This Just In: More Upgrades and Downgrades

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At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about.

Banking on a concept
By all rights, Skullcandy (NAS: SKUL) shareholders should be dancing in the streets. Yesterday, six separate analysts issued glowing reports on the company:

  • Jefferies: "We like Skullcandy for its powerful brand, exposure to the growing music lifestyle and compelling growth opportunities, both domestically and internationally."
  • Piper Jaffray: "Management will leverage the strength of the Skullcandy brand, investments in infrastructure and mobility trends to drive long-term global growth."
  • Raymond James: "Skullcandy has revolutionized the product design and marketing of a commoditized product ... enabling the company to grow its revenues from just $9 million in 2006 to an estimated $217 million in 2011."
  • KeyBanc: "SKUL's product offering spans from the accessible ($20-$70) to high-end (Aviator at $150 to Mix Master at $250) and distinctive marketing and advertising allows it to target youth as well as mobile professionals."
  • Bank of America/Merrill Lynch: "SKUL ... should achieve market share gains ... while providing compelling returns with its low capital, high margin model."
  • Morgan Stanley: "Trading at just 14x ... 2012 EPS, well below growth peers' 20x, headphone maker SKUL presents an opportunity to play strong music and smartphone growth."

Needless to say, each of these banking professionals recommends that you buy stock in Skullcandy. Most argue that the shares -- currently worth $16 apiece -- should hit anywhere from $20 to $25 within the next 12 months.

But I'm more interested in what the analysts leave unsaid: All of them helped to underwrite the Skullcandy IPO. Collectively, they helped to hawk a minimum of 9.4 million Skullcandy shares to the public -- perhaps as many as 10.8 million, given that the IPO had an overallotment option. As a result, there are about $172 million reasons for these bankers to do everything in their power to make this IPO look like a success -- because success has been notably lacking ever since the IPO took place.

So the bankers recommending you spend money on Skullcandy this week are conflicted. I'm sure Casablanca's Captain Renault will be shocked, shocked, when he hears of this. But could the bankers actually be right? After all, they did bring this company public at $19 a share, and it closed its first day of trading at $20.Who's to say investors were right to sell off Skullcandy subsequently?

Well ... I am.

This is your brain on Skullcandy
First off, the analysts' arguments just don't make sense. Morgan Stanley says Skullcandy's a "buy" because it trades for 14 times next year's earnings, which is cheaper than its "peers." But who are those peers?

Sony (NYS: SNE) , Philips (NYS: PHG) , Panasonic (NYS: PC) , and Apple (NAS: AAPL) are four major publicly traded electronics firms making headphones that compete with Skullcandy's. Three of these firms, however (Sony, Philips, and Panasonic), are unprofitable and have no P/E to compare. The fourth, Apple, costs only 12 times next year's earnings estimate -- cheaper than Skullcandy. A fifth competitor, Harman International (NYS: HAR) , costs less than 10 times 2012 earnings. Meanwhile, across the industrial electrical equipment industry, valuations average less than 13 times trailing earnings -- and are even lower going forward. So on its face, Morgan's argument just doesn't ring true.

Even weighed on its own merits, Skullcandy doesn't look worth the price it fetches today, much less the 25%-plus profit Wall Street is promising us. Never mind Wall Street's attempt to base its valuation on 20% profit "growth" (KeyBanc) at a company currently producing negative GAAP profits. That sounds nonsensical. Let's say we value the company for the free cash flow it's producing today.

In that case, Skullcandy's annual free cash production is currently under $5 million per year (and on a decline from last year). From that small base, 20% annual growth makes Skullcandy look worth a whole lot less than the $500 million and change KeyBanc projects.

Foolish takeaway
This looks to me like just another case of Wall Street hyping an overpriced stock -- then scrambling to save it with rosy forecasts after the IPO craters. Skullcandy's headphones may eventually prove to be more than a passing fad. Whether they do or don't, there's an excellent reason why Skullcandy's stock has lost popularity: It costs too much.

At the time this article was published The Motley Fool owns shares of Bank of America and Apple.Motley Fool newsletter serviceshave recommended buying shares of Jefferies Group and Apple, and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days.Fool contributorRich Smithdoes not own (or short) any company named above.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 433 out of more than 180,000 members. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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