In a February 9 article, The Motley Fool called headphone maker Skullcandy (Nasdaq:SKUL), one of the market's most hated stocks. Citing facts like 66% of its tradable float being short and a competitive advantage that is nearly non-existent, the analysts heaped piles of scorn on the colorful brand. I'm here to defend the tiny company providing several reasons why you shouldn't sell Skullcandy short, both figuratively and literally.
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Competitive Advantage or Lack Thereof
The problem with this kind of analysis is that the same thing can be said about pretty much any brand, even ones as strong as Apple (Nasdaq:AAPL). Brands are funny. You can analyze them from every angle and sometimes you still don't know why consumers buy.

I personally don't get the Lululemon (Nasdaq:LULU) phenomenon, yet thousands of women (and men) do. This despite the fact at least four companies have products that should be able to compete with them: Nike (NYSE:NKE), Under Armour (NYSE:UA), VF Corp. (NYSE:VFC) and the Gap (NYSE:GPS).

To blithely trot out products like Beats by Dr. Dre or 50 Cent's Sleek as evidence it has no competitive advantage and zero barriers to entry misses the point of branding in the first place. The assumption that brand extensions into clothing and footwear have somehow led the company down the garden path to destruction is absurd. Go to their website and you will see it has partnered with brands like Rip Curl and DC Shoes in addition to its own products.

Its headphones might not be anywhere near Dolby Labs (Nasdaq:DLB) quality, but that doesn't mean its customers aren't happy with their headphones or the brand. To dismiss its competitive advantage simply because it has some competition implies that investors should also dismiss Apple's perceived superiority, knowing that Samsung and many others are nipping at its heels. It's nonsensical.


Expansion
A look through its third quarter 10-Q provides some very telling information. International net sales in Q3 were $14.6 million, an increase of 75.9% over the same quarter in 2010, which represents 24.1% of overall revenue for Q3. Most of the increase came from Europe, where in August it acquired its exclusive distributor for $18.6 million. Rule number one when building a strong international brand is to control your distribution as best you can, and now it does.

Revenue growth in the U.S. was a more modest 37.2%, which is still well into double digits and more than enough. Online sales in the third quarter increased 416.7% to $6.2 million. Excluding the $2.9 million in online sales from its $10.8 million acquisition of Astro Gaming, organic online sales actually increased 175% year-over-year. For those of you who follow bricks-and-clicks retail, you are probably fully aware of the profitability of online retail.



As of the first nine months of the year ended September 30, Skullcandy's online sales were 9.1% of total revenue. Every 100 basis point improvement in this number is worth at least a 70 basis point improvement in overall operating profits. For example, Skullcandy expects 2011 revenues of $231 million. At 9.1% of total revenues, online sales will be $21 million with an estimated operating profit of $6.3 million out of a total of approximately $34.7 million for the entire company.

However, if its online sales are 10.1% of overall revenue, its operating profit from online sales is $7.0 million out of a total of $35.4 million or 70 basis points higher without adding a single dollar of new revenue. The shorts forget that profits don't just come through Best Buy (NYSE:BBY) and Target (NYSE:TGT).


Valuation
Skullcandy went public last July at $20. As of February 13, it was trading at $14.78. That's a P/E ratio of 15.9 based on the company's January guidance of 93 cents a share. Its net profit of $22 million is the highest in its nine-year history. Is 15.9 times earnings so ridiculous? Lululemon trades at about 58 times earnings while Nike and VF Corp. both trade at 23 times earnings. But they're apparel brands, the shorts will protest.

A fairer comparison is Apple at 14.8 times earnings they'll argue. But I'd counter this simply makes an argument for Apple longs and not the other way around. The fact remains that to a certain extent, every product has some commoditization attached to it. iPad's aren't built in Paris, they're assembled by hand in China in massive Foxconn factories.

I own a Mac but I don't feel any sort of sentimentality towards it because it was built by some faceless Chinese worker thousands of miles away. No, I like my Mac because it works and the brand's cool. How's Skullcandy any different? (For related reading, see The P/E Ratio: A Good Market Timing Indicator.)


The Bottom Line
IPOs tend to be priced too high. A Canadian investment manager I'm fond of quoting believes you should never buy an IPO right out of the gate because inevitably, one or two years later, the stock is trading for less than its offering price.

He suggests you buy it then. Skullcandy is currently trading 26% below its IPO price. My advice is to buy a small position today, watching to see if it drops back to its 52-week lows as it nears its one-year anniversary in July. Despite what the shorts would have you believe, Skullcandy is doing just fine.


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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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