Seeking Alpha
Long only, special situations, contrarian, research analyst
Profile| Send Message|
( followers)  

Short squeezes are usually reserved for weak (or weakening companies) that have fallen too far, too fast, and have so many shares sold short that even a hint of good news can send the stock soaring. But when a profitable company with solid fundamentals has the vast majority of its float sold short, the situation often becomes too compelling to ignore. And we believe that such a situation has developed in shares of Skullcandy (NASDAQ:SKUL). Frankly, as a headphone maker, Skullcandy's business is not that exciting. The company is not some newly public Silicon Valley company on the cutting edge of technological innovation (Skullcandy is based in Park City, Utah, not flashy Silicon Valley). Nor is Skullcandy a biotechnology company with a blockbuster drug in development. But that does not matter. What excites us about Skullcandy is not the company's business, but the potential profits that the company can deliver for investors in the months to come. Skullcandy went public in July 2011, and since then, has lost over 17% of its value, as investors fret over its margins and position in the marketplace (factors that we will address later).

(click to enlarge)

Skullcandy is not some unprofitable technology start-up with a sky-high valuation. As of this writing, the stock trades at 14.03x estimated 2012 EPS of $1.16 (based on consensus analyst estimates), hardly a stretched valuation. But what makes the situation at Skullcandy truly unique is its short interest. At this point in time, over 72% of Skullcandy's float is sold short (this is equivalent to 42.55% of the company's outstanding shares). We have never seen such a high level of short interest in a company that is actually profitable, and has a clear growth trajectory. And as previous articles have stated here on Seeking Alpha, a short squeeze is highly likely. Skullcandy needs only a small dose of good news to ignite a rally in its stock. What we wish to explore, however, are Skullcandy's fundamentals, financials, and valuation, for we are hesitant to recommend a stock based solely on short interest. And in our view, Skullcandy shines on all 3 of those fronts, and we delve into them below. For the record, unless otherwise noted, all financial figures and management commentary cited in this article will come from one of 3 sources: Skullcandy's Q2 2012 earnings release, its Q2 2012 conference call, or its latest 10-Q.

Operational Overview

Skullcandy reported its Q2 2012 results on August 2, and the company beat on both the top and bottom line. Skullcandy posted EPS of 24 cents and revenue of $72.436 million, beating consensus estimates of 22 cents in EPS and $65.4 million in revenue. Gross margins came in at 49.239%, a drop from 51% a year ago. Gross margins were pressured in the quarter from a shift to over-ear headphones, but they improved sequentially from 48.8% in Q1 2012. Revenues grew 38.2% in Q2 2012 from a year ago, and EPS rose by 9.09%, reflecting a different mix of product offerings.

Skullcandy is going through a transition on a number of fronts. The company is preparing to launch new headphones (in both the Astro and Skullcandy brands) and is shifting to a new retail and distribution format in Europe, where Skullcandy will now distribute product via a direct distribution model. The Astro brand was acquired in April 2011, and it is a premium gaming brand, and one of the leaders in the market. The first new headphone since the acquisition was launched in late July, the Astro 250, which retails for $299 (for readers who may be unfamiliar with Skullcandy, the company's headphones are available at a variety of price points, ranging from the hundreds of dollars to $30). While it is still early, reception has been positive. Skullcandy CEO Jeremy Andrus stated on the conference call that the company has sold a significant number of these headphones via its e-commerce platform. And PC Magazine named the Astro 250 as its Editor's Choice gaming headphones. We expect much more color regarding the Astro 250 when Skullcandy reports its Q3 results. The company reiterated its 2012 outlook of $280-$300 million in revenues and EPS of $1.10-$1.20.

On the company's conference call, Skullcandy was asked if the turmoil at Best Buy (NYSE:BBY), its largest retail partner, is affecting business. CEO Jeremy Andrus replied that normally, Skullcandy does not discuss individual retailers. But, given the importance of Best Buy to the company, he did comment on Best Buy. Andrus said that Skullcandy is actually gaining shelf space and prominence at Best Buy, and that the managerial changes and turmoil at the retailer have not caused an adverse impact on Skullcandy. Furthermore, Andrus stated that Skullcandy is working on educating Best Buy employees via its retail education group, and the response has been good, according to CEO Jeremy Andrus. The only potential adverse impact from increased turmoil at Best Buy would be a loss of brand awareness. Customers who are loyal to Skullcandy brand will buy its products from any retailer. As for potential new customers, Skullcandy is working on increasing brand awareness, via endorsement deals with the NBA, as well as model Kate Upton. Therefore, we feel that any impact from increased turmoil at Best Buy, particularly store closures, will not be that material to Skullcandy's future.

International Expansion

Skullcandy, up until this point, has been primarily an American company and brand. But that is steadily changing. The company's European operations are ramping up, and its Switzerland office now has 22 people, and that number is set to rise as Skullcandy revamps its distribution model and expands. The company has also opened an office in China, and sees tremendous opportunity there, as the music and audio accessory markets grow alongside the Chinese consumer class.

In Q2 2012, Skullcandy's international sales soared 59.9%, and sales in Europe grew by 33.1% to $8.1 million (Europe now accounts for 11.18% of overall sales). And international sales outside Europe grew by 98.7%. While we understand that investors may be hesitant investing in any company with exposure to Europe, we believe that Skullcandy's results show that it is fairly resilient to the macroeconomic stress that is present in Europe. The company is ramping sales off of a smaller base, and its product resonates with consumers. Starting next quarter, Skullcandy will provide a more detailed breakdown of its sales by geographic region, which will improve transparency and allow investors to have a better picture of the potential opportunities and risks that Skullcandy faces. Skullcandy began transitioning to a new retail model in Q3 2011, and the company has made solid progress on that front. It is still in the process of auditing retailers and finalizing partnerships. On the call, CEO Jeremy Andrus stated that in his view, Skullcandy needs to focus on 2 sides of the European retail sector: the smaller, independent stores that drive brand energy and form the "lifeblood of our business," and larger stores that drive volume. Skullcandy is focusing on both sides of the market, and we believe that in the quarters to come, Europe will become a much more significant part of the company's overall business, something that we view as a positive, not a negative.

Margins: More Than Meets the Eye

As we alluded to earlier, Skullcandy's shares have been battered by concerns over the company's gross margins. And on the surface, there is room for concern, for the company's gross margins have indeed fallen. But, while gross margins are certainly important, they are not the only margin metric that investors need to utilize, and we break down Skullcandy's performance based on several margin metrics below.

Skullcandy Margins
Q2 2012Q1 2012Q2 2011
Gross Margin49.239%48.769%51.146%
Operating Margin16.176%2.785%18.272%
Profit Margin9.409%2.096%8.126%

Skullcandy's gross margin may have fallen from a year ago, but its profit margin improved, helped in part by a lower tax rate. In Q2 2011, Skullcandy's income tax rate was 41.583%, for the company sold most of its product here in the United States. In Q2 2012, however, the company's tax rate fell to 38.945%, as Skullcandy shifted towards a more international business. We believe that investors are underestimating the impact of this in the quarters to come. As more and more of the company's profits are earned overseas, Skullcandy will have a lower tax rate going forward, which will boost the company's bottom line. The company was asked about gross margins going forward on its conference call, specifically as they relate to the Astro brand. VP of finance Ronald Ross responded by saying that, "pushing further into the gaming headphones, as Jeremy [CEO Jeremy Andrus] mentioned in his prepared remarks, they have more technology associated with them. Therefore, higher cost to produce them. So they are a lower-margin products. However, overall, we expect that the mix shift or the mix of those products for the gaming platform, considering that there's a higher percentage of that business in the online channel, will be 50% margins, maybe slightly more than that for this year. And over time, we expect about mid-40s from a gross margin standpoint for that component of our business." When Skullcandy acquired Astro in 2011, the brand's margins were in the high 20% range, and Skullcandy has dramatically improved the financial performance of Astro since then. Will a shift to over-ear models put some more pressure on Skullcandy's gross margins? We believe that it will. But, we also believe that this impact has already been priced into the stock, and that Skullcandy can surprise investors in the quarters to come with its margins. And in any case, a lower tax rate (due to shifts in where income is earned) should neutralize most, if not all of the impact of lower gross margins.

Financials & Valuation

Skullcandy is in good financial shape. As of the end of Q2, the company had $6.971 million in cash and equivalents on its balance sheet, and $5.083 million in borrowings from its bank line of credit. Skullcandy has no other debt. Our analysis of Skullcandy would not be complete without a mention of the company's cash flow.

In the first 6 months of 2012, Skullcandy had operating cash burn of $7.882 million, compared to operating cash flow of $5.149 million in the first 6 months of 2011. On the surface, this would seem like cause for concern. However, several factors are at play here that make this a one-time issue, in our view. Skullcandy's cash flow for the first 6 months of 2012 was impacted by spending to increase inventories, which is a necessary component of the company's distribution shift in Europe (this is why inventory on the company's balance sheet jumped by 31.881% in Q2 2012 from the previous year). Furthermore, changes in working capital, primarily accounts payable and other accrued liabilities, contributed to negative cash flow in the first 6 months of 2012. However, we are not concerned about Skullcandy's financials. The company's fiscal year is back-end loaded, with the back-to-school season included in Q3 results, and the holiday shopping season included in Q4 results. Skullcandy had operating cash flows of $29.068 million for all of 2011, and we are confident that the company can exceed that number in 2012.

Skullcandy's valuations are not stretched by any means, in our view. The stock closed at $16.27 on August 28, 2012. Based on the midpoint of the company's guidance ($1.15 in EPS), Skullcandy trades at 14.15x 2012 EPS, and just 11.38x estimated 2013 earnings of $1.43 per share.

(click to enlarge)For a company trading at just over 14x forward earnings, Skullcandy's future growth rate is impressive. Earnings are set to grow by over 23% in 2013, and in our view, the market is not giving Skullcandy credit where credit is due.

Conclusions

In our view, the market is dramatically underestimating Skullcandy. The company is profitable, growing, and has an unassuming valuation. That, combined with a stock that is among the most shorted in the entire market, make for a winning combination, in our view. Skullcandy's best days are ahead of it, and we feel that the company will prove its critics wrong in the next several quarters. Skullcandy is expanding its brand and market reach, and has a number of opportunities ahead of it, both here in the United States as well as abroad. We believe that investors who add to or initiate positions in Skullcandy at this point in time will be rewarded for their convictions. Skullcandy's business may not be that exciting. i But its solid fundamentals, as well as the potential for a substantial short squeeze are, and that is what matters.

Source: Short Squeeze Looms For Skullcandy, And Solid Fundamentals That Add To The Stock's Luster