PSB Monthly Issue June 2013

And you know what?

All of it has been completely true.

Smartphones and other mobile devices have changed everything.  From the way we work, communicate, surf the internet, and much more, mobile technology has altered the way we live.

These days, desktop computers are becoming dinosaurs. Even laptop sales are on the decline.  More and more, traditional computers are only being used for specialized purposes.

What’s more, software and hardware development has shifted focus to mobile devices.

For instance, the video game industry is beginning to be dominated by games designed for smartphones and tablets.  The days of paying $60 for a console or PC game may quickly be behind us.

On the hardware side, one major area of product growth is in audio and gaming headphones.  As sound, music, and gaming become a more mobile experience, the significance of the market for headphones is becoming clear.

And one of the top, up and coming companies in the audio and gaming headphones space is Skullcandy (NASDAQ: SKUL).

THE AUDIO AND GAMING HEADPHONES BUSINESS

Skullcandy develops performance audio and gaming headphones and other related products under the Skullcandy, Astro gaming, and 2XL brands.  The company offers in ear, on ear, and over ear audio headphones, speaker docks, mobile device cases, and gaming headphones.

One of the impressive aspects of SKUL is what the company has done for the industry in general. Skullcandy’s products were some of the first to go mainstream with the goal of actually making wearing headphones “cool”.

The company’s headphones are based on action sports and lifestyles cultures, such as youth lifestyle.  The products blend a mix of audio quality and innovative design.

Here’s what we really like about SKUL…

As I mentioned earlier, the audio headphone market is huge and growing rapidly.

SKUL estimates the global headphone market to be over $5 billion.  And, the US headphone market alone grew 23% in the last year.  As demand for mobile devices increases, so does demand for headphones.

In fact, smartphone shipments are expected to increase 30% year over year.  So, that’s bound to continue giving a boost to headphone sales.

And that’s not all…

SKUL is actively focused on increasing their presence in gaming headphones.

The gaming headphone market is expected to be worth over $1 billion.  What’s more, one company controls about 50% of the market.  As such, there’s plenty of room for additional competition in the space.

Even better, the gaming accessories market is over $6 billion.  By establishing a strong foothold in gaming headphones, it would be a natural transition to expand into other gaming accessories.

Finally, SKUL is shifting more resources towards international expansion.  The company is still very early in the international sales process. So, there’s ample room for growth.

Now, let’s look more closely at the numbers.

THE NUMBERS

Skullcandy’s financials are a tale of two financial statements.  In a nutshell, the income statement is less than stellar while the balance sheet is rock solid.

On the income side, sales and profits are both down year over year in the most recent quarter.  Net sales dropped from $53 million to $37 million for the quarter.  The decrease was mostly due to the company scaling back its highly-discounted sales from a year ago.  While hurting sales numbers, this strategy should improve margins over the long-term.

Meanwhile, profit margins were hurt by the write off of certain end-of-life products. This type of event is non-recurring. Moreover, despite the drop in revenue and earnings, the company maintains a robust operating cash flow of over $30 million per year.

As SKUL expands into new products and markets, you can bet the income statement will improve dramatically.

On the other hand, the company’s balance sheet is in great shape.

Cash holdings are $34 million compared to zero debt.  Plus, current assets are a strong 4.2x current liabilities.  Essentially, the company’s health is of no concern whatsoever.

INVESTMENT RISKS

As with any investment, SKUL does have a few risks.

An unexpected slowdown in the economy could reduce demand for SKUL’s products as they are considered luxury items.

New entrants into the audio/gaming headphone market could put pricing pressure on SKUL and hurt revenues or margins.

Finally, if the international economy continues to deal with slow economic growth, SKUL’s expansion plans may not add as much as expected to the top line.

POTENTIAL RETURN OF 100% OR MORE

SKUL has a huge potential market for its products including expansion into gaming headsets/peripherals and international markets.  Plus, the company has a very strong balance sheet and operating cash flow.

Despite the positives, the shares are trading at just 8.6x earnings.  That’s a bargain price considering analysts expect SKUL to grow earnings by 131% next year.  Not to mention, the company’s main competitors trade at over twice SKUL’s price to earnings ratio.

Finally, the stock is trading well below its 200-day moving average.  In other words, there’s plenty of room for the shares to run higher.

Based on our analysis, we see SKUL climbing to $10.90 a share or more.  Buy the shares now for potential gains of 100% or higher!

ACTION RECOMMENDATION

BUY Skullcandy (NASDAQ: SKUL) up to $6.00 per share.

Don’t forget your position sizing and stop-loss rules.