While the past 6-12 months have seen a marked increase in the number of “short-seller” reports (or hit pieces, depending on your perspective), seldom have we encountered situations wherein more than one participant or observer highlights warning signs at the same time, or wherein the company releases potentially troubling news concurrent with these reports.
Today is one of these rare occasions where the short-sellers stars align. The trifecta of pain, in no particular order:
1. (In)famous short-seller-cum-analysis-shop Citron Research released a report on ZAGG, Inc, a maker of cellphone protectors and other accessories raising a number of orange and red flags. I strongly suggest you read it in its entirety before continuing.
2. Roddy Boyd – author of the authoritative book on the rise and fall of AIG – released a report on his website highlighting not only the shady past of ZAGG‘s executives and directors, but the firm’s reliance upon one commoditized product to generate HUGE revenue gains and margins in an industry known for razor thin ones. ZAGG’s balooning inventory balance should be of particular concern, increasing 5-fold year over year and almost 19% in the past three months, as Roddy explains:
It even continued to spike after a sharp revenue drop from the fourth quarter last year to this year’s first quarter, something that made no sense (then or now.) Some growth in inventory is naturally warranted as sales expand but this seems to defy logic. From an investors point of view, the “beauty” of this business is that it’s easy to rapidly produce a large volume of finished product, so maintaining large inventories of raw materials and work-in-progress is unnecessary. [Actually, large inventories are counterproductive for Zagg since the cellphone/mobile-device market is evolving so rapidly that models come and go, often in little more than a year, leaving older shield models virtually worthless. Moreover, polyurethane film is hardly a rare commodity, so storing a ton of it makes little sense.]
The firm also just acquired a maker of earbuds and other similar cell phone/mp3 player accessories, for a whopping $110 million, whopping considering prior to a recent run-up in the stock, ZAGG itself was not worth much more than that (and still isn’t by reasonable comparison). This acquisition was in no small part financed by a $45 million term loan from notoriously investment firm Cerberus Capital Management and PNC (a $45mm revolving credit facility was also arranged concurrently).
While not unparalleled, firms that are growing revenues 200% and net income 300% per quarter generally don’t 1. (need to) make transformative/material acquisitions, and 2. need significant debt financing (cost of capital discussions aside for the time being). This is unless, of course, they are hemorraging cash (usually from operations), as ZAGG appears to be doing, specifically in that inventory balance. In fact a cursory look at their last 10-q indicates had the firm not monetized its receivables, it would have lost significantly more cash than it did.
3. The company filed a statement of an offering of exempt securities (form D), stock issued to help finance the aforementioned acquisition. Again, while not unheard of, this filing is sufficiently vague to raise an eyebrow, after all, they disclosed neither the amount of (proceeds from) securities sold nor the investors who bought them, only mentioning that there were 5 investors. Perhaps there’s some fair explanation in other filings I missed in my cursory read, but considering the warnings raised by Citron Research and Roddy Boyd, I wouldn’t be so quick to just ignore it.
There are possible explanations for these flags, however I don’t think any prudent investor should give the firm (and its management) the benefit of the doubt, quite the contrary you should take a deeper look into the firm’s SEC filings and ask a few questions.
Why, for example, is a firm with such huge revenue and income growth also growing inventories so fast (+19% in q1), while fixed assets (Property, plant & equipment) bare budged (+3%)? They say they outsource high-volume precision cutting and even some packaging of their products, which makes me wonder what exactly the firm does in its “manufacturing” facilities (which are leased), and what equipment (computer and otherwise) it really needs, short of a few dozen PCs and some relatively affordable warehouse equipment. $500,000 in computer equipment & software and another $930,000 in “Equipment” at year-end seems a bit high for a firm that doesn’t actually do any real manufacturing or even assembly, no? Did the firm buy five dozen licenses for every product made by Autodesk (CAD, etc software) instead of the 1 or 2 programs and 5-10 licenses – at most – it needs? (Perhaps this is how they have – allegedly – products for >5,000 different mobile devices, an absolutely stupid number if true) Maybe they told their IT guy to go wild and order servers & network equipment capable of supporting a firm 10x this size?
The firm also acquired PP&E of $175,000 in the first quarter of 2011, >30% annualized increase over their gross 2010 year-end balance. The firm does not provide any further explanation as to what assets it actually acquired.
As Roddy mentioned, their raw materials (primarily polyurethane) aren’t exactly scarce last I checked, and their relationship with what appears to be their sole supplier (repeated use of supplier, singular, in their 10-k) is “on excellent terms,” neither of which necessitate the firm’s raw materials account increasing almost 25% in the first quarter.
All things considered, I spent about 15 minutes perusing a few of the firm’s recent SEC filings and found more orange and red flags than I’ve seen from any firm I’ve looked at since China MediaExpress Holdings.
Curiously, the stock is up over 1% on the day after being down around 10% earlier. I’m chalking this up to much of the daily volume being from technical/momentum traders, and not fundamental/value investors. If I’m one of the institutional investors with millions of dollars in this stock though, you bet your ass I’m scouring over my previous work and seriously considering hedging my long exposure by buying some puts (if I haven’t already). Maybe the company is legit, but there’s more than enough anomalies in the financial statements – combined with the Boyd and Citron reports – to warrant a much more skeptical look.