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If the Market Moves Lower, This Stock Looks Especially Vulnerable

Melvin Pasternak

On May 1, a variety of economic data highlighted the still-fragile state of the U.S. economy.

For starters, employment numbers fell to a seven-month low. Manufacturing growth slowed. The Fed vowed to continue economic stimulus to help the economy. After a long climb in the major stock market averages, many stocks are beginning to look extended and are showing signs of weakness.

One stock appearing particularly vulnerable is specialty audio and gaming headphone company Skullcandy (SKUL). The company manufactures DJ headphones, gaming headsets, earbuds and sports buds. Recently, many stocks are showing signs of technical weakness; SKUL has been doing so for a long time. If the overall market corrects, SKUL should be particularly vulnerable.

Since August 2012, Skullcandy shares have been in a major downtrend, plummeting nearly 70%, from a high of $16.75 to their current low near $5.15. Several disappointing announcements have brought the shares down.

In March 2013, management issued a weak first-quarter outlook, warning sales would likely plummet 30% from the year-earlier period. Skullcandy admitted that packaging errors and failure to adapt to changing market conditions had hurt the company.

When Skullcandy's CEO, Jeremy Andrus, unexpectedly stepped down, the company was also left in the lurch. The new president and CEO, Hoby Darling, an ex-Nike executive, has announced plans to redo packaging and discount poorly selling items. But these steps -- even if successful -- will take time to find their way to the bottom line.

Skullcandy acknowledges the growing global market for headphones -- currently worth over $5 billion -- is highly competitive. Consumers recently have preferred on-ear and over-the-ear headphones.

Skullcandy, however, specializes in producing in-ear buds. Although they make on- and over-the-ear models, they are priced higher than competitors' products. With Skullcandy losing the contest for the hearts and minds of consumers, analysts expect full-year revenue and earnings to substantially drop from last year.

The technical picture is bleak.

From the August 2012 $16.75 high, the stock has fallen steadily. Since September 2012, shares have formed a pattern which resembles a descending staircase. Each "step" in the staircase is a small rectangle. A rectangle is a technical pattern characterized by a narrow band of support and resistance established over several weeks.

On the chart, the next downward step is reached when a support level is breached and the stock falls. Since September 2012, four steps (labeled on the chart) have formed. Three have resolved bearishly.

At present, shares are trading between support, around $5.06, and resistance, near $5.85. This April 27 trading week, $5.06 support was tested. Although the stock is currently holding support, the shares remain below the intermediate downtrend line that's been in place since September.

If support is breached, the stock will break a fourth rectangle. According to the measuring principle for a rectangle, calculated by subtracting the height of the pattern from the breakout level, the stock could reach at minimum a new low of $4.14 ($5.98-$5.06=$0.92; $5.06-$0.92=$4.14).

At current levels, shorting the stock could reward traders with nearly 20% returns. However, since there would then be no historical support in sight, shares could tumble even further, bringing even higher rewards to short sellers.

The bearish technical outlook is reinforced by poor fundamentals.

This Thursday, Skullcandy announced weak first-quarter results for 2013. Because of diminished demand, revenue dropped 30.4% to $37.1 million from $53.3 million in the comparable year-earlier period.

With demand for Skullcandy products expected to remain low, analysts project second-quarter revenue will fall 19.4% to $58.4 million from $72.4 million in the comparable year-ago period.

For the full 2013 year, analysts estimate revenue will dip 14.2% to $255.4 million compared to $297.7 million in 2012.

The earnings outlook is equally weak.

Because of the drop in revenues, first-quarter earnings turned negative, falling to -$0.25 per share from $0.04 per share in the comparable year-earlier period.

Based on weak demand, analysts expect second-quarter earnings will tumble 95% to $0.01 per share from $0.24 per share in the year-ago quarter.

For the full 2013 year, analysts anticipate earnings will plummet 84% to $0.16 per share compared to $1 last year.

Based on the technical and fundamental outlook, I plan to short the headphone company.

Recommended Trade Setup:

-- Short SKUL at $4.99, below current support at $5.06
-- Set stop-loss at $5.85, slightly above current resistance and the intermediate downtrend line
-- Set initial price target at $4.05, for a potential 18.8% gain

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