The Good, the ZAGG, and the Ugly

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This article is part of our Rising Star Portfolios series.

Last week's Foolish 8 and Modified Foolish 8 screens produced some strong candidates, and I've been deep diving into some of the more interesting names. Today I'll offer up some quick thoughts on tiny ZAGG (Nasdaq: ZAGG  ) , which barely exceeds our Rising Stars minimum market-cap requirement of $200 million.

ZAGG makes cases and screen protectors for cell phones, iPads, and other electronic devices. It also makes a few other accessories such as headphones and keyboards. Its products are interesting and well-marketed, and it's hard to visit the website without buying something.

The good
The business is experiencing strong sales growth, though off a small base (from $34 million to $58 million the past 12 months). Return on equity is a healthy 39%, and I like the 32% insider ownership.

There should be a lot of room to grow in this space, as the number of electronic devices ZAGG can potentially (and literally) cover is multiplying every month. Apple (Nasdaq: AAPL  ) , for instance, is continuing to fire on all cores, and there are rumors of the iPad 2 being unveiled as early as next week. There will, of course, be the yearly iPhone update -- and plenty of Android phones are hitting the market constantly.

The ugly
While the growth prospects are exciting, I'm not convinced that ZAGG's margins can hold up well enough in the long run. The company is trying to differentiate itself in a commodity market, which is very hard to do. As long as margins in this space remain the least bit attractive and barriers to entry low, competitors will continue to pour in -- causing lower pricing and margins for everyone. That's just the way it is.

Then there's the matter of not having a diversified customer base. Best Buy (NYSE: BBY  ) is ZAGG's largest customer, accounting for 42% of its revenue. Not only does ZAGG have to fight for space in that important store with names like Belkin and Griffin, but it also battles Best Buy's own Rocketfish Mobile brand. I'd be uneasy having my largest customer also competing against me.

ZAGG also has some troubling aspects in the area of inventories and receivables. Its cash conversion cycle has soared steadily from around 12 in 2007 to 96 today. That means it's now taking 96 days for a dollar to work its way through the business. Such troubling trends can end very badly.

Finally, the company seems to be distracted by short-sellers who question management's past affiliations and activities (as well as its current business strength). Short interest now composes roughly 26% of the float. In a move reminiscent of Patrick Byrne's battles with shorts, ZAGG issued a press release questioning the shorts' motives and said it "will aggressively pursue its rights with authorities." This kind of stuff would really bother me if I were a shareholder; I'd want management focusing on the tough task of running a small business -- and thus countering the short-sellers with stellar long-term results.

Foolish bottom line
There are too many worries for me to consider buying ZAGG for my portfolio, so I'll be zigging along and continuing to research other candidates. If you're still interested in it, however, just add it to your free watchlist. In the meantime, you can keep up with me via Twitter, and join the Rising Stars conversation on my discussion board. 

Fool analyst Rex Moore sometimes zigs, sometimes zags. He owns no companies mentioned here. Best Buy is a Motley Fool Inside Value recommendation. Apple and Best Buy are Motley Fool Stock Advisor picks. The Fool has written puts on Apple. The Fool owns shares of Apple, and Best Buy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 24, 2011, at 8:07 PM, TheAnalyst101 wrote:

    Good points and ugly points. One big error is misinterpreting the growing A/R's and Inventory. In 2007 they were primarily a web based retailer with few A/R's. It only makes sense as they grow into the large retailers like carphone warehouse and best buy that their A/R days are going to grow as their business grows with them. Don't mistake this as a negative trend however. They have the short term working capital support through their A/P and line of credit. As long as they stay well cushioned with collateral and can easily pay their interest expense this is just a case of a growing company finding their stable business model.

  • Report this Comment On February 28, 2011, at 6:05 PM, StockMillionare wrote:

    Have been bullish on zagg for awhile. This stock isn't done moving up in value. I wouldn't be suprised to see zagg trading at $20 plus by the end of the year.

  • Report this Comment On March 17, 2011, at 4:24 PM, Gtrinvestor wrote:

    Hey, nice insights beyond just the numbers. Thanks for the write-up.

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