Morgan Stanley Helps Shorts Crowded In Skullcandy, Creates Buying Opportunity

Sep.14.12 | About: Skullcandy (SKUL)

Skullcandy (NASDAQ:SKUL), a developer and distributor of audio accessories, is back in focus. Morgan Stanley slammed the company with a downgrade from overweight to equal weight and a cut in its price target from $21 to $15. On a day when the S&P 500 (NYSEARCA:SPY) rallied 1.6% to near 5-year highs, I was quite surprised to see a downgrade cause SKUL to drop 16% on extremely strong volume to an all-time low. The stock closed the day at $11.92, creating, according to Morgan Stanley, a 26% upside opportunity.

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SKUL plummets to all-time lows

Source: FreeStockCharts.com

Note that the above weekly chart shows that SKUL has experienced a wave of sell-offs and rallies since its IPO quickly failed to hold its initial price. Each peak has been lower than the last but the $12 dollar level has generally held. A further breach of all-time lows could generate follow-on selling (increasing the upside opportunity for intrepid buyers).

According to Morgan Stanley's earnings cut, SKUL now has a 10.6 P/E for 2012 and a forward P/E of 8.5 for 2013. These valuations seem quite reasonable and further underline the buying opportunity for SKUL. (For additional SKUL fundamentals see one of several SKUL articles from SA contributor Tom Payne).

Eric Savitz provided Morgan Stanley's rationale in "Skullcandy Shrs Gets Kick In The Head From Morgan Stanley." Essentially, Morgan Stanley is concerned about growing competition that seems to be driving prices down for SKUL products. Morgan Stanley is also worried that SKUL does not compete well at the high end.

I have covered SKUL several times. A year ago, I noted insider buying by the CFO in the recent IPO as a reason to buy shares. Six months ago, I removed SKUL from my list of insider buying trades after the CFO left the company. Since then, another company officer spent $248,760 on company stock on May 10, 2012 making SKUL intriguing all over again. I usually ignore the transactions of directors who in SKUL's case have both bought and sold stock.

In April, I noted how shorts had piled into the stock after the CFO exit. Shorts have further crowded into the stock since then and of course greatly benefit from Thursday's panic. Shorts are now an amazing 72% of SKUL's float.

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Over the past 3 months, shorts have finally stopped piling into SKUL

Source: NASDAQ short interest

Given the ferocity of Thursday's selling, I am expecting follow-through for maybe one to two days. But in that period, I think the market is offering a very good risk/reward entry in SKUL. With short interest apparently hitting a plateau, the balance should now tilt toward short-covering to lock in profits. I am even guessing Morgan Stanley is surprised by the depth of the selling and will have to switch its rating right back to overweight which indicates expectations that a stock will outperform the market over a period of time (typically a year). With a price target 26% higher from current levels, SKUL will very likely outperform any diversified benchmark from current levels.

Be careful out there!

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