Seeking Alpha
Long only, growth at reasonable price, contrarian, long-term horizon
Profile| Send Message|
( followers)  

Summary

  • Skullcandy delivered solid Q1 results that indicate meaningful progress in its turnaround efforts.
  • If true, Apple's $3.2 billion Beats acquisition validates mega-growth prospects ahead for "cool" audio equipment brands.
  • Skullcandy is grossly misunderstood and undervalued.

Skullcandy (NASDAQ:SKUL) is being misunderstood by investors after its Q1 results, while the rumors of Beats' acquisition validate SKUL's strategy of cool-driven audio. A little background on the SKUL story...

Since 2006, Skullcandy has consistently generated 50%-plus returns on capital, double-digit EBIT margins and robust free cash flow. They have also averaged over 40% annual sales growth since 2006, growing from $9.6 million then to $210 million today. Despite bears' claims of achieving this through channel stuffing, they have grown their top accounts even as late as a few months ago in Q3, 2013. The biggest indicator of channel stuffing is that such top partners don't reorder. Obviously, they have been hugely loyal to SKUL.

However, SKUL's thirst for growth led them to make some mistakes that resulted in product quality and brand perception issues. The debate in the investing community is if these issues represent a permanent, unfixable situation or a temporary challenge. SKUL management is obviously in the latter camp, and last year they took drastic steps to try and overcome the brand/product obstacles. They did this by investing heavily in SG&A and cutting sales to lower-tier retailers. As the numbers tanked for 2013, it was unclear if this was actually a planned effort by management, or just the natural result of a dead brand getting whipped by the competition.

So that's the backdrop for their recently announced Q1 results. The numbers themselves came in at -$0.12 vs. -$0.17 expected by analysts, with a closely corresponding $0.06 raise to annual guidance. Despite the headline, the numbers were essentially a meet and not a beat (they benefited due to a few one-time items, such as marketing spend shift, etc.). Bears are touting this -- along with claims of an overpriced stock, international channel stuffing and flat U.S. sales -- as proof of the poor investment SKUL represents.

This is the source of confusion for many investors. It deserves to be clarified.

1. Q1 results, meet vs. beat. The company met their guidance on revenue and EPS and is on track to meet full year guidance. Hitting guidance is typically a non-event, but for a company with a new management team that is amid a turnaround within a very challenging macro environment, there is plenty of reason for a meet to be greeted enthusiastically.

2. U.S. sales growth. You may have heard that the retail environment in the U.S. is awful right now. Q1 GDP was negative (reported 0.1%, but sure to be to revised down), and it's been an especially brutal stretch for SKUL's core market of teen and electronics (e.g., a headline from earlier in the year: "As traffic slumps and teen-oriented stores struggle, retailers suffer worst holiday season since 2009"). Tilly's -- one of SKUL's larger specialty partners -- is guiding for comp sales drop to 5% in Q1. Target is forecasting a 2%-6% comp sales decline for Q1. Office Depot is closing 400 stores. Radioshack is closing 1000. The list goes on, but it's hard to argue that the environment is good for retailers right now.

With this backdrop, SKUL grew U.S. domestic sales 1% in Q1. This growth was driven by strong sales of Crusher headphones, gaming headphones and the Air Raid speaker (which by itself tripled the mix of speakers from 1% of sales to 3%). Important to note is that the Crusher and Air Raid are both among the company's most expensive products, retailing for $100 and $150 respectively. The fact these products are doing extremely well does not fit with the idea that the Skullcandy brand is weak, as these are exactly the type of products that wouldn't work for a dying brand.

The company also saw growth internationally, with sales rising 17%. This is a great indication that the brand travels well abroad and validates the huge opportunity to continue growing globally.

3. International Channel Stuffing. Bears dismiss the exceptional international growth by saying the lower year-over-year international gross margin (45% this year, vs. 48% last year) is a result of "channel stuffing." This is completely ridiculous, considering Hoby explicitly mentioned the success of Crusher in international markets in the quarter (e.g., No. 1 Skullcandy product in Japan vs. nil last year, No. 1 Skullcandy over-ear product in China, and sales "greatly exceeded expectations" in Canada). Crusher carries a lower margin than buds (confirmed with the company), so it's not at all surprising that GM would decline if there was a heavier mix of Crusher internationally.

4: Valuation. Bears are mistakenly valuing SKUL strictly on an EPS basis. They are taking this year's forecast results of $0.18/share, and saying the company is expensive because SKUL shares trade at 40x this EPS. That may look scary, but valuing a company using EPS is a terrible idea that no intelligent investor considers seriously. Way more important than net income is free cash flow, or "owner earnings," as Warren Buffett describes it. This year, SKUL should generate about $12 million of such earnings (net income of $5 million + $13 million of D&A and other non-cash charges = $18 million, then subtract $6 million of necessary capex = $12 million). The company's current valuation of $150 million ($200 million market cap, less $50 million of net cash) equates to 12.5x owner earnings, or an 8% cash return for anyone who buys the company today. Keep in mind the company is growing such earnings at a rate of about 100%/quarter, so you get an 8% return today that will grow nicely in the future.

This is far from expensive. What if SKUL returns to their historic double-digit EBIT margins, not exactly a Herculean task? Owner earnings would jump to $30 million-plus. Applying a modest 12x multiple would equate to a $425 million valuation, or about $15/share (net of cash). Keep in mind that SKUL has already proven they can generate this amount of earnings. They did it in 2008, 2009 (on sales of just $100 million, 40% of their current sales!), 2010, 2011, and 2012. Last year and this year, the company is not as focused on profitability and is instead focused on revitalizing its brand. That does not mean investors should forget the company's ability to generate such profits in the near future.

Now that's just returning to historic sales/profitability. There's also a pretty big kicker, which a Beats acquisition would hammer home: The potential for growth in this space is enormous. Apple (NASDAQ:AAPL) did not make its largest ever acquisition to try and monopolize a tiny $2 billion headphone market. Although they could theoretically use ridiculous marketing muscle to try and squeeze market share from Beats competitors, the profits of the entire industry -- roughly $200 million -- wouldn't dent Apple's bottom line. Furthermore, they could've done this with their own line of headphones, which would be more in keeping with their traditional policy of building new products in house.

This is a much bigger play than people understand. As computers become increasingly attached to our bodies, there is a growing need to camouflage such "wearable" tech. Making it look like a fashion accessory has proven to be the answer for headphones, and Tim Cook realizes the incredible value in owning a company that knows how to do that. Keep in mind, this is not a minor acquisition for Apple. It is literally the company's largest acquisition ever. They've said "no thanks" to countless leading brands, tech companies, etc. Why care so much about a company that can make headphones look cool?

Anybody who doesn't grasp the potential of smart headphones should check out this product. Or how about this headset that uses brainwaves to control objects (really). Of course, these are just a couple of examples showing how audio/headsets fit into the coming wearables war. Affordable wireless headphones linked to smart devices are probably closer to hitting store shelves than those mentioned above, but even that is a game-changing product cycle.

Whatever the form factor, it's obvious to Apple (and Facebook (NASDAQ:FB) and other rumored bidders on Beats) that headphones provide an invaluable launching pad into this exciting frontier. Of course, any old headphone company won't do. What's needed is a headphone brand widely known around the world for being cool, fun and as fashionable as it is functional. Beats certainly fits this bill, but no better than Skullcandy.

Skullcandy's brand is edgier, younger and more authentic while their products are of superior quality and style (Time Magazine recently reviewed 3000 headphones and ranked Skullcandy ahead of Beats). Aside from Skullcandy, there are only a couple of other noteworthy competitors in the cool headphone space: SMS & Sol Republic, and both are much smaller than Skullcandy in every category, especially brand awareness.

The race is on.

Important to note, Skullcandy recently announced a partnership with Spotify. The partnership is extremely fresh and limited to cross promotional opportunities at the moment, but as Hoby mentioned on the Q1 call "there's definitely more to come on this one." The merging of software with headsets/audio equipment into the next big thing(s) is just beginning. Skullcandy is right in the sweet spot.

Source: Skullcandy Misunderstood After Q1 Results, Beats Acquisition Underscores Unseen Value