Skullcandy is cheap on its fundamentals and is a great way to buy a call option on China devaluing its currency.
SKUL trades at 2.9x 2015 EBITDA in a growing industry where their revenues increased 11% in 2015 on a constant currency basis (8% on a USD basis) and should see positive operating leverage in 2016. Besides the status quo fundamentals, there are two potential catalysts for a revaluation to take place this year. One is that Apple is expected to remove the headphone jack from their next iPhone model. This should set off an upgrade cycle towards wireless headphones and headphones with lightning connectors. The second major catalyst is much more speculative, but could be much higher impact. SKUL’s cost of goods sold is around 60% and 100% of their products are manufactured in China. A 10% devaluation in the reminbi could lead to a 4-6% reduction in their cost of goods sold. Their current operating income margins are slightly under 4%, therefore a 10% devaluation could literally more than double their operating income. If Kyle Bass / Mark Hart / others are correct and China devalues by 50%, then their cost of goods sold could decline by 20-30% which could raise their operating income by 5x+.
Skullcandy sells headphones in two categories – regular headphones (under the Skullcandy brand and the discount 2XL brand) and premium gaming headphones (under the Astro brand). They sell through big box retail (Best Buy, Dick’s Sporting Goods, Target & Walmart) and smaller specialty retailers. 70% of their revenues are generated in the US.
They have the #1 market share by units of headphones / earbuds sold in the US, with particular strength in the $20-$100 range. Astro has greater than 60% market share in the over $200 console gaming headphone category which is growing quickly, although its margins are below the company average.
The headphone industry has been growing quickly over the years fueled by the adoption of smart phones. Amongst the major competitors, Beats and Bose have leading market share in the $100+ category. Bose is known for its sound quality and technology while Beats is endorsed by Dr. Dre and has the cool factor.
In the sub $100 category, Skullcandy and Sony have strong market shares. Sony is known as a dependable but not sexy brand while Skullcandy stands for excitement via its endorsements from action sports athletes. Skullcandy originally sold based on availability and color but has improved its sound quality over the last few years as they hired audio engineers away from their competitors.
The market had been growing at a mid teens rate in 2015 up until the fourth quarter. Beats offered discounts on their products to make up for the shortfall in unit sales they were encountering which pressured the category into contracting year over year. Skullcandy took market share with +16% sell through year over year while the overall market was down. Skullcandy’s ASP was +12% due to a mix shift towards wireless while the industry ASP was negative as a whole.
The headphone category is likely to return to growth as Apple introduces the iPhone 7 and as virtual reality headsets demand better sound to help create immersive experiences. Gaming headphones have been growing rapidly and are expected to continue doing so as we move further into the console cycle.
A large revenue opportunity for SKUL lies in promoting Astro internationally. Their revenues are primarily domestic right now and the company believes that eventually it will be 50/50.
One other item to note is that Skullcandy opened a sports and human potential lab last year that is conducting research on how music affects performance. It could turn out to be a waste of money or it could add a meaningful patina to the brand.
The company has disappointed the street for the last four quarters and the stock has fallen from above $10 to around $3.50. The fourth quarter saw a $6 million revenue shortfall. Half of the shortfall was caused by Beats discounting their headphones over the holidays and half of the shortfall was caused by a decision by management not to sell inventory into the discount channel. In prior years they had old inventory that they wanted to liquidate and this year all of their inventory was fresh. They didn’t want to upset their primary retailers by undercutting them with the same merchandise in a discount channel, so they chose to forgo the revenue. All in all, the company gained market share in an environment that was surprisingly weak.
The first quarter saw a rebound in the domestic market to a mid single digit growth rate with SKUL continuing to gain share. They had continued issues with their Chinese distributor which cost them 2 cents per share.
Their market share on Amazon is below their overall market share so as Amazon gains share SKUL may see its share eroded.
The founder appears to be a seller of 37,500 shares per week regardless of price. His sales may pressure the stock.
S,G&A costs seem to be largely fixed and thus revenue shortfalls could imperil operating income.
The fourth quarter represents the vast majority of their annual operating income.
Risk & Reward
My base case is that without the Chinese devaluing the yuan, SKUL will report $283 million in revenue and $0.26 in earnings. With a 10x multiple and adding back the net cash, one would get a $4.20 target price.
My downside case is that revenues shrink to $256 million, with $0.05 in earnings and $12 million in EBITDA. Were SKUL to trade at 3x EBITDA, one would get a target price of $2.85.
My upside case if that if the yuan devalues 10%, then EBIT improves to $26 mm and earnings increase to $0.58. With a 12x multiple and adding the net cash one would get ~ $8.00 target price.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.