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There are many great companies trading on the stock market today. Companies with solid business plans, strong balance sheets and growing profitability. However, many of these same companies are trading at, or a premium to, fair value. It has become much harder now than it was at the beginning of the year to find deeply discounted stocks unfairly trading below their fair values. There are 2 stocks trading far under value on the market today with highly differentiated products, aggressive growth and strong balance sheets which are trading at a deep discount to their fair valuation.

Apple (AAPL)

Overview

Apple is a master of creating products consumers want, how they want it. Their core business model is in designing and selling premium consumer products, including the iPhone, iPad, iPod, and iMac. Its product lines have consistently experienced tremendous demand, quickly making it the most valuable company in the world.

Apple's key driver for success is its skill in creating exactly the products consumers are looking for: something sleek, intuitive and innovative. Through this differentiated business strategy, Apple has penetrated and dominated every market it's entered. Much of Apple's tremendous growth is attributable to its highly profitable iPhone and iPad sales, which accounted for 72.6% of Apple's total sales in the three months ending June 30th.

iPhone Demand

In the 3 months prior to June 30th, Apple sold over 26 million iPhones; however, in just the opening weekend, Apple sold 5 million iPhone 5s. In a feat that would catapult any company's market cap, Apple's opening iPhone 5 sales figures sent the stock crashing from a high of $705.07 to $609.84 in merely one month, stripping $90 billion from its market cap.

For the quarter ending September, median analyst estimates project 27 million iPhone sales and Munster is projecting 49 million iPhone sales in the holiday quarter. With gross margins of 55% per iPhone 5, the effect on Apple's bottom-line is staggering, excluding the tremendous demand from Apple's iPad 3 and possible upcoming iPad mini.

Overall, the issue wasn't that demand had outpaced supply, but rather, supply couldn't support the demand during the opening week (there's a subtle difference). It's true that demand for Apple's iPhone 5 has been tremendous; however, because of Apple's JIT supply chain system, even the smallest hiccup in the supply chain causes a larger effect on the production process. Investors are worried that Apple won't be able to deliver its iPhones quickly enough and may lose consumers (thus, affecting the bottom line). Ultimately, this is actually true. Out of the tens of millions of consumers who want the iPhone 5, some will jump to competitors like Samsung and Google (GOOG) to avoid waiting. However, I'm arguing that this effect will be minuscule. The iPhone 5's release has been the most anticipated smartphone release in history and consumer demand has been tremendous and will remain strong, despite the supply chain issues. I'm also arguing that the extreme pessimism that has surrounded Apple has caused its shares to become oversold and, consequently, undervalued.

Valuation

Currently, Apple's valuations on an individual and relative basis are staggeringly undervalued, especially for being a large cap corporation. Apple is a technology company trading at only a P/E of 14.34 and forward P/E of 11.41, in an industry where P/E ratios are almost always above 20. Apple's nearest competitor, Google, is currently trading at a P/E of 20.21 and forward P/E of 13.79 (even amid its recent tremendous crash in valuation). Also to note, Apple's PEG is only at 0.66, when anything under 1.0 is generally considered undervalued, and its projected 5-year earnings growth stands at a staggering 21.81%. Google, on the other hand, is trading at a PEG of 1.2 and 5-year projected earnings growth of 16.86%.

Finally, two other key ratios which Apple is leading head-over-heels by are its return on assets and return on investments, towering at 29.77% and 38.27%. For comparison, Google's return on assets and return on investments are a bleak (in comparison) 14.72% and 17.21%.

Although I take analyst ratings with a grain of salt, I still believe researching them is valuable in the investment process. Of the 55 analysts polled, 23 rank Apple as a strong buy and 26 as a buy, meaning that 89.1% of the analysts in the sample group assigned Apple's stock as a strong investment. Google, for comparison, has 15 ranking it a strong buy, and 20 a buy; accounting for 42 ratings, 83.3% rated Google as a strong investment.

Finally, let's discuss Apple's fair value assessment. Any investment, whether it be bonds, stocks, or real estate, can be broken down and valued at a cash-flow basis to find its fair value. Essentially, analysts project an investment's projected cash returns (EBITDA), net taxes and capex, assign a terminal value (the value of an investment in the future), discount these future values to present value, and determine its fair value through this process. Basically, the fair value of a company is the total returns it can generate for a shareholder.

Apple's fair value is calculated by projecting the company's total life-long profit-generating ability, net taxes and capex, assigning a terminal value, and dividing the values by Apple's total outstanding shares after discounting them to present value. It's a difficult process which yields varying results, currently ranging anywhere from $270 to $1,111, with a median value of $780. With the median figure in mind, Apple's current stock is trading at a 22% discount to fair value.

Overall though, Apple is a company that has created tremendous value through its highly differentiated brand. Its global expansion, especially into Asia and Europe have yielded tremendous results so far, with tremendous growth opportunities still available. In just the last quarter, which is a "soft" quarter for Apple, segmented market sales increased as following:

America Q/Q: 26% increase in net sales

Europe Q/Q: 16% increase in net sales

Japan Q/Q: 33% increase in net sales

Asia Q/Q: 25% increase in net sales

Even in Europe, which is facing a contracting economy, net sales increased 16% quarter-over-quarter. Apple has experienced tremendous growth in Asia, primarily from Japan and China and hasn't even tapped into the full potential of China's market yet. China Mobile, the biggest telecommunication provider in China, has a subscriber base of 698 million, and is still a potential play for Apple.

Emerging dominating markets, like that of India and Brazil's, will prove to become further components of Apple's rapid growth in the near future. At the time, Apple is anticipated to unveil an iPad mini on October 23rd, with the sole purpose of dominating the entire tablet market while competing against Amazon, Google and Microsoft. Apple's recent $90 billion devaluation in respect to "missing" initial sales estimates is too short-sighted, given Apple's upcoming holiday season, which will prove to be unlike any other.

Skullcandy (SKUL)

Overview

Skullcandy has created very strong brand image through a highly differentiated marketing approach emphasizing on grass-roots brand development. They're a maker of headphones and earphones and have created a strong business model which revolves around a highly segmented product line, allowing Skullcandy to compete in the $10-$20 range with its highly popular Ink'd earphones, all the way to the $350 range with its Mix Master headphone.

Fellow contributor Helix Investment Management summed up beautifully the rapid changes Skullcandy is going through in his article Short Squeeze Looms For Skullcandy:

"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. 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."

Sales Growth

In terms of sales, Skullcandy has been growing at a tremendous rate, experiencing 60.2% compounded annual growth from 2007-2011, with sales projected to increase from 20.4%-29.0% in 2012. On a year-over-year, quarter-over-quarter, and sequential quarter growth, Skullcandy has performed tremendously:

2012 Q1/Q1 sales growth: 47.93%

2012 Q2/Q2 sales growth: 32.25%

2012 Q3/Q3 sales growth: To be determined

2012 Q4/Q4 sales growth: To be determined

So far, Skullcandy has experienced aggressive sales growth through its highly successful grassroots marketing, targeted distribution, brand image, and celebrity-brand association. Skullcandy markets to multiple markets simultaneously and attracts a widely diversified consumer base, allowing it to successfully expand its product lines in international growth. Currently, Skullcandy has begun its European expansion through a direct business-to-consumer online based approach and is determined to penetrate the rapidly growing Chinese market as well.

Valuation

Skullcandy is currently trading at a P/E of 15.31 and a forward P/E of only 8.59 for year 2012. Its PEG ratio is at 0.75, price-to-sales only 1.21, and current ratio of 2.97. Its earnings growth for 2012 is projected at 213.62% and 5-year projected earnings growth is at 20.42%, which I believe is conservative. Also, to make things even more attractive, Skullcandy has experienced rapid EBITDA margin growth at an annualized rate of 21.2% from 2007-2011. With recent acquisitions, Skullcandy has experienced margin compression from a strategic shift to over-ear headphones, which is where the market is currently trending towards.

Product Demand Misconception

Last month, Skullcandy received a downgrade from Morgan Stanley's Jay Sole, from $21 to $15. In his report, he cited the following "evidence" to support his downgrade:

"1) Our latest Target store visit revealed SKUL's high volume "Ink'd" product now selling for $16.99, down from $19.99 and 2) Monster is taking further peg share; 3) We have also seen Radio Shack 30% off SKUL discounts; and 4) Staples is replacing SKUL's high-price Aviator product with Soul's offering."

Jay Sole is wrong on multiple accounts in his analysis and the "evidence" he used to support his downgrade.

1) Jay Sole made a huge point on the fact that Target was selling Skullcandy's Ink'd product at a discount of $16.99, as opposed to its normal $19.99. This would be substantive, if Skullcandy and its retailers had a profit/revenue-sharing agreement; however, that is not the case. Skullcandy sells its products at a fixed wholesale price, from which the retailer then marks up and resells. Target providing a discount to clear through inventory does not affect Skullcandy's profitability and, in fact, paves way to increasing future sales.

2) Jay Sole stated with conviction that "Monster is taking further peg share." However, he conveniently failed to disclose whether that Peg share was from Skullcandy or not. Ultimately, what can be inferred is that Monster is gaining Peg share. However, we cannot assume it's from Skullcandy, which Jay Sole attempted to portray without evidence.

3) Again, Skullcandy does not have a revenue/profit-sharing model with its retailers, including RadioShack. Many products often go on sale and overanalyzing it can be, and is, meaningless.

4) For an analyst working at Morgan Stanley, Jay Sole should have at least gotten this part right: Staples has never carried the Skullcandy Aviator model. They have the Hesh model which has seen some movement of their endcap program which was scheduled to end in October. However, as Skullcandy's Investor Relations representative stated, "it's inconsequential to our business."

Conducting my own channel checks

In direct response to Jay Sole's stock downgrade in response to one channel check he performed at a Target store, I decided to conduct my own channel checks, but across a larger and more definitive sample size. I contacted 31 Target stores across America, including those in the most populous cities, and asked them a set of highly strategized questions created to extract as much information as possible. I presented myself as a first-time purchaser of headphones/earphones and asked them the following questions:

1) Which brand of headphones/earphones do you recommend the most?

2) Which brand is your most popular seller?

3) Over the past months, has Skullcandy been gaining or losing popularity.

The first question was designed strategically to understand which brand the salespeople are pushing to sell. This is critical because it helps illustrate the extent to which Skullcandy's supplier (Target) is pushing to sell the product.

The second question was designed solely to understand how Skullcandy's product sales rank in respect to its competitors in the highly competitive marketplace.

The third question was designed to help project future demand of the Skullcandy product line. If Skullcandy headphones and earphones have been gaining in popularity, then we can assume that demand will continue to remain strong in the future whereas, if Skullcandy's popularity has been declining, we can predict weak future sales, especially during the holiday quarter.

Results

The results I found have been staggering.

1) When asked the question "which brand would you recommend the most", 45.2% solely recommended Skullcandy, and 45.2% recommended Skullcandy and another brand (like Sony or Phillips). Overall, 90.3% of Target representatives recommended Skullcandy as their top, or top two, choice. Some sales representatives even noted, without being asked, that they've experienced extremely little to no returns on Skullcandy products, which is indicative of a very satisfied consumer market.

2) When asked the question "which brand is your best seller," 93.6% of Target representatives stated that Skullcandy was their best seller

3) When asked if Skullcandy has been gaining or losing popularity over the past few months, of the 25 (not 31 in this case) stores asked, 84% claimed that Skullcandy was gaining popularity, 8% claimed its sales haven't changed, and 8% claimed they weren't sure.

Beyond the inherently subjective bias presented through human contact, my channel checks have shown that Skullcandy is being met with tremendous demand from consumers with an equally strong supply push from its retailers. Skullcandy has been extremely proactive in educating its retailers' employees about Skullcandy as a brand and lifestyle, which has been met with high recommendations in not only my Target channel checks, but also in Best Buys.

But wait! There's more!

Did I forget to mention that Skullcandy is in a perfect situation for a short squeeze? Currently, 37.83% of Skullcandy's total shares outstanding have been shorted, creating a 64.22% short float. As we speak, Skullcandy reigns as one of the most heavily shorted stocks in the market, and unjustly so. Typically, investors short sell companies with disastrous financials who are facing insolvency and decreasing profitability, among other factors. Essentially, shorting a stock aggressively, especially in this respect, is only done for companies on the near brink of bankruptcy; however, Skullcandy has experienced tremendous growth over the years, has created a strong brand image, has a well diversified product line, and is expanding both domestically and internationally. Their business model is profitable and will increase in profitability as global expansion provides them economic benefit through economies of scale.

Technical Analysis

From a technical perspective, three indicators are pointing to oversold conditions for Skullcandy. First, the stock is currently right above its support level of about $11.79-$11.91. Second, its RSI of 15.38 is literally screaming oversold, especially when an RSI of 30 or below is indicative of an oversold stock. Finally, over the last 2 weeks (excluding last Friday), Skullcandy has traded on incredibly low volume which allows for rapid price movements with relatively small transactions.

Skullcandy: Bottom Line

Skullcandy is a relatively new company who had its IPO last year and, since then, experienced a 30% devaluation. They provide a highly differentiated product line across all price targets, allowing them to compete and dominate in multiple market segments. They've created a very strong and highly recognizable brand image through aggressive grassroots marketing, strategic celebrity partnerships, and providing high quality products. Their strategic outlook is consistent with market trends and they plan to capitalize on the trend towards the higher end, over-ear headphones market.

Skullcandy still has much room to grow domestically and internationally. Its product lines are highly differentiated and rapidly gaining market acceptance and momentum. They still have tremendous growth potential through expanding current distribution outlets through vendors like Wal-Mart and into current markets in Europe potential markets in Asia. I believe the stock is undervalued given my analysis of the company, its market, and its relative valuation.

Source: 2 Aggressive Growth, Highly Profitable, Deep Discounted Stocks