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Skullcandy (NASDAQ:SKUL) invented the cool headphones category. Now, competitors playing in Skullcandy's sandbox may doom the company's long-term prospects.

I was personally interested in their 2011 IPO because I knew of the brand before many others did. I remember trying out some headphones in 2006 at a demo-day held by a local ski shop. That shop stocked the headphones in 2006/2007, back when other independent retailers were probably the bulk of Skullcandy retailers.

Since then, the company has grown astronomically, now doing hundreds of millions of dollars of revenue per year and by selling at major retailers all across the world. This success was the result of the company's ability to invent its own category - cool headphones. Prior to Skullcandy's arrival, there were no lack of audio options; companies like Sony (NYSE:SNE) and many less- and more-expensive competitors made everything from low-end earbuds to ultra-expensive over-the-ear devices. But everything was pretty similar and predictable; there was function, but no fun, and no differentiation other than price and performance.

Skullcandy introduced fun, hipness, and excitement into headphone world, really creating a new category of products, defined by a more-than-practical product, a coolness factor, and endorsement by athletes or celebrities. To provide an example of a similar market-creating company, 5 Hour Energy did the same thing; they created the energy shot market, eroding share of established items like energy drinks (HANS) and coffee (NASDAQ:SBUX).

Competitors will always emerge. 5 Hour Energy's dominance is being challenged by many new products. But Skullcandy is in a much worse position; their market dominance is nowhere near the level of 5 Hour Energy, yet many serious competitors are already eroding its share.

Beats by Dre, a headphones company featuring Dr. Dre, a famous rapper/producer, as a creative force/figurehead, is surely one of Skullcandy's most-feared competitors. Beats has one-upped Skullcandy by partnering with HP (NYSE:HPQ) to create Beats Audio, which spans platforms and strengthens the Beats brand. Another rapper/entrepreneur, 50 Cent/Curtis Jackson, has gotten in on the game by partnering with SMS Audio, a smaller company, to create SYNC by 50. Many other small companies are producing similar high-quality headphones that are eroding Skullcandy brand value and appeal.

On the other hand, Sony and other large manufacturers continue to produce headphones, and quality and attractiveness of products will rise to meet the demand in the market. Skullcandy managed to get a toehold by doing something new, but it's not hard to replicate what they've done now.

Another development that I believe to be worrisome is Skullcandy's expansion into non-related products; a quick check of their website shows that they now sell things like shirts and wallets. While such expansion may increase top- and bottom-line results in the short term, a focus on its core business (headphones) is the best way to create long-term profitability.

In the short term, there's definitely a chance that Skullcandy shares could increase in value. As another Seeking Alpha author has noted, fundamental factors including good earnings, massive short positions and a change in momentum could boost shares. But in the long term, I would not invest in Skullcandy. It has no true competitive advantages, and some of its competitors (namely Beats by Dre) have already replicated and improved on Skullcandy's own business model. Shareholders may not get burned too badly, as the current share price isn't projecting massive future growth. That's a good thing, because I think that Skullcandy's prospects are limited to remaining a niche player or potentially getting acquired by a larger rival.

Source: Why Skullcandy Will Be A Sour Long-Term Investment