ZAGG INC ZAGG S
February 04, 2011 - 8:53am EST by
hxf82
2011 2012
Price: 9.89 EPS $0.39 $0.47
Shares Out. (in M): 24 P/E 25.0x 21.0x
Market Cap (in $M): 234 P/FCF NM NM
Net Debt (in $M): -6 EBIT 0 0
TEV ($): 228 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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Description

Readers can take a look at the previous write-up on VIC by Lukai on 7/26/10 for an overview of the company, although this report is going to present a quite different thesis. This is a recommendation to short ZAGG stock or buy May 2011 exp puts. 

 

I would like to introduce you to a very overhyped fad stock run by a management team with a shady history of penny stock promotion.  The company is called ZAGG Inc. (ZAGG).  Their main business, which accounts for over 95% of their sales, is selling screen protectors for smartphones and tablet computers.  The stock has appreciated 280% in the last 6 months driven by a big jump in Q3 2010 results and by being seen by day traders as an iPad trade.  I could have made an impressive argument for shorting ZAGG just based off valuation and the competitive dynamics of the screen protector industry.  I would have first pointed out that ZAGG trades at an astronomical trailing P/E of 33x and a forward P/E based over 20x (based on highly questionable earnings).  The stock also trades at almost 4 times sales.  I would have pointed out competitors selling 5-packs of screen protectors for $1.38 (here).  I would have also pointed out that the huge growth in Corning’s Gorilla Glass renders all screen protectors obsolete as consumers catch on to the fact that they are unnecessary.  It would have convinced you that ZAGG’s stock is going to die a slow death, that forward earnings estimates were way too high and that the valuation was destined to come back down to earth.

 

We could have made all those arguments but there is a much better reason for you to short ZAGG and that is that the company is a complete scam.  All the signs are there if you take the time to dig beneath the surface.  The company has a history with shady stock promoters that were banned by FINRA, the SEC and the OCC.  These banned individuals were involved in funneling millions of dollars out of ZAGG.  We uncovered these facts when we hired a private investigator to do thorough background checks on all the senior executives at ZAGG.  We also uncovered that ZAGG’s CFO, Brandon O’Brien, while VP of Finance at Fonix, was in charge of due diligence on a $33 million acquisition that is now being targeted by the SEC for being a fraud.  We have made a copy of the due diligence report available to the public and a link can be found here.   It is an incredible read.

 

http://www.scribd.com/doc/45466615/ZAGG-Presentation-12-14-10-Final-2

 

Just one example of ZAGG’s tabloid history is a press release in which ZAGG touted a “Leading Canadian Wireless Distributor to Carry invisibleSHIELD” and went on to claim that the distributor, Z-Tech had “strong national retail channels such as Bell, Rogers, Telus, Fido, Solo, Koodo and Virgin Mobile.”  When we did a background check on Z-Tech we found out that the company had just been founded a month before this press release and that the President of Z-Tech, Scott Wicks, previous experience was working at a copy shop. 

 

ZAGG’s management is quick to brag about their relationship with Best Buy every chance they get, making wildly promotional statements that on at least one occasion almost got them kicked out of the retailer.  Management has routinely claimed that Best Buy was only getting keystone markup (100%), or $12-15 per shield only to have the story proven wrong by some savvy analysts that found out that Best Buy employees using their cost-plus employee pricing could buy the product for less than half that price.  When caught in the lie management admitted they actually get only $6 per shield.  Miraculously, management made no adjustment to reported gross margin despite the “price cut” from $12 to $6.  

 

ZAGG management has also been dogged by claims that Best Buy and the other wholesale channel merchants’ contracts all contain buy-back clauses, both written and implicit, which would make ZAGG’s sales recognition when product is shipped to Best Buy improper and a channel stuffing scam.  ZAGG’s CFO adamantly stated that Best Buy had no right of return in a quarterly conference call only to be forced to revise his remarks in an 8k (link here) on Nov. 30 admitting  “Best Buy can return products to the company under limited circumstances, including where products are defective or other similar customary reason.”   Those customary reasons are certain to include whenever there is too much inventory in the channel according to interviews we conducted during our extensive due diligence.  ZAGG will be forced to give Best Buy a credit to their accounts payable to ZAGG for all of the millions of dollars worth of excess Christmas and other obsolete inventory (Palm Pre shields!) recently returned that is now being auctioned for pennies on the dollar at sites like liquidation.com.  Just go there and see it for yourself.

 

As with most scams, ZAGG claims it has been profitable for over 2 years but has only ever burned cash (consistently large disconnect between FCF and reported earnings).  All of the supposed earnings piled up in Accounts Receivable and Inventory.  Accounts Receivable is hugely overstated because of the massive phony channel stuff with ZAGG now being forced to buy back millions of unsold inventory thus taking charges to A/R’s that will wipe out a major chunk of all accumulated earnings.  Incredibly, despite the Q3 channel stuffing Inventory just keeps going up.  Management has even been warning analysts that Inventory will stay elevated at year-end, which is utter nonsense, as the inventory not sold during the holiday season is either being liquidated on liquidation.com or should be written down.   Keep in mind Q1 is by far their weakest quarter of the year and cell phones go out of style every six months.  We have tried to get the company to let us inspect this “phantom” inventory only to get the reply that their inventory actually resides in a 3rd party fulfillment center not open to the public.   We are certain that at least 80% of the stated inventory of over $12 million does not exist.  ZAGG has been dramatically understating their Cost of Goods to report phony profit margins combined with sales channel stuffing to report earnings that simply don’t exist.  The future holds a combination of A/R and Inventory write-downs that are certain to wipe out almost every dollar of “profit” that ZAGG ever reported.

 

One might think that this type of scam would be impossible to pull off; that the auditor Hansen Barnett & Maxwell (HB&M) would catch it and not allow it to happen.  HB&M is a small Salt Lake City auditor ZAGG’s used for years since its RTO and was found to have audit deficiencies in its previous inspection by PCAOB.   Incredibly, just 3 weeks into the new year in the middle of the crucial audit process and after the key year-end inventory count, ZAGG dismissed HB&M and made a hasty decision to risk upgrading to “big four” auditor KPMG.   This desperate move, after presumably failing its HB&M audit, might be the first sign that ZAGG management is ready to start coming clean and is ready to take a “big bath” to pass muster with KPMG.  We’re certain that ZAGG will not pass a KPMG audit any other way.  KPMG might even quickly resign out of frustration with the mess at ZAGG.  Plus KPMG will surely decide they need to go back and re-audit the last two years, which will undoubtedly significantly delay filing of final audited financials, perhaps forever.  If they are ever able to pass the audit, it is certain that most if not all of ZAGG’s previously report earnings will be wiped out.  With any of these scenarios happening, we believe the stock is destined to fall back to the $2-$3 range.

 

Catalysts: Further auditor resignation, Failure to file 10K on time, restatement of prior earnings

 

Risk: The largely retail investor base continues to ignore the red flags, chasing anything remotely tied to Apple which might prolong the disconnect between the stock price and reality.

Catalyst

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