What ZAGG Bulls Are Missing & Why

Today, one of the most ugly stocks I’ve seen in a while (that isn’t a total fraud ala China MediaExpress Holdings etc) is up >5%, much of which is probably due to a bullish mention from The Motley Fool, and possibly from seemingly higher bullish sentiment/posting on some message boards. I’ve heard the latter is part of a pump-up effort paid for by the company, but that’s for the SEC/DOJ to investigate. Moving on to the more concrete stuff, and there’s a whole bunch of it so prepare yourselves!

I want to focus first on why I think people tend to be so bullish on many of these momo/”hot” stocks even in the midst of much publicly available information to suggest they should reconsider their views. With a company like Zagg, you’ve got a combination of factors conspiring against investors’ ability to make intelligent decisions, leading many to adopt bullish views when such views are very unlikely warranted:

- An extremely promotional (some might call sleazily-so) management team that takes every opportunity they can to dodge the myriad questions about their actions and the firm’s problems. To say they’re cheerleaders doesn’t even begin to describe it; these are people who very well may be non-violent (I hope) sociopaths or pathological liars (similarl to maybe Overstock’s Patrick Byrne, although he’s on another level entirely) in that they really believe their own BS, that a company that has no comparative advantages that sells commodity products in an increasingly competitive industry is really the greatest thing since sliced bread. Some people find charismatic, promotional managers to be an indication that the company will be successful, I suppose another way of putting this is that even those who should know better can find themselves drinking the Kool-Aid, especially when they lack the time, expertise, and/or inclination to do further research.

- The company/management has and is constantly trying to convince investors that its a play on growing smartphone adoption/Apple derivative play. Since everyone “knows” the device market is growing like mad, many people find this story easily believable, and as a result are resigned to accept things at (presented) face-value. After all, if everyone’s getting smartphones and tablets and iphones and ipads, surely a company that makes accessories for them will do great, right? Alas, investors using such “logic” are completely ignoring any sort of industry or bottom-up analysis; its lazy and more importantly its self-defeating. Picking winning (and losing) investments is HARD! If you don’t want to put the work in, you’re investment strategy is basically a combination of relying on those whose goals are likely not the same as yours and luck. While I don’t have any academic research to support it, I don’t believe that is an investment strategy likely to generate positive returns (let alone alpha).

- With the internet and social media its fantastically easy for those already long the stock to pump up their positions, and they can do so with little fear of negative consequences. It was always easy for fund managers and big traders to get quoted in/make media appearances where they’re doing little (if anything) but talking their book, but with the web, its a whole new ball game. When a hedge fund manager is on CNBC talking his book, at least you’ve got a chance of piggybacking a guy/team who’s done their homework and thus have a decent chance of the trade working out. But now, any schmuck with an internet connection can pump up a position, and its really quite easy. Anyone with some time and motivation can create 50 anonymous Yahoo Finance (or wherever) accounts appearing to be 50 different people talking up a particular stock and it could actually move the market, especially for a small relatively thinly-traded company like Zagg. I can’t tell you how many people bullish on Zagg I’ve interacted with (Twitter, Stocktwits, blog comments) who have clearly never even clicked over to EDGAR, let alone read the firm’s regulatory filings let alone done any market/industry research/analysis.

This one particular individual with whom I went back/forth today is highly instructive of what I’m talking about. A person who is very clearly long the stock accusing me of 1. being short and not disclosing my position (I don’t even have a brokerage account and our company policy specifically prohibits active investing), 2. not knowing what I’m talking about (while failing to address the merits of my arguments and the facts I’ve presented), and 3. probably (if not clearly) not even reading everything I’ve wrote before responding so naively. There’s a difference between trading and investing. If you’re just looking for a swing/momo gain that’s fine if you practice effective risk management, part of which includes researching both the bull and bear case from a technical AND fundamental perspective.

- Similar to but slightly different than the above is the proliferation of financial news/”analysis” websites and newsletters, starting with some of the first ones like The Motley Fool and catering to every type of market participant in all corners of the internet, all professing to varying degrees to host informed, well researched content. Unfortunately, the % of such content being produced that I’d consider well informed/reasoned is probably less than 5% across all of these sites (some are much higher, some are 0%). For varying reasons, some of these sites have developed strong reputations (at least amongst certain investor classes) so anything published by them is given the credibility of the outlet itself by many readers, regardless of the quality/accuracy of the individual article in question. The Motley Fool article I mentioned at the beginning of this post is a perfect example of this phenomenon.

That being said, let me say this as plainly as I can: Zagg is not a quality stock, although there is some non-zero chance with several acts of God it may be semi-successful, the chance is far closer to 0 than 100%, very, very far.

We’ve warned you about orange/red flags in Zagg since July, here, here, here, and here. Other analysts/investors have done so as well, namely investigative financial journalist/analyst Roddy Boyd, The Davian Letter, and “Worthless Pennies“, a fund manager who has conducted significant research (FD: he has shared some of it with me).

I have yet to read a single bullish take on the stock supported by anywhere near the amount of research/analysis myself and others have conducted. In fact, almost every one is about as simplistic and naive as the one from The Motley Fool today. Keeping in mind the list of factors that I think drive stocks like Zagg above their fair value (and hopefully you’ve read the articles by myself and other critics above), lets take a look at a few things many Zagg bulls can’t seem to wrap their heads around.

First, many bulls think Zagg actually makes stuff. Uh, no. This is likely because (especially novice investors) just kind of assume that’s how things work, and , because of what I think are disclosure violations in Zagg’s regulatory filings. Page 1 of their last 10-k says “Headquartered in Salt Lake City, Utah, ZAGG Incorporated designs, manufactures and distributes protective coverings, audio accessories and power solutions…” but later-on we see that the firm outsources production, which has been confirmed by those who’ve researched the company and reading their other filings. Depending on which page you read, the company alternatively says it both is an is not a manufacturer, which might be why some people think Zagg actually manufactures stuff, but, if you read deeper (or do further research), it seems pretty clear they do not, at least not in any real volume/scale. From the last 10-k: “…we out-source high volume precision-cutting of the materials, which we consider to be more cost effective.” I haven’t verified this myself – and am NOT saying this is the case even though I trust the source – but I’m told from someone (FD: who is short Zagg) that a company not far down the road from Zagg HQ named Integracore does all of Zagg’s invisibleSHIELD stamping and packaging, handles all of their fulfillment and holds all their inventory, too. Whether that is (even partially) true or not, newly-acquired subsidiary iFrogz doesn’t look like they actually make anything either, lest you were wondering. A little hint would be noticing there’s no in-process inventory on its balance sheet like you’d expect for a manufacturing company. See page 11 of this 8-k

Now maybe I’m wrong, but this doesn’t sound like a manufacturing operation to me, which is why I also cannot understand why the company’s raw material inventory balance keeps growing. Why do yo you need to keep a ton of commodity raw material (polyurethane) laying around, especially when you outsource production and said raw material is readily available from a number of sources (even though Zagg’s supply chain is painfully, painfully concentrated, worse even than their customer base!). A non-manufacturing company hoarding raw material inventory suggests at the least poor working capital management, never a good thing especially for a firm that isn’t exactly throwing off tons of cash.

Second, many bulls point to Zagg’s revenue growth and management’s hyping up of results. I wouldn’t put much faith in anything management says. Recently at CES, the firm (HzO) said its in talks with Apple about getting the technology into Apple devices. I find this extremely hard to believe, if for no other reason than because Apple’s product development is so secretive, there’s no chance in hell they’d let a potential supplier make a public comment like that. Even if there are real, productive talks with Apple to get HzO into its devices, I wouldn’t be surprised if HzO yapping about it caused Apple to go with a competing supplier/technology, of which there are several, such as Liquipel and P2i, which supplies the waterproof technology Motorola is already using in the RAZR smartphone and Xoom2 tablet.

For crying out loud coating electronics in such a way is not really new nor unique, look at this for crying out loud! When you take management’s word for it instead of doing a little of your own research you come to believe the bullshit they’re trying to sell you. Don’t be lazy unless you want to end up owning shit!

Zagg management does not exactly have a history of being honest or forthcoming, if you were wondering, as “Worthless Pennies” article (along with the aforementioned/linked-to one by Roddy Boyd) thoroughly explains.

At the end of the day, you have to choose for yourself who to believe. Management (with a less than credible history), or the information available to anyone willing to look for and analyze it. Growth is possible of course, but there’s only so much growth you’re going to get out of a company that makes nothing itself, only sells commodity products in increasingly competitive industry with zero barriers to entry (more on this later).

Third, while there’s no denying that there’s plenty of accessories to be sold as the mobile device market grows, but revenues don’t necessarily mean profits, which if you look at the history of the computing and consumer electronics markets, are largely arbitraged away fairly quickly. This is even more true today than ever before.

While the Apple/mobile device halo effect has attracted so many competitors that much of the profit/margins will be (and is being) arbitraged out. The mobile device industry has some of the lowest barriers to entry and most competition of any industry. For example, there are more than 1,300 different earbuds for sale on Alibaba from over 1,200 different suppliers!! What’s stopping me from buying a bunch, slapping on my logo, setting up a website/Amazon store, buying ads through Google and competing in that market? Probably not much more than $20,000 or so to pay for the site, initial inventory, logo design/application, etc. Look for protective covers and earbuds/headphones on Amazon, there’s dozens and thousands of options, respectively, most of which are at least as good if not better than what Zagg sells. Is the brand really worth anything to consumers when they can buy the same or better thing for 50% less? I doubt it.

Sure, the company has been trying to expand into “higher-value” gadgets like the Zaggsparq and the Zaggfolio iPad keyboard/case and they seem to be decent-enough products, but again, low barriers to entry, little if any brand loyalty, and intense industry rivalry/competition do not bode well for Zagg and/or any firm selling non-differentiated products in the mobile device accessory industry. And lets face it, its pretty hard to sustainably differentiate in the mobile device accessory industry. Its not like you can patent most of this stuff, so there’s not much stopping competitors and new entrants from immediately replicating/immitating any successfully differentiated product in a matter of months if not weeks after the initial launch, so profits from any differentiated higher-cost/margin products should be relatively short-lived.

I’m not even going to comment on the people who cite the handful of analysts who actually “cover” the stock and their earnings estimates, as I think anyone of you who’ve been here before knows how I feel about sell side research, although I’m even more cynical in this case as its a small, shady company and I highly doubt the sell-side analysts are doing the leg work to figure it out.

Ultimately, this company may grow earnings and the stock will go up for years and the bulls will gloat and rub it in my face, but I think eventually, and possibly in the near future, more likely outcomes are:

- Zagg might default on the iFrogz acquisition debt,

- Issue additional shares/dilute existing shareholders to raise cash to avoid doing so (proceeds would have to be used to pre-pay the outstanding debt per the loan agreement),

- Suffer an auditor resignation and/or have to restate prior periods financial statements which I believe is quite likely given the recent disclosure, “Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review” just last week. The filing says that management doesn’t believe it will have to restate the financial statements, but going back to my earlier statement about not particularly trusting management, taken together with all of the other issues, I hope KPMG won’t risk the reputational harm that would come from signing-off on Zagg’s financials (etc) in turn for the relatively tiny fee they’re getting paid to audit the company.

Logically, I do NOT understand how its possible that we should rely on their previous financial statements when they’ve admitted to insufficient internal controls AND that their previous auditor didn’t actually have enough staff to, you know, perform the damn audit. Of course, the big 4 accounting firms have a storied history of not doing the right thing (oligopoly business, out of court settlements, neither admitting nor denying wrongdoing, etc and all) but that’s another story found all over the internet, in textbooks, and the business press, so who knows, maybe KPMG will shoot itself in the foot and sign off on the financials/etc, but I just don’t see the issues with Zagg going away; eventually, an auditor is going to resign and/or find screwy things going on at Zagg and it things will come to light.

- Run into issues with one of their primary customers (e.g. Best Buy) who likely have purchase contracts with Zagg that are written to be extremely tilted towards protecting the customer to Zagg’s detriment given the enormously disproportionate bargaining power of a Best Buy vs. a small supplier like Zagg. I wouldn’t be surprised if these contracts allowed the big customers to return unsalable (or too heavily discounted/low margin) product to Zagg (at Zagg’s expense), and a number of other things that wouldn’t be in Zagg’s favor. Of course, as the firm says in its 10-k, since their customers are so concentrated (i.e. a handful or so of customers account for a significant % of sales), if a Best Buy or Walmart or similar decided to stop selling Zagg products, Zagg’s revenues/earnings are going to take a big hit, and that may not be the extent of the negative consequences…

These are just a number of things to consider when looking at buying Zagg. Remember: The company doesn’t actually make anything, sells only commoditized products into increasingly crowded markets, has little if any barriers to entry, is run by semi-shady managers, and is in less than excellent financial condition, and that’s just the 1-sentence summary! Does that sound like a company in which you’d like to invest your (or your investors’) hard-earned money, or would you rather put it into a company with a better specific and industry outlook with less orange/red flags?

Look, Zagg could turn out to be a huge gainer, but given what we’ve discussed, it sure as hell doesn’t look like it to me. In fact, I’d bet (were I a betting man) the opposite is far more likely to come true, that is, the company is a loser.

I haven’t done a full valuation/scenario analysis so I’m not going to go so far as to estimate what the stock is worth, but I am fairly confident that investing in a company based off the advice of a guy who doesn’t seem to know what the hell he’s talking about is probably not a great idea. But hey, sometimes you get lucky, so you’ve got that going for you…

As always:

CAVEAT EMPTOR

*I suppose I should actually thank people of influence/who work for influential outlets when they make uninformed recommendations that move the market as it gives us and our clients/readers the ability to profit off the information asymmetry*

This entry was posted in Uncategorized by Jordan S. Terry. Bookmark the permalink.

About Jordan S. Terry

Founder & Managing Director, Stone Street Advisors LLC. Investment research and consulting for institutions, funds, family offices, wealthy individuals. Long/Short fundamental, value-oriented ideas with the occasional special situation throw in for good measure.

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