Skullcandy Turnaround Could Lead to Short-Squeeze

Put your contrarian hats on for this one!

SKUL HAS BEEN A DOG

Since its IPO in July 2011, SKUL’s share price has been in a determined downtrend. 2011/2012 bears were correct in their analysis of the company when they predicted margin difficulties related to increased marketing spend and concurrent decline in incremental pricing. 2010 saw peak gross margins of 53.2%, followed by 49.7% in FY 2011 – a resounding decline. FY 2012 GM’s through the third quarter suggest further margin compression, possibly as low as 48.0%, but this number will hinge on the results of the fourth quarter holiday season. Management has deflected the margin issues by claiming that it reflects a transition to higher-priced, lower-margin products.

Not only have margins compressed, but sales growth has struggled as well. The domestic business’s growth rate on a rolling 4-quarter basis is down significantly. In Q4 2011, the domestic business grew 10.1%. The Q4 2012 growth rate could be as low at 3%.

One of the saving graces of the company has been its international expansion. SKUL spent $18.6M in August 2011 to buy its European distributor. Since then, its international business has been the driver of revenue growth while its domestic segment has organically decelerated.

WILL IT CONTINUE TO BE A DOG?

So, SKUL has been a dog, but there is a good chance its net sales deceleration is stabilizing – at least for the next quarter. On the Q3 conference call, SKUL management tightened the FY 2012 guidance to $290-$300M from the previous range of $280-$300M. This is a fairly noteworthy event as $280M in net sales would have signaled the company’s first rolling 4 quarter loss as a publicly traded company. The middle of the guidance ($290M) range would imply a continuation of the status quo -- ~3% growth on a rolling 4 quarters basis. And the top of the range would be a surprisingly positive note -- a 7.1% growth rate on a rolling 4 quarters basis.

Should SKUL somehow beat the top end of its guidance range, there is the possibility of a FOSL-like short squeeze circa August 2012.

SHORT INTEREST

SKUL is one of the most heavily shorted stocks. The float is only about 15M shares and as of December 31, 2012, there were 6M sold short.

Given the company’s recent guidance update, I would advise the shorts to cover. Interestingly, January 2013 has seen the most volume in SKUL shares since its IPO in July 2011. It seems plausible that the large shorts were covering either in anticipation of something at ICR XChange Conference in January or simply prior to the FY 2012 results.

VALUATION

In my opinion, the most attractive aspect of a long position in SKUL is its very undemanding valuation. At $7/share and anticipating the company will be flush with cash following the Q4 Holiday season, SKUL’s enterprise value is ~$150M. 2012E EBITDA should be about $50M, give or take a couple percent. At $7/share, SKUL trades at a mid-teens FCF yield (to enterprise value).

At 3x EBITDA, you have a chance to buy a decently quickly growing public company at a private lower-middle market valuation. SKUL is priced in such a way that not much needs to go right for the company to see a favorable move in the stock price.

POSSIBLE EVENT OUTCOMES

There is a chance SKUL is bought in the near future – likely by management with a PE sponsor. SKUL could be bought for 5.0-5.5x by a financial buyer and 6.0-6.5x by a strategic partner with minimal equity. I envision 3 turns of EBITDA on a senior term loan, 1 turn on sub debt, and actually quite a bit on a revolver due to SKUL’s considerable A/R and inventory (granted Best Buy’s A/P isn’t really great collateral at banks these days).

With almost $50M available on its current credit facility and no debt besides a small amount on its revolver, SKUL could become an acquirer of smaller, established brands. I would not support this course of action because it would involve significant operational risks.

Finally, management could explore a levered recapitalization of the company and a return of capital to shareholders.

CATALYSTS

*Potentially favorable results for FY 2012

*Rumors surrounding sale scare the shorts (like this: http://www.bloomberg.com/news/2013-01-09/skullcandy-turns-takeover-target-after-66-drop-real-m-a.html?cmpid=yhoo)

*Management retains an investment bank to explore sale

*Kate Upton Skullcandy YouTube video goes viral (http://www.youtube.com/watch?v=WbRttglYgOs) (this is a joke)