“Reminds me of Apple…same cult-like following but at 1/40th the price—and growing twice as fast.”

by Travis Johnson, Stock Gumshoe | June 12, 2012 2:45 pm

George Leong teases that "If You Like Apple, but Can’t Afford it—You’ll LOVE this Stock"

That quote above is from George Leong, who’s trying to get you to sign up for his Small-Cap Growth Stocks newsletter. He says that new subscribers can “be the FIRST to read about a great undervalued, undiscovered American company that could hand you a $120,000 gain by year’s end.”

Sound good? Well, he makes it sound even more exciting by invoking the names of two of the patron saints of stock-picking individual investors, Peter Lynch and Warren Buffett:

“Peter’s stock-picking strategy: Act like a private investor, quickly snapping up companies unnoticed.

“He also used a style of investing popularly referred to as: “Buy What You Know.”

“Today, Warren Buffett Swears by It

“Hands down, it’s the most perfect investment strategy for all investors—especially for investors who don’t have the time much less the desire to learn complicated quantitative stock analysis or read lengthy financial reports.

“In fact, Peter often said that, as an individual investor, you are far more capable of scoring a 10-bagger than a mutual fund manager.

“Why? Because you’re able to spot great investment opportunities in your day-to-day life—long before the experts on Wall Street can.

“And that’s exactly how I discovered this company I want to tell you about today—which could reward you with a $120,000 gain—if you act fast, and unnoticed….

“I found this deliciously undervalued small-cap stock at … of all places … the mall.”

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He then goes on through a long spiel about the target market for this secret company, which is the “echo boom” generation — the first echelon of whom are just hitting adulthood. He talks about this generation’s passion for music, which is similar to every past generation, but makes the point that this one is different because there are no stereos anymore — there’s just the smart phone. Here’s how he puts it:

“The 1st BIG key to this company’s wild success with kids…

“Kids want better sound—just like we did and still do.

“So here are all these kids—literally spending BILLIONS of dollars online for music—but the sound quality on their smartphones, iPods and laptops is, to put it bluntly, CRAP!

“Fast Facts:

“The headphones that come with an iPhone or iPod are terrible. And yet, Apple is the “prestige” mobile device maker!

“Note: Most of these kids have never heard an acoustically accurate stereo set-up. And when they do—it blows them away—just like the first high-fidelity stereo systems blew baby boomers away in the mid-1950s.

“Okay, now fit the pieces of the puzzle together…

“Kids have money, kids love music, which they play on mobile devices that sound terrible… BINGO!

“Headphones Are the New Hi-Fi Sets

“If you’re buying a $130 iPod or a $500 iPhone, spending another $50 to $60 for better sound—better headphones—makes perfect sense.”

So yes, you guessed it, he’s pitching a headphone company. Which one? Well, Leong knows that his target audience is folks in their 50s and 60s (that’s who all investment newsletters target, with a sub-preference for grumpy white men of means), and he has to explain to this audience that fancy headphones are more than just a little niche market:

“Even during the recession, headphone sales surged as traditional stereo sales evaporated. Headphones are now a $1.2-BILLION market, according to market research firm NPD Group.

“After trending at 30%, headphone sales spiked 42% last year. The curve is getting steeper!

“Kids under age 24 account for 25% of this high-end headphone craze. Just a year ago, they were only 13% of this market segment, so they’re getting into better sound in a BIG booming way.”

So which headphone company is he teasing? Don’t worry, we do get a few more specific clues:

“… it’s been able to skyrocket to the #2 position among headphone makers (and the #1 position for earbud headsets), with 14% of the market, second only to Sony with 23% ….

“This Company Is PROFITABLE!

“And the 2nd BIG reason kids want these headphones: The ‘coolness factor!’

“While older audiophiles may scoff at the wild colors and ‘extreme’ design on the company’s headphones, the kids love it (even the company’s name is edgy, and bordering on the outrageous).

“You know as well as I, with teens it’s all about making a statement—image and brand is everything!

“Want proof? Go to the mall, or Best Buy, or Radio Shack (this company’s headphones are also available at Target, Wal-Mart, and Dick’s Sporting Goods, among other retail outlets) and ask the guy behind the counter what brand the kids are buying (a true Peter Lynch tactic)—and you’ll immediately hear this company’s name” ….

“… currently derives 6% of its net sales from Europe….

“bought out its European distributor for $18.6 Million, giving it a better base to expand in that region and the ability to inflate its margins by absorbing the middleman.”

And then we get into the lovely little “numbers” clues that often help us confirm the answers from the Mighty, Mighty Thinkolator:

“… $428-Million market-cap company—selling in more than 70 countries….

So who are we being told to buy? According to the cogitations of the Thinkolator, this is the headphone company Skullcandy (SKUL)

If you’re at all like me (old, boring, hates the mall, doesn’t watch music videos), then you may well have not heard of these guys — but they are a substantial brand both in mainstream retail and in specialty music/extreme sport circles, with a fairly substantial gaggle of prime-time endorsers and users in both the music (rap, mostly) and X-sports genres (skateboarding, surfing, snowboard especially). They sell high-end headphones that generally run from about $50-$300, and fancy earbuds that generally range from $15-$50.

And they are both profitable and growing pretty fast, and they have a lot of investors betting against them. I can’t claim to know the company or its products particularly well — I’m neither an audiophile nor a skate park habitue, and I’ve never heard of most of its celebrities — but they do seem to have built a nice little brand, and there might be an opportunity here for investors if the brand turns out to be anywhere near as powerful as George Leong appears to believe. That’s because there is a huge short position in this stock — and if the fundamental performance comes close to what analysts expect there could be a nasty short squeeze to bump the share price up.

Short-selling, for those who don’t know, is betting against a stock — you borrow the stock and sell it, then hope that it will drop in the near future so you can buy back the shares to return them at a lower price. There is such substantial insider ownership in the shares (much of it from pre-IPO investors, the stock went public a little less than a year ago) that there aren’t a lot of shares available for shorting, so more than 2/3 of the “float” (shares that typically can trade) is short. It would take almost a month of trading at the current volume to cover those short bets, so if the company announced a positive deal or a great quarter it could possibly cause those short-sellers to have to buy the stock in a hurry to cover their shorts if they’re afraid it will rise higher (or if they get a margin call because it’s climbing quickly), and with a small float it doesn’t take much of this panicked buying to drive the shares substantially higher, which then forces even more of the short-sellers to cover. That’s what’s called a “short squeeze.”

That said, there are good reasons to bet against the company — you’re talking about a brand in a very competitive marketplace with no switching costs and no huge distinction between products in terms of efficacy (audiophiles can debate which brand or technology provides better sound, but they’re all far better than the earbuds that come with your iphone and most people won’t care about subtle differences). So really, it’s just about brand, brand image, and the desire of the coveted 18-24 demographic to be seen wearing the right brand of headphones… and, in the blocking and tackling part of operating these businesses, it’s about getting prime shelf space and good retailer distribution, which they certainly seem to have.

So if you’re interested in Skullcandy, your bet is basically that the Wall Street guys don’t “get it” — that this is an emerging and powerful brand that will not only reach more customers as they grow, but will extend to clothing and shoes and inspire customer loyalty. Their logo is a little shadowy skull and their endorsers all have tattoos and no one in a suit and tie has ever heard of most of them, so you can see why the Wall Street analysts might not buy this argument. There’s also the fact that this is a recent IPO, so although there hasn’t yet been a surge of insider selling following the first six-month lockup period we could certainly see some selling pressure in the years ahead as early investors seek an exit.

I’m no arbiter of taste or fashion, to be sure, and that’s what this company is built on — I wouldn’t want to bet against them, but do keep in mind that there are other folks selling fancy headphones with a brand message, and plenty of other “legacy” audiophile brands. If the analysts are right about this stock, it’s trading for less than ten times next year’s expected earnings and is expected to grow earnings by almost 20% a year for several years to come … which gives them a real bargain-basement PEG ratio of about 0.6 (PEG is Price/Earnings divided by expected Growth rate, a staple of Peter Lynch valuation which generally calls any number less than one a bargain).

Then again, the company that is driving much of their customer base to demand better headphones, Apple (AAPL), is, despite the fact that a large company should have growth disadvantages versus a smaller one, trading at an even lower PEG ratio of 0.5 (yes, Apple’s growth rate is a ridiculous aberration for a megacap company — but still, it’s growing earnings a lot faster than tiny Skullcandy and could, if they chose, buy Skullcandy with about 2-3 days of profits).

You know that I own Apple already, and I confess that I’m intrigued by Skullcandy (I have never owned it). I’d want to learn more about their insiders and their possible selling plans and lockup period (I think they had a six-month lockup, which expired in January, but I didn’t double check that), but from a quick glance at their numbers and their latest investor presentation[1] they are doing a lot of things right as they try to boost the brand and turn it into a mass-market phenomenon. Doesn’t mean it will work, of course, and there’s are good reasons why short-sellers might target an upstart brand like this in a competitive marketplace … but it’s also true that Wall Street can sometimes underestimate the power of a brand, particularly a brand that appeals to people Wall Street doesn’t understand very well, and short squeezes can be fun to ride if you’re aggressive and nimble (and right) — witness how ZAGG, with a somewhat similar competitive market of iphone cases and screen protectors, held up pretty well after getting the short-sell pitch[2], though the short ratio there is also still very high. I haven’t invested in SKUL, but I’ll probably give them a closer look.


Endnotes:
  1. their latest investor presentation: http://files.shareholder.com/downloads/ABEA-5FMQI8/1920947018x0x548289/DE072634-D64B-4F6A-8E83-A5684A82FCFF/Skullcandy_Investor_Presentation.pdf
  2. ZAGG, with a somewhat similar competitive market of iphone cases and screen protectors, held up pretty well after getting the short-sell pitch: http://stockgumshoe.com/reviews/strategic-short-report/crime-scene-analyst-digs-up-one-toxic-nasdaq-stock-headed-straight-for-a-body-bag/

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