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Investors: Beware of Trendy Stock

By: OptionsANIMAL
Posted: 1/4/2013 12:19:00 PM
Referenced Stocks: AAPL;RIMM;SKUL

Most of us are aware that teenagers are fickle beasts. The trials of Skullcandy (SKUL) should not, therefore come as a surprise. Like anybody who follows the market, I am constantly on the lookout for stock that is oversold or overbought, so SKUL’s 52% drop over the last few months caught my attention.

 

On the surface, SKUL at these levels appears to be a good buying opportunity for a contrarian. The stock is at all-time lows following a rapid decline, but the company is still profitable. On the last earnings call management had a strategy to turn things around following disappointing results; a renewed focus on over-ear headphones, a new line of gaming headphones and aggressive promotion stood out. There is certainly no shortage of pundits claiming that this is a great trade, but the trend among large brokerage houses is toward downgrades. So who is right?

To my mind, SKUL has two basic problems. Firstly, they are a one trick pony. It is hard to be truly innovative in a field such as headphones. They all perform a basic function, some better than others, but since the advent of ear bud sets very little has changed. This makes them vulnerable to competition from cheaper competitors and keeps increasing pressure on margins.

Secondly, and most importantly, their success has been based on being trendy. Annual sales growth of around 90% from 2006 to 2011 is impressive, but by definition cannot continue forever. According to their SEC filing, the company “redefined” the headphone market. Call me a cynic, but I am not sure that using bright colors and a cool name constitutes “redefining.” Companies that make products, (particularly electronics) that are subject to the whims of fashion must diversify to continue growing. Just look at the relative success of Research in Motion (RIMM) and Apple (APPL). The younger the target demographic, the more this applies. There are solid, long-lasting manufacturers of electric razors, but the importer of ”Silly Bandz” and the cabbage patch doll specialists didn’t thrive long term.

Over time, then, I believe the decline in sales that SKUL sees could be nearly as spectacular as was the rise. Over the next few weeks, however, in the build up to February’s earnings figures, the preponderance of “great value” stories indicates that we may see a rally of some kind from these levels. This presents a timing problem for traditional stock traders, but for those who agree with my analysis and are familiar with options, it is just an opportunity.

The belief that something will rally in the short term before falling again can be traded via a calendar put spread. In this case, you would sell short term puts and put the proceeds towards buying longer term puts at the same strike price. The hope is that the near dated options expire worthless, and then the stock begins to fall. The catalyst for a downturn here could well be the February 20th earnings release by SKUL. One could therefore, using the last traded price at the time of writing, sell February 16th expiration $6.00 puts for $0.40 per share and buy March 16th puts at the same strike for $0.50. If the stock holds above $5.60 until February expiration, then falls on a bad earnings report, the February options would expire worthless and you would be holding $6.00 puts that cost you a net $0.10. Depending on the level of risk you are comfortable with, other strike prices and expirations could be used.

Of course, nothing is simple and foolproof. If the exact opposite were to happen, the leverage involved in options could magnify losses, for example, and the above illustration ignores brokerage costs. Options are not for the unaware, which is why we at Options Animal focus on education. They are not right for everyone, but in difficult markets it makes sense to have as many tools as possible at your disposal.

Whether you choose to use options or try to time the stock, the fact is that Skullcandy is a company that has had tremendous success maximizing sales of a trendy product. No amount of tweaking of that product or aggressive marketing will help when their customers move on to the next trendy thing. Beware of trendy stock.