Capital last week.

Given the valid turnaround plan, the solid financial position and appealing brand, I remain slightly optimistic.

Roth Capital Turns Bullish

Analysts at Roth Capital upgraded their rating on Skullcandy from "Neutral" to "Buy" last week. Analyst Dave King raised the price target by two dollars towards $7.50 per share, suggesting 24% upside potential for the shares at the time.

Note that shares ended the day of the upgrade nearly 12% higher as investors followed King's advice.

King notes that the company is well positioned for trends toward in-ear headphones. New products like Crusher and Air Raid are making progress while management is making progress as well. King sees earnings of $0.10 per share in 2014, a penny ahead of consensus estimates.

Skullcandy's Financial Performance

At the end of October, Skullcandy released its third quarter results for 2013. The company ended the period with $34.7 million in cash and equivalents. As Skullcandy holds no debt, it operates with a solid net cash position.

Revenues for the first nine months of 2013 fell sharply, being down 29.9% on the year before to $137.8 million. As a result, Skullcandy reported a $6.6 million loss which compares to earnings of $14.4 million a year earlier.

Trading around $7 per share, the market values Skullcandy at $195 million, or operating assets at $160 million.

Given the operational challenges, Skullcandy does not pay a dividend at the moment.

Performance In Recent Years

Skullcandy went public as recently as the summer of 2011, when shares were sold to the general public at $20 per share. The strong offering allowed the company to raise the issue price and offered size, on the back of the very strong reported growth. Note that Skullcandy has grown revenues from $80 million to $295 million between 2008 and 2012.

While earnings have been on the rise as well, profit margins fell in recent years. This growth was followed by a terrible operating performance in 2013 with revenues falling hard, while the company was forced to report losses on the back of increased competition.

Takeaway For Investors

Back in October, Skullcandy released its third quarter revenues of $50 million, still down about 30% on the year before. While selling, general and administrative expenses were still up compared to the year before in the first nine months of the year, despite revenues shrinking by 30%, the company managed to finally reduce these costs on an annual basis in the third quarter.

As a result, the company posted a quarterly profit of $1 million for the third quarter, the first earnings being reported by the firm this year. International sales for the quarter came in at $15.2 million, up 11.9% on the year before. Unfortunately, US sales fell by 39.4% to $34.8 million on intensifying competition.

According to the company itself, Skullcandy remains a leading brand in a niche focused on action sports and lifestyle cultures. Another key attractive area is of course the game area, representing a $1 billion opportunity in the US alone per annum.

To offset the intensifying weakness the company has reacted a bit too slowly, according to investors. Yet management changes have already taken place after the hiring of new CEO Hoby Darling and CFO Jason Hodel later this year. New appealing products which are gaining traction, as well as the solid financial position, should allow the company to move along with the recovery of the brand and the company at large.

Darling focused on fine tuning the distribution model, more full price selling and strengthening the premium brand positioning. Stronger execution and a better corporate culture should furthermore boost results going forward, allowing Skullcandy to deliver improved results next year.

Back in January of 2013, I last took a look at Skullcandy's prospects. Essentially shares traded at similar levels around $7 per share, yet investors saw a painful ride to lows of $5 during the summer.

While I recognized the declining sales growth as well as earnings growth, I was surprised in hindsight to see these kinds of operating declines. The company has focused on a recovery this year, with shares trading at similar levels already.

Given the appealing valuation, despite competition and the strong financial position, I decided to enter a long valuation around $7 per share, with shares being dead money ever since, after they luckily have bounced from this summer's lows.

Even if the company can recover to 2012's results, with annual revenues of around $300 million and earnings of $25 million, a valuation of $400-$500 million should be within reach given significant growth prospects and the strong financial position. This would represent a roughly $15-$20 target in a bullish scenario, with the chances of this increasing given the steps taken by the company. At least current levels look safe, with the company breaking even at the moment, despite the harsh times with better times seen ahead. Crucial to watch in the recovery are declining year-on-year revenues trends, cuts in selling, general and administrative expenses and the outlook forward.

For now I remain slightly optimistic on the back of a relatively cheap valuation, valid turnaround efforts and a strong brand equity.

I hold a small residual long position, which I plan to keep.

Disclosure: I am long SKUL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.