Skullcandy: The Facts Behind The Fad, And The Inevitable Squeeze

| About: Skullcandy (SKUL)

I've been bullish on Skullcandy (NASDAQ:SKUL) for almost a year now, publishing my first article outlining my initial thesis back in September 2011. Here's a look at what has happened since then:

1. Earnings estimates of $0.90 per share for 2011 were surpassed and earnings of $1.00 per share were reported.

2. Estimates for earnings in 2012 have risen from $1.13 at the time of my first article to $1.17 now.

3. Short interest in the stock has risen from 2.9 million to over 11.2 million shares, an increase of about 350%.

4. Skullcandy has beat analyst EPS estimates in every quarter since going public thus far, and by 15.8%, 21.4%, 9.3% and 25%, respectively.

5. Two different insiders have purchased over $200,000 worth of shares each, and there have been no insider sales.

6. Skullcandy closed its acquisition of Kungsbacka 57 (its old European distributor) to improve European margins and expansion.

7. European sales have continued to rise over 40% on an annual basis (consistent with other revenue streams) despite the debt crisis.

8. Asian expansion, the next huge growth opportunity has been put into motion by the expansion of Skullcandy India and a new Skullcandy office opening in China (in June of this year).

9. Despite an exceptionally weaker economic environment across the globe, Skullcandy grew sales faster in 2011 than they did in 2010.

10. All of the 9 analysts covering the company have either maintained or initiated, "Buy"or "Strong Buy" ratings.

Ironically, since my first article the stock has fallen 12%. I choose to believe this is continued irrationality on the part of the market. At the time of my first article Skullcandy was trading at a forward P/E of 16.1, that has since fallen to 10.8. The combination of higher earnings estimates and a lower stock price have made Skullcandy well over 30% cheaper in the past year alone.

This mysterious reason for Skullcandy's ridiculously cheap valuation and phenomenal short interest can be easily explained by Wall Street generally interpreting the company as a fad. The bearish arguments usually sound something like "headphones are a commoditized business" or "Beats are better and Skullcandy can't stay competitive much longer." Unlike the rest of the market, I interpret Skullcandy's phenomenal growth since inception (in 2003) as manifestation of the fasted adopted technology ever; portable electronics (aka smart phones).

Behind The "Fad"

Skullcandy makes headphones, headphones are used to privative sounds emitting from almost all consumer electronics. Thus, it's pretty straight forward and rational to assume that as consumer electronics become more prevalent headphones will as well. But don't take my word for it, let's look at some quick facts.

In 2010 the mobile accessory market stood at a whopping $26.5 billion, that is set to double by 2015 to well over $50 billion. Just to put that into perspective the US economy is growing at 1-2% per year, and mobile accessories are growing at around 40% per year (at least for the next 5 years).

I have a hard time reading that as a fad. Especially considering Skullcandy has grown even faster than the mobile accessory market in the past year.

Still not convinced? Let's take a gander at May NPD headphone data. Year over year market growth was 53%, meaning Skullcandy's sector is outperforming the mobile accessory market as well. Just for a little comparison, that was the only sector in consumer retail to display any growth at all.

Let's keep the numbers rolling. NPD also reported in April 2012 that sales of headphones in the $100+ price range "more than doubled" in 2011. Skullcandy has made numerous moves to capitalize on this trend by releasing its signature Aviators (co-branded with Jay-z's Rocnation), and seriously expanding its offering of the Mixmaster headphone line.

It gets even better, that same April NPD report also included that by a huge margin, the two biggest factors consumers consider when buying headphones are brand and sound quality. This report is coincidentally timed with Skullcandy's major product refresh called "Supreme Sound," that along with being arguably the most established headphone brand (besides Beats), puts them in amazing position to continue to profit from this booming trend.

After looking at the numbers, I can only seem to conclude that we've seen just the very beginning of Skullcandy's growth. Skullcandy is phenomenally well positioned in a high growth market that is backed by the most revolutionary technology we've every seen. I'm buying.

X Factor: The Squeeze

Yahoo Finance reports that Skullcandy has a 15 million share float, and that there are 11.2 million shares short. The average daily volume for Skullcandy sits around 300,000-400,000 shares per day. As I mentioned earlier Skullcandy's short interest isn't stalling, it's actually about the only thing growing faster than their profits.

The downside from here is limited (at $12.66 per share), Skullcandy has bounced around the $12 level 6 times, despite never going lower than $11.79 per share.

Shares are trading at a huge support line and longs know that, the only difference from Skullcandy at $12 back in September compared to now? EPS estimates were ~10% lower, and there were only 2.4 million shares short. Yet the stock was still able to rally to nearly $20 per share on good Q3 earnings in November.

With almost 4x more ammo and a valuation that's 30% more attractive, Skullcandy is ready to fly on any good news. If Skullcandy continues to beat earnings estimates (as it have done in every quarter since going public) the squeeze will be inevitable.


As Skullcandy shorts continue to put money on the wrong side of the smart phone craze, and drive down Skullcandy's already irrational valuation, for the long term Skullcandy appears to be a very strong buy at $12 per share.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SKUL over the next 72 hours.