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 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.
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 Overstock.com 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.