One Person's Trash Is Another Person's Treasure Selection: Skullcandy

Two months ago, I announced my intention to create a portfolio composed of 10 companies that investors have unjustly cast aside. My goal in creating the One Person's Trash Is Another Person's Treasure portfolio is to highlight just how successful value investing and contrarian viewpoints can be, as well as uncover some great companies that have a good chance of turning their fortunes around. For a more thorough explanation of what I hope to accomplish and how I'll measure my success, I encourage you to visit my portfolio mission statement.

For reference, here are my previous seven selections:

For my eighth selection, I've chosen headphone and audio accessories manufacturer Skullcandy (NASDAQ: SKUL  ) , a recent purchase in my personal portfolio.

Why traders have given up on Skullcandy
Since going public in the summer of 2011, Skullcandy shares have lost about two-thirds of their value as concerns over increased competition and margins have weighed on the headphone manufacturer.

Of primary concern, Skullcandy lowered its full-year outlook in early November when it noted that lower-margin products were selling considerably better than higher-margin products, that it was being forced to discount more to move its product in the U.S., and that European markets were dragging down growth prospects. In total, Skullcandy's full-year guidance was mixed at best, with the low end of its revenue forecast jumping from $280 million to $290 million, but its EPS forecast dropping to a range of $1.00 to $1.04 from previous expectations of $1.10 to $1.20.

In theory, pessimists have genuine concerns given that higher-end audio dealers like privately held Bose, Sony (NYSE: SNE  ) , and Harman International (NYSE: HAR  ) , have pushed Skullcandy almost entirely out of the mid-tier market and have given them little chance at entering the high-end market. With its product being highly commoditized, margin worries are a persistent issue.

Why investors should trust Skullcandy
At the outset of this series I warned everyone that I would be taking some chances by promoting deep-value and often contrary picks -- micro cap Skullcandy is a perfect example of this.

The first factor that weighed in my own decision to purchase Skullcandy on the day that research firm Jefferies downgraded the company was its relationship with Apple (NASDAQ: AAPL  ) . Apple's stores are far and away the highest-grossing retail stores on a square-foot basis than any other retailer, and simply being one of the featured audio choices, alongside headphone products from Beats Electronics (Beats by Dre), Harmon, Bose, and Logitech (NASDAQ: LOGI  ) with its UE series, gives it an edge. It's true that Skullcandy's products are only occupying the lower price points, but entry-level headphones still sell like hotcakes in an Apple store when you're paying $200 to $1,700 for a mobile device.

Second, this is a deeply undervalued play by the numbers. Even if Wall Street's projections are correct that revenue growth will slow to 15% in 2013 and just 3.5% in 2014, Skullcandy's impressive free cash flow and ability to adjust its product offerings and pricing should keep it healthfully profitable. Just yesterday, shares received a nice boost as buyout chatter caused a minor bump up in its share price. While analysts have dismissed the rumors of interest by Sony or Bose as nothing but chatter, they've also conceded that at such a low valuation and maintaining such a prime price point (sub-$50), these high-end headphone makers may have enough interest to make a bid. 

What you'd get here
As I alluded to above, what you'd get here is an incredibly cheap electronics maker. Following what appears to be another overblown sell-off on the Jefferies downgrade, Skullcandy is trading at just seven times its current full-year forecast and just six times next year's earnings. Skullcandy only has about $3.3 million in net debt, which is of little concern considering that it produced more than $21 million in free cash flow in 2011. Simply put, Skullcandy's FCF is enough to expand its business and cover development costs without the need to get itself deeply in debt.

Moving forward, I would love to see Skullcandy deliver a quarterly dividend to shareholders (even if it's just $0.08 annually), but given its most recent quarterly cash position of $1.9 million and its need to invest heavily in R&D to protect its price point, I'd understand if this didn't materialize in 2013. Ultimately, if Skullcandy can continue to promote itself within Apple's stores while also generating new retailer relationships and establishing its dominance of the sub-$50 price point, there's really no reason it couldn't double (or more) from current levels. It's the perfect value and contrarian play for this portfolio!

Check back next week, when I unveil the ninth in a series of 10 selections to the One Person's Trash Is Another Person's Treasure portfolio.

What's inside Supernova?
Apple has been a longtime selection of Motley Fool co-founder David Gardner, helping lead his stock picks to gains of more than 120% in our Stock Advisor service since it launched in 2002. David has managed to trounce the market by always being on the lookout for revolutionary stocks and recommending them before Wall Street catches on to their disruptive potential. If you're interested in how David discovers his winners, click here to get instant access to a personal tour behind David's Supernova service.


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