Market Overreaction on This Headphone Distributor: Skullcandy Inc (SKUL), Sony Corporation (ADR) (SNE), Harman International Industries Inc. (HAR)

Skullcandy Inc (NASDAQ:SKUL) has recently experienced a significant drop of more than 22% in one trading day, due to the stock market’s worry about its future. Its interim CEO Rick Alden warned that the company expected to generate a loss in the first quarter and a decline in sales next year. Let’s take a closer look into the company to determine whether investors should stay away from Skullcandy, or if a recent decline is a buying opportunity.

Skullcandy Inc (NASDAQ:SKUL)A growing 2012

Skullcandy Inc (NASDAQ:SKUL), founded by Rick Alden in 2003, is the developer and distributor of headphones and other audio accessories to retailers in the US and in more than 70 other countries globally. It operates in two geographical business segments: North America and International. The majority of its revenue, $250.3 million, or more than 84% of the 2012 revenue, was generated from the North America segment, while the International segment generated $47.4 million in revenue. While its net sales increased significantly, from $232.47 million in 2011 to nearly $297.7 million in 2012, its operating income decreased slightly, from $42.16 million to $41.5 million. The decrease in the operating income was due to a significant increase in its SG&A costs. However, the net income rose by more than 39% to $25.8 million, thanks mainly to the lower interest expense in the year.

Good cash flow generator with a conservative balance sheet

Skullcandy Inc (NASDAQ:SKUL) is quite conservatively financed. As of Dec. 2012, it had $142.1 million in total stockholders’ equity, $19.3 million in cash and no debt. Its total liabilities stayed at nearly $44 million. What makes me worry is the significant jump of more than 50% in its account receivable, from $50.6 million in 2011 to $76.3 million in 2012. Thus, even the net income increased by more than 39%, its operating cash flow dropped by more than 53% to $13.5 million in 2012. Since 2009, Skullcandy has generated consistently positive operating cash flow, in the range of $13 million – $29 million. The four-year average cash flow is about $18 million.

It seems to be quite cheap now

At a current trading price of around $5.20 per share, its total market cap is around $143 million. The market is valuing Skullcandy Inc (NASDAQ:SKUL) at only 2.6 times EV/EBITDA. Compared to its peers including Harman International Industries Inc. (NYSE:HAR) and Sony Corporation (ADR) (NYSE:SNE), Skullcandy has the cheapest valuation. Harman, at $44 per share, is worth more than $3 billion on the market. It has the most expensive valuation at 6.6 times EV/EBITDA. Sony isthe biggest company among the three, with nearly $15.7 billion in the total market cap. At around $16 per share, Sony is valued at nearly 4.4 times EV/EBITDA.

Interestingly, Skullcandy generated the highest operating margin at 14%, while the operating margins of Harman International Industries Inc. (NYSE:HAR) and Sony Corporation (ADR) (NYSE:SNE) were 7% and 0.5%, respectively. Skullcandy delivered quite a high return on capital among the three at around 40%. The return on capital of Harman was 40.6% while Sony generated net losses. Among the three, Sony has the highest forward dividend yield of 1.9% while Harman pays to existing shareholders a 1.4% forward dividend yield. Skullcandy Inc (NASDAQ:SKUL) does not pay any dividends to shareholders.

In the first quarter of 2013, the company expected to generate a loss between $0.25 to $0.30 per share. Interim CEO Rick Alden admitted: “We have not kept up with all the changing trends nor have we led with our own innovations.” Indeed, I would expect the similar downtrend in the short-term for the company, indicating by the wider divergence between its operating cash flow and its net income.

Foolish bottom line

Skullcandy Inc (NASDAQ:SKUL) is definitely not a good stock to hold for a long term investor. However, with a historical high operating margin, low leverage, and low valuation, this company seems to be a good pick for opportunistic investors. If the company can turn its business around, its stock price may advance significantly.

The article Market Overreaction on This Headphone Distributor originally appeared on and is written by Anh HOANG.

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