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Article / 06 September 2012 at 8:41 GMT

Skullcandy – Have stock ‘shorters’ got it wrong?

Sverrir Sverrisson Sverrir Sverrisson
Partner - Senior Portfolio Manager / PP Capital Asset Management
Denmark

Skullcandy stock is shorted

As I wrote a few days ago, Skullcandy (NASDAQ:SKUL) holds the dubious honour of being the most shorted stock within the US market. The company, whose stock was listed at USD 20 per share in 2011 in its Initial Public Offering has grown to become one of the largest headphone makers in the US. Short sellers however certainly do not believe this company can keep growing. But the question is, have ‘shorters’ got it wrong?

Financial performance
Revenues
For a stock to be shorted so heavily you would think its financials were simply a mess. That is not the case for Skullcandy. For the past 14 quarters, Skullcandy has successfully significantly grown its revenues on average 40 percent year-on-year. 

Quarterly Revenues

There is an obvious seasonal trend in Skullcandy’s revenue figures. The holiday season has proven to be the most lucrative season of all. The current quarter, which includes the back-to-school season in the US, as well as the upcoming holiday season in Q4, will surely help Skullcandy to maintain its pace of revenue growth. Additionally, an increased effort to promote its headphones in Europe might give an extra boost to revenues this holiday season.

Margins
Establishing a headphone brand and maintaining it requires a huge marketing and sales effort. So too does breaking into new markets. Amongst other initiatives, Skullcandy brands its headphones through celebrities, which comes at some cost as well. All increased marketing and sales efforts from the company narrows its profit margins substantially. 

Quarterly Gross-, EBIT-, & Net Profit Margins

A quick review of numbers alone reveals that Skullcandy has had fairly stable gross margins, around the 50 percent mark for the past 14 quarters. The EBIT Margin and Net profit Margins have fluctuated more, though the company has remained profitable since its IPO.

In comparison to its peers, Harman International Industries, Koss Corp, VOXX International and Plantronics, only Plantronics beats Skullcandy’s margins.

Earnings per share
In its start-up years, the company experienced losses, delivering a total loss of USD 10 million in 2010, the year before its IPO. Nevertheless, ever since Skullcandy has become a publicly traded entity, its earnings have been above market expectations. Furthermore, analysts expect cumulative annual growth of earnings per share to be roughly 42 percent for the coming three years.  

EPS - Actual & Consensus

So with growing revenues, okay margins, a  five quarter history of positive EPS surprises and a FY1 P/E of 12.8, this doesn’t look like the worst stock on the US market. Investors therefore seem to be heavily punishing a new brand in the market and completely omitting its future potential.

Who is right, ‘shorters’ or analysts?
Analysts seem to believe investors are being naive! It is true that being a fairly new brand in the market and competing against bigger players such as Bose, Sony, or Sennheiser adds the risk of being crushed. Nevertheless, 11 analysts hold a 100 percent buy rating on the stock, giving it an average target price of 22.45. That is roughly 46 percent upside from the stock’s closing price!

Analysts view on Skullcandy

Possible short squeeze?
Analysts seem certain that the ‘shorters’ are way off. If Skullcandy continues to deliver positive surprises, the downward pressure on the stock must stop at some point. With such a massive short interest, and fairly good financials, Skullcandy might be the ultimate contrarian bet. Any tiny bit of positive news could send the stock surging as ‘shorters’ would rush to close their positions, thereby significantly raising demand for shares. In other words a short squeeze could take place.

Risk factors
As with many other small cap stocks, investing in Skullcandy poses a few risks. The company’s success is mainly built on its brand value and customer appraisals. Any minor mishap could have adverse effect on its performance, which is what quite a few investors seem to be hoping for. Supplier wise, the company only has a few suppliers on board, which makes its supply chain vulnerable, should business relationships deteriorate.

However, should the stock continue to beat analysts’ estimates, its products continue to increase in popularity, and its business relationships remain stable, the stock might be in for a nice ride - just like analysts expect!

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