Skullcandy Pessimism Has Reached Epic Proportions

| About: Skullcandy (SKUL)
This article is now exclusive for PRO subscribers.

Much has been said about Skullcandy (NASDAQ:SKUL) recently. About a month ago, I wrote an article speculating that Skullcandy is positioning itself as a takeover target. The next morning, DA Davidson analyst Andrew Burns, who has a Buy rating on Skullcandy along with a $26 price target, reiterated my thesis and said that the sell-off based on the Morgan Stanley downgrade a few days earlier is overdone. This past Thursday, Raymond James downgraded Skullcandy from Strong Buy to Market Perform, citing the consumer shift toward higher priced on-ear headphones from its core strength of earbuds.

Here we are now, after coming full circle. Following a brief rally of over 20% off the late-September lows, shares of Skullcandy are back to where they began their latest surge. This seems to be a pattern that is followed every time into earnings, as detractors come out of the woodwork to doubt the ability of the company to hit the numbers or deliver sustained sales growth -- later to get blown away as Skullcandy easily beats the estimates, but then make it back in the following weeks as the stock falls again. I have made my bet that history will repeat itself and backed up the proverbial truck with shares during the discount sale that went on in the latter part of Friday's trading session.

In this article, I will outline the reasons why I believe Skullcandy is a James Harden slam dunk buy at current levels.

  1. Pessimism in the company operations has reached epic proportions. As I mentioned on Oct. 3 when writing about Audience (NASDAQ:ADNC), the time to buy is when a stock has been written off for dead. In Audience's case it was the lack of presence of earSmart technology in the Apple (NASDAQ:AAPL) iPhone 5 infrastructure. In Skullcandy's case -- and it's worth mentioning that it has an exclusive deal with Apple that nobody talks about -- its the market perception that the competition is simply too strong and this will pressure sales and margins going forward. I don't believe that this theory is correct. As part of my research, I wanted to see what ordinary consumers have to say about Skullcandy. I started on its Facebook page. From this, I got the impression that the brand is gaining momentum, even among those who were previously detractors. There are a number of comments from new fans who are recent Skullcandy converts. The overall vibe seems to be quite positive, when a year ago it was overwhelmingly negative as quality control issues plagued the company. Also, I read a number of recent reviews on Amazon and on YouTube. Following this, a clearer picture began to emerge about a brand that is finally hitting its stride in the eyes of the consumer. It certainly appears that product quality and innovation is on the upswing as the majority of new reviews are overwhelmingly positive. This is particularly true with the new SLYR gaming headsets that are garnering rave reviews in respectable publications that never backed Skullcandy products in the past.
  2. There are an incredible number of catalysts moving forward. Besides the hiring of Kyle Wescoat, which I have already wrote about as a near certain indicator of some sort of private equity takeover down the road, there are a number of potential events that could send the shorts into a mad dash to the exits. I recently had the chance to watch an Enterprise Video by Bloomberg about Skullcandy. In it, CEO Jeremy Andrus is asked by the reporter if a potential deal with Wal-Mart is in the cards. Seeing is believing, but as a 20-year poker veteran I can spot a tell from a mile away, and watching this video certainly made me a believer that a deal with Wal-Mart is imminent. Distribution deals with Wal-Mart and to a lesser extent Office Depot or Staples, offer tremendous growth opportunities going forward. It is foolish to think that Monster Beats by Dre will maintain their exclusive monopoly in Wal-Mart that much longer. Detractors constantly cite the lack of growth prospects when analyzing Skullcandy, but in reality the Skullcandy distribution has not even reached the tip of iceberg yet. This is a company and brand that is still in its infancy and by all rational accounts is heading in the right direction in every facet other than on Wall Street.
  3. Since day 1 as a public company, Skullcandy has always beat the numbers. For the past five quarters since becoming a public company, Skullcandy has always significantly beat analyst estimates and guided toward increased growth. There is simply no reason to believe that this upcoming third-quarter release will be any different. Estimates call for earnings of $0.23 on just under $70 million in revenue. Skullcandy has always been conservative in guidance and has exceeded expectations every quarter. So, given the prevailing positive business trends that I have noted, I do not believe that this time will be any different. Simply put, Skullcandy has been credible with financials from its inception as a public company, so the odds are in the favor of a third-quarter numbers beat over a miss. This time I believe that Skullcandy will gap up and not look back.
  4. The Skullcandy stock simply represents incredible value by any conventional metric. Here we have a rapidly growing company with no debt that beats the numbers and guides higher every quarter. The stock is trading at a forward P/E of about 10. Strictly as a value play, I cannot find another company in the market that is growing anywhere near the pace of Skullcandy and is trading at such a compelling valuation. Based on the current share price, which is just about a 50% discount from the oversubscribed IPO price from last June, you would think that the company is embroiled in some sort of SEC controversy or facing declining sales or a mass exodus of executives. None of these things are happening, and all we have here is a greatly misunderstood story of a true grassroots lifestyle brand that is just starting to realize efficiencies through improving margins by re-engineering the products and increasing its highly profitable online and international sales and distribution presence. Outside of Wall Street, Skullcandy is a true American success story.

As a final point, I would like to state that many arguments rest on the false premise that Skullcandy has nothing proprietory and is simply a commodity play. In reality, nothing could be further from the truth. In addition to actual patents held by Skullcandy, the brand itself is completely proprietary. Skullcandy owns a number of trademarks that protect the brand, images, logos, and slogans. This is no different than Nike (NYSE:NKE) or Lululemon (NASDAQ:LULU), and nobody suggests that these iconic brands have nothing proprietary or are simply just commodities.

In fact, Skullcandy does have a commodity headphone division called 2XL, which competes on the lower end earbud market in stores like Walgreens (WAG) and CVS (NYSE:CVS) among others. Skullcandy clearly differentiates the brands in order to protect its image. In fact, during the last earnings call on Aug. 2, the company stated that it discontinued selling clearance items on in order to protect brand integrity. This hardly sounds like a good approach to selling a simple commodity.

Regardless of what I have to say here, Skullcandy stock has Nasdaq-leading 40% short interest, so clearly many are not buying the growth story that I portray. We will find out soon enough who is right and who is wrong as Skullcandy is set to release third-quarter earnings after the bell on Nov. 1. If you like action, be sure to tune in for the fireworks. I have placed my bets on long; where have you placed yours?

Disclosure: I am long SKUL. 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.