Skullcandy Valuation and Recommendation (11/12/2012)

SKULLCANDY, INC.                    Recommendation: BUY
                                                                                                Target Price: $15.51
                                                                             Market Price(11/18/12): $9.05 

 

Investment Summary

After valuating the intrinsic value of the current stock price and analyzing the economic outlook for the industry, I suggest a strong hold/buy on Skullcandy equity. I recommend this buy due to what has been happening in the tech industry, the upcoming holiday season and the cheap buy-in opportunities of a well performing company.

The historical performance of the stock is short, but very sweet. For being publicly traded for only 18 months, it has beaten market expectations, especially in key financial ratios. As far as how the company is run, a new CEO has come to better improve the overall appeal of the deflated equity price and the financial reports are very strong. 3^rd quarter reports are promising as the company heads into the final, most profitable quarter of the year while looking to break its own revenue records.

Skullcandy has taken some heat lately from critics who are optimistic about the success of the newly designed Apple ear buds that were released with the new iPhone 5. The error in this optimism for Apple headphones from many consumer reports is the new headphones were merely an improvement in fit and comfort, but not in sound. Those who care enough about the quality of music they listen to will buy more comfortable, better quality headphones from companies like Skullcandy who provide affordable quality and comfort in their products.

Business Description

Skullcandy is an audio company that specializes in headphones, earphones and ear buds that are catered to a younger, artistic generation. While Skullcandy is a publicly traded company, it is a non-conventional corporation, doing what it can to stay away from the Wall Street stereotype. Skullycandy headphones use bright colors and abstract model names to get recognition and maintain the individualistic nature of the company while developing and distributing its products to retailers worldwide. Skullcandy was a local name in Utah but word spread quickly as the Park City-based company gained reputation with skiers, snowboarders, and skateboarders around the world. The company broke through the international market in 2008 when it began distributing to retailers in Europe. Since then the company has kept producing new designs and products modeled after professional surfers, skateboarders and snowboarders. Skullcandy has a strong, innovative design team that has always focused on putting out creative colors and design for all their products which keeps the consumers coming back for more.

 

Industry Overview and Competitive Positioning

The audio industry is a tricky one, with new technology and ergonomic design features coming out every month. To be competitive in this market you need to have innovative minds on your team that know what the public is wanting. Skullcandy has been a smaller company in the past but has grown with overseas operations and public relations coming from professional riders such as Dan Brisse and Tanner Hall. The company is now competing with Bose, Harman International, and Sony, which are pretty big names in the sound industry. The chart below gives a comparison of competitors in the industry and an industry benchmark. Although Harman’s information is available, Sony and Bose are privately held so their information is not so easily accessible. The industry rundown is found below:

 

	Skullcandy	Harman International	Sony	Bose	Industry Average
LFY Revenues	280.13M	4.31B	N/A	N/A	212.96M
LFY Net Income	26.74M	335.73M	N/A	N/A	N/A
Beta	N/A	2.02	N/A	N/A	1
LT Debt	0	0	N/A	N/A	N/A
Free Cash Flow	21.24M	219.87M	N/A	N/A	N/A
P/E Ratio	8.89	7.94	N/A	N/A	13.90

 

 

Valuation

It was interesting going through the valuation process of the company since it hasn’t been around for too long but the analysis is correct and proves for an interesting look at how the company is being treated in the market. Since the company doesn’t have enough historical data, the correct Beta is not listed and therefore cannot be calculated into key valuation methods such as the CAPM. Skullcandy also has very little debt and does not issue dividends, contributing to the calculation of the Divend Discount Model. I will use the Dividend Discount model and other evaluation models to show the current intrinsic value of the equity, based on third quarter reports and theoretical intrinsic value.

Even though the company does not issue dividends, the DDM shows the most accurate calculation. The other two methods used for the price calculation show a price based on a on average of a volatile industry so even though they are less accurate, they still show just how undervalued Skullcandy is on the market.

The first Fair Value per share analysis gives us a look at what the company should be worth relative to the other companies in the industry. The industry average P/E ratio multiplied by the Earnings per Share of Skullcandy lets us see what the price of Skullcandy should be. The second method uses current capital values from the 3^rd quarter financial reports that help us estimate the price of the equity. I will stick with my first method as I have more value in that method.

                            

                                                                             

The fair value of Skullcandy is set at $18.34 per share; meaning that this equity is traded at nearly 50% of its theoretical fair value price in the market as of today.

Overall, the most accurate methodology used is the Dividend Discount Model. That model generates a share price of $15.51 while the two Fair Value per Share methods produced share prices of $18.34 and $13.78. The fact that the most accurate method produces a price in between the less accurate models makes sense and adds to validity of the theoretical intrinsic value of the company, as it is extremely undervalued.

Other factors that boost the intrinsic value of Skullcandy include the Earnings per share ratio (low ratio = cheap and healthy) and the increasing revenues over the last 18 months. I would expect revenues in skyrocket with the approaching holiday season.

(Blue - EPS, Red - Revenue)

The chart below also gives us some useful information that we can visually track over the last 18 months. The Orange line represents the Return on Assets starting from when the stock began its public trading and has increased steadily ever since. It is currently in the position to keep moving in that upward direction. The Blue line on the chart here shows the Price/Earnings ratio of the company for the last 12 months. With a low P/E ratio, we can assume a cheap, solid buy in equity.

The WACC was calculated from the most recent financial statements showing the capital structure of Skullcandy. The company carries very little debt which is extremely impressive for a company this successful and this young.

             

Skullcandy is so impressive that is has beaten out the Russell 2000 Consumer Index of small cap stocks for the last few years in nearly every key ratio. This report was pulled directly from Bloomberg with the only editing being in the formatting of the chart so it is easy to follow: Green = beat market returns, Red = lost vs market returns

HIGH/LOW		2013 F	2012 F	Current	2011	2012	2009	2008
H	SKUL Return on Equity	22.05	23.01	24.26
	Russell 2000	19.17	19.4	18	18.8	14.69	12.2	10.4
H	SKUL Return on Capital			22.51	25.22		41.82
	Russell 2000			15.94	16.09	15.11	13.84	13.38
H	SKUL Operating Margin			14.96	18.14	11.15	25.71	26.4
	Russell 2000			9.85	9.97	9.5	8.24	9.35
L	SKUL Price/EPS	7.81	9.08	9.43	14.39
	Russell 2000	14.07	17.6	19.31	25.62	14.11
L	SKUL Price/Book	1.43	1.86	1.99	3.21
	Russell 2000	1.62	1.8	2.37	2.17	2.57	2.24
L	SKUL Net Debt/EBITDA			0.07	-0.3	4.18	1.77	0.39
	Russell 2000	1.97	2.21	2.15	2.1	1.98	2.57

What really brings down the price of the stock are the short sellers. There is much speculation of Skullcandy of whether it can really stay and compete as a publicly traded company on Nasdaq. The nature of the company is the opposite of what is marketed towards most financial gurus on Wall Street and because of that there is must negative connotation with Skullcandy. The chart to the right breaks down how much of the publicly traded shares are sold short, giving a clear indicator of what the market thinks of Skullcandy. Nearly 60% of all shares float are sold short as of Oct. 15, 2012.

         Financial Analysis

The financial statements for this year are looking very solid, showing growth and preparation for further growth in the upcoming quarters. Overall, I only found a couple things to that aren’t consistent with the outlook:

·         Total Cash dropped this last quarter by about $6 million which prompts us to ask the question, where did all that cash go? The inventories on the balance sheet show an increase in product of about $10 million that I assume will be distributed to retailers over the remainder of this quarter in anticipation of big sales revenue during the holiday season.

Earnings

The earnings reports show strong revenue streams and even stronger projections for the next coming years. Sales have been increasing annually along with free cash flows. With the holiday season coming up and a company that has very little debt, there will be large cash flows to report for the fourth quarter, making it a record-breaking quarter and year from the company.

·         Income from operations went up to $10.6 million this quarter, a 29.1% jump from last quarter.

·         Net revenue was reported at $71 million this quarter, a 17% jump from the same quarter last year. The fourth quarter in 2011 showed a remarkable 37.5% growth from the 3^rd quarter of 2011. Historical patterns and new products this year both show extremely positive outlook for this last holiday quarter of 2012.

Cash Flow

The ever-increasing cash flows have proven strong for Skullcandy, beating market banchmarks, expectations and even its own projections. Cash was spent on investing activities from acquisitions which shows the company is expecting to grow and expand in the coming years. Even with these investments the company still produced higher net cash flows from previous years, indicating growth at an accelerated rate. For me, this company will be reporting exponential numbers in the fourth quarter where the share price will jump significantly.

Balance Sheet & Financing

The thing that really brings Skullcandy into the limelight for investors should be the debt situation: there is none. This company has historically been a company that has stayed away from debt and leveraging in order to maintain strong financial statements. As well all know debt isn’t a bad thing, but for Skullcandy, staying true and “not buying when you don’t have money” has proven very beneficial. No dividends and zero long-term debt show that they are very financially independent and do the majority of their financing in house, which is a great selling point for investors.

Investment Risks

The risks that are incorporated when involving a tech company like Skullcandy are self-explanatory: it’s a tech company.

That doesn’t mean you have to pull the plug on it but there are some things to take into consideration:

·         The Tech Wave: There are many people are firms that build their investing platform on riding out the wave of popular and trendy tech products. With the world so fierce when looking at the tech industry, it is truly a dog-eat-dog world and new technology and cheaper manufacturing are daily battles that are fought with serious consequences. Your company can be up one day but can be plummeting the next with news of a faster, lighter, better product coming from your competitor. So just watch your back.

·         Targeted Market Share: When a new, hip company comes along to get attention from kids it might get exactly that: attention from kids. Skullcandy is a younger company that is targeting younger consumers and therefore losing a large part of the market share. When competing with companies like Bose, Sony, and Harman, Skullcandy may want to reconsider the type of products that it produces and look into diversifying. These three competitors put their audio technology not only in headphones, but in home theater systems, commercial sporting arenas and the best selling luxury automobiles in the world. If Skullcandy really wants to compete with the big wigs, it must increase its market share.

·         Shorting: In recent financial findings, it is reported that sixty percent (60%) of its shares are sold short. This goes to show there is much speculation in this young company and this shorting is driving down the share price.

Figure 1: Income Statement

in millions

Source: Company Documents, Student Estimates

Fiscal year is January-December. All values USD millions.	2007	2008	2009	2010	2011	5-year trend
Sales/Revenue	35.35M	80.38M	118.31M	160.58M	232.47M
Cost of Goods Sold (COGS) incl. D&A	18.16M	41.12M	60.85M	75.08M	116.93M
COGS excluding D&A	18.13M	40.98M	60.43M	74.4M	114.9M
Depreciation & Amortization Expense	30,000	140,000	415,000	677,000	2.03M
Depreciation	30,000	140,000	415,000	677,000	2.03M
Amortization of Intangibles	0	0	0	0	0
Gross Income	17.18M	39.26M	57.47M	85.51M	115.54M

	2007	2008	2009	2010	2011	5-year trend
SG&A Expense	7.35M	18.04M	28.57M	67.6M	71.38M
Research & Development	0	0	0	0	0
Other SG&A	7.35M	18.04M	28.57M	67.6M	71.38M
Other Operating Expense	0	0	0	0	0
Unusual Expense	0	0	0	0	2M
EBIT after Unusual Expense	0	0	0	0	(2M)
Non Operating Income/Expense	13,000	54,000	111,000	(14.56M)	(1.76M)
Non-Operating Interest Income	-	-	-	-	-
Equity in Affiliates (Pretax)	0	0	0	0	0
Interest Expense	91,000	586,000	8.34M	8.39M	7.47M
Gross Interest Expense	91,000	586,000	8.34M	8.39M	7.47M
Interest Capitalized	0	0	0	0	0
Pretax Income	9.76M	20.69M	20.66M	(5.04M)	32.93M
Income Tax	3.5M	7.67M	8.32M	4.65M	14.31M
Income Tax - Current Domestic	4.31M	7.7M	8.63M	7.53M	13.32M
Income Tax - Current Foreign	0	0	0	0	0
Income Tax - Deferred Domestic	(809,000)	(27,000)	(313,000)	(2.87M)	982,000
Income Tax - Deferred Foreign	0	0	0	0	0
Income Tax Credits	0	0	0	0	0
Equity in Affiliates	0	0	0	0	0
Other After Tax Income (Expense)	0	0	0	0	0
Consolidated Net Income	6.26M	13.02M	12.34M	(9.69M)	18.62M
Minority Interest Expense	0	0	0	0	4,000
Net Income	6.26M	13.02M	12.34M	(9.69M)	18.62M
Extraordinaries & Discontinued Operations	0	0	0	0	0
Extra Items & Gain/Loss Sale Of Assets	0	0	0	0	0
Cumulative Effect - Accounting Chg	0	0	0	0	0
Discontinued Operations	0	0	0	0	0
Net Income After Extraordinaries	6.26M	13.02M	12.34M	(9.69M)	18.62M
Preferred Dividends	0	0	9.99M	30,000	17,000
Net Income Available to Common	6.26M	13.02M	2.35M	(9.72M)	18.6M
EPS (Basic)	3.89	0.49	0.09	(0.36)	0.93
Basic Shares Outstanding	1.61M	26.78M	26.78M	26.78M	20.08M
EPS (Diluted)	3.89	0.49	0.09	(0.36)	0.79
Diluted Shares Outstanding	1.61M	26.78M	26.78M	26.78M	23.57M
EBITDA	9.86M	21.36M	29.31M	18.58M	46.19M

Copyright 2012 FactSet Research Systems Inc. All rights reserved. Source FactSet Fundamentals.

Figure 2: Balance Sheet

in millions

Source: Company Documents, Student Estimates

Assets

Fiscal year is January-December. All values USD millions.	2007	2008	2009	2010	2011	5-year trend
Cash & Short Term Investments	-	21.62M	1.73M	37.54M	23.3M
Cash Only	-	-	-	-	-
Short-Term Investments	-	-	-	-	-
Total Accounts Receivable	-	24.48M	29.27M	46.68M	50.62M
Accounts Receivables, Net	-	24.48M	29.27M	46.68M	50.62M
Accounts Receivables, Gross	-	25.49M	30.74M	49.68M	51.22M
Bad Debt/Doubtful Accounts	-	(1.01M)	(1.48M)	(3M)	(599,000)
Other Receivables	-	0	0	0	0
Inventories	-	9.45M	17.86M	22.56M	43.98M
Finished Goods	-	9.45M	17.86M	22.56M	43.98M
Work in Progress	-	0	0	0	0
Raw Materials	-	0	0	0	0
Progress Payments & Other	-	0	0	0	0
Other Current Assets	-	2.44M	2.82M	8.87M	12.48M
Miscellaneous Current Assets	-	2.44M	2.82M	8.87M	12.48M
Total Current Assets	-	57.99M	51.68M	115.64M	130.37M

	2007	2008	2009	2010	2011	5-year trend
Net Property, Plant & Equipment	-	1.21M	2.02M	3.97M	10.29M
Property, Plant & Equipment - Gross	-	1.38M	2.53M	5.16M	12.99M
Buildings	-	-	-	-	-
Land & Improvements	-	-	-	-	-
Computer Software and Equipment	-	266,000	666,000	1.03M	2.81M
Other Property, Plant & Equipment	-	744,000	1.37M	2.74M	5.06M
Accumulated Depreciation	-	178,000	511,000	1.19M	2.7M
Total Investments and Advances	-	0	0	0	0
Other Long-Term Investments	-	0	0	0	0
Long-Term Note Receivable	-	0	0	0	0
Intangible Assets	-	169,000	247,000	991,000	27.55M
Net Goodwill	-	0	0	0	13.87M
Net Other Intangibles	-	169,000	247,000	991,000	13.68M
Other Assets	-	3.67M	3.7M	3.8M	402,000
Tangible Other Assets	-	0	0	0	0
Total Assets	-	63.04M	57.65M	124.4M	168.61M

Liabilities & Shareholders' Equity

	2007	2008	2009	2010	2011	5-year trend
ST Debt & Current Portion LT Debt	-	97,000	2,000	10.8M	9.88M
Short Term Debt	-	97,000	2,000	10.8M	9.88M
Current Portion of Long Term Debt	-	0	0	0	-
Accounts Payable	-	2.89M	5.26M	13.46M	23.21M
Income Tax Payable	-	-	2.77M	-	-
Other Current Liabilities	-	8.92M	8.63M	15.53M	25.1M
Dividends Payable	-	-	-	-	-
Accrued Payroll	-	-	1.94M	3.84M	7.01M
Miscellaneous Current Liabilities	-	8.92M	6.7M	11.69M	18.09M
Total Current Liabilities	-	11.91M	16.66M	39.79M	58.19M
Long-Term Debt	-	27.53M	56.4M	11.42M	0
Long-Term Debt excl. Capitalized Leases	-	27.53M	56.4M	11.42M	0
Non-Convertible Debt	-	0	25M	-	0
Convertible Debt	-	27.53M	31.4M	-	-
Capitalized Lease Obligations	-	0	0	0	0
Provision for Risks & Charges	-	-	-	-	0
Deferred Taxes	-	104,000	489,000	0	3.61M
Deferred Taxes - Credit	-	104,000	489,000	-	3.61M
Deferred Taxes - Debit	-	-	-	-	-
Other Liabilities	-	0	0	0	0
Other Liabilities (excl. Deferred Income)	-	0	0	0	0
Deferred Income	-	-	-	-	-
Total Liabilities	-	39.54M	73.55M	51.21M	61.8M
Non-Equity Reserves	-	0	0	0	0
Preferred Stock (Carrying Value)	-	2.92M	0	0	0
Redeemable Preferred Stock	-	2.74M	0	0	0
Non-Redeemable Preferred Stock	-	178,000	0	0	0
Common Equity (Total)	-	20.58M	(15.9M)	73.19M	106.21M
Common Stock Par/Carry Value	-	0	-	3,000	3,000
Retained Earnings	-	19.14M	-	7.27M	30.34M
ESOP Debt Guarantee	-	0	0	0	0
Cumulative Translation Adjustment/Unrealized For. Exch. Gain	-	0	0	0	0
Unrealized Gain/Loss Marketable Securities	-	0	0	0	0
Revaluation Reserves	-	0	0	0	0
Treasury Stock	-	0	-	(43.29M)	(43.29M)
Total Shareholders' Equity	-	23.5M	(15.9M)	73.19M	106.21M
Accumulated Minority Interest	-	0	0	0	604,000
Total Equity	-	23.5M	(15.9M)	73.19M	106.81M
Liabilities & Shareholders' Equity	-	63.04M	57.65M	124.4M	168.61M

Copyright 2012 FactSet Research Systems Inc. All rights reserved. Source FactSet Fundamentals.

Figure 3: Statement of Cash Flows

in millions

Source: Company Documents, Student Estimates

Operating Activities

Fiscal year is January-December. All values USD millions.	2007	2008	2009	2010	2011	5-year trend
Net Income before Extraordinaries	6.26M	13.02M	2.35M	(9.72M)	18.62M
Depreciation, Depletion & Amortization	30,000	140,000	415,000	677,000	2.03M
Depreciation and Depletion	30,000	140,000	415,000	677,000	2.03M
Amortization of Intangible Assets	0	0	0	0	0
Deferred Taxes & Investment Tax Credit	(808,000)	(27,000)	(313,000)	(2.58M)	805,000
Deferred Taxes	(808,000)	(27,000)	(313,000)	(2.58M)	805,000
Investment Tax Credit	0	0	0	0	-
Other Funds	373,000	1.43M	15.49M	46.68M	12.34M
Funds from Operations	5.85M	14.56M	17.95M	35.05M	33.8M
Extraordinaries	0	0	0	0	0
Changes in Working Capital	(5.96M)	(19.08M)	(6.19M)	(18.42M)	(5M)
Receivables	(8.26M)	(15.21M)	(5.26M)	(19.78M)	(4.22M)
Accounts Payable	1.39M	1.02M	2.37M	8.2M	7.62M
Other Assets/Liabilities	(158,000)	(3.39M)	2.57M	(3.5M)	(4.63M)
Net Operating Cash Flow	(111,000)	(4.51M)	11.76M	16.63M	28.8M

Investing Activities

	2007	2008	2009	2010	2011	5-year trend
Capital Expenditures	(596,000)	(932,000)	(1.31M)	(2.94M)	(7.59M)
Capital Expenditures (Fixed Assets)	(596,000)	(763,000)	(1.23M)	(2.63M)	(7.56M)
Capital Expenditures (Other Assets)	0	(169,000)	(79,000)	(313,000)	(31,000)
Net Assets from Acquisitions	0	0	0	0	(29.46M)
Sale of Fixed Assets & Businesses	0	0	0	0	0
Purchase/Sale of Investments	0	0	0	0	0
Purchase of Investments	0	0	0	0	0
Sale/Maturity of Investments	0	0	0	0	0
Other Uses	0	0	0	0	0
Other Sources	0	0	0	0	0
Net Investing Cash Flow	(596,000)	(932,000)	(1.31M)	(2.94M)	(37.05M)

Financing Activities

	2007	2008	2009	2010	2011	5-year trend
Cash Dividends Paid - Total	0	0	0	0	0
Common Dividends	0	0	0	0	0
Preferred Dividends	0	0	0	0	0
Change in Capital Stock	2.26M	358,000	(28.24M)	285,000	71.04M
Repurchase of Common & Preferred Stk.	0	0	(28.64M)	0	0
Sale of Common & Preferred Stock	2.26M	358,000	396,000	285,000	71.04M
Proceeds from Stock Options	2.17M	146,000	0	0	69.9M
Other Proceeds from Sale of Stock	86,000	212,000	396,000	285,000	1.14M
Issuance/Reduction of Debt, Net	(425,000)	23.86M	(95,000)	(9.91M)	(47.7M)
Change in Current Debt	(425,000)	(463,000)	(95,000)	10.8M	(919,000)
Change in Long-Term Debt	0	24.32M	0	(20.71M)	(46.78M)
Issuance of Long-Term Debt	0	24.32M	0	0	0
Reduction in Long-Term Debt	0	0	0	(20.71M)	(46.78M)
Other Funds	(548,000)	0	253,000	662,000	1.77M
Other Uses	(548,000)	0	(326,000)	(50,000)	0
Other Sources	0	0	579,000	712,000	1.77M
Net Financing Cash Flow	1.29M	24.22M	(28.08M)	(8.96M)	25.11M
Exchange Rate Effect	-	-	-	-	(25,000)
Miscellaneous Funds	0	0	0	0	0
Net Change in Cash	580,000	18.77M	(17.63M)	4.73M	16.84M
Free Cash Flow	(707,000)	(5.28M)	10.53M	14.01M	21.24M

Copyright 2012 FactSet Research Systems Inc. All rights reserved. Source FactSet Fundamentals.

 

Figure ·: Other Statements or Exhibits

in millions

Source: Company Documents, Student Estimates

Disclosures:

Ownership and material conflicts of interest:

The author(s), or a member of their household, of this report [holds/does not hold] a financial interest in the securities of this company. 

The author(s), or a member of their household, of this report [knows/does not know] of the existence of any conflicts of interest that might bias the content or publication of this report.  [The conflict of interest is…]

Receipt of compensation:

Compensation of the author(s) of this report is not based on investment banking revenue.

Position as a officer or director:

The author(s), or a member of their household, does [not] serves as an officer, director or advisory board member of the subject company.

Market making:

The author(s) does [not] act as a market maker in the subject company’s securities.

Ratings guide:

Banks rate companies as either a BUY, HOLD or SELL.  A BUY rating is given when the security is expected to deliver absolute returns of 15% or greater over the next twelve month period, and recommends that investors take a position above the security’s weight in the S&P 500, or any other relevant index.  A SELL rating is given when the security is expected to deliver negative returns over the next twelve months, while a HOLD rating implies flat returns over the next twelve months.

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[Society Name] Investment Research Challenge as part of the CFA Institute Global Investment Research Challenge is based on the Investment Research Challenge originally developed by the New York Society of Security Analysts.

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The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with [Society Name], CFA Institute or the Global Investment Research Challenge with regard to this company’s stock.