3 Reasons to Sell ZAGG

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The incredible adoption rate for smartphones is still ramping up, with Apple's (Nasdaq: AAPL  ) iPhone leading the way. Plenty of new devices means lot of opportunity for companies such as ZAGG (Nasdaq: ZAGG  ) to jump in and sell you a screen protector, or a bottle-opening case, or a nifty case-stand-keyboard combo for tablets. Unfortunately for ZAGG, the feast is coming to an end.

Single product reliance: ZAGG makes the invisibleSHIELD screen protector, which covers smartphones and tablets and protects them from scratches. Last quarter, sales from invisibleSHIELD accounted for 48% of ZAGG's revenues, and the biggest problem is that ZAGG has no proprietary rights regarding the film used in this specific product. With regard to the proprietary rights the company does have, the company cautions that "no assurance can be given that ... the intellectual property rights that we have are sufficient to protect other persons from creating and marketing substantially similar products."

So the risks for similar products are known, but the real problem is with superior products. The iPhone, Galaxy line, and many Droids already sport Corning's (NYSE: GLW  ) Gorilla Glass. The glass is more scratch-resistant and thus less likely to need an invisibleSHIELD. While the product is not perfect, continued development by Corning could put a serious dent in future ZAGG sales.

Margin erosion: Because of its single product reliance and lack of competitive moat, ZAGG has felt obliged to enter into a huge range of product markets. The company has begun selling covers, earbuds, cases, and miscellaneous mobile accessories. All this expansion has hurt operating costs.

Starting in 2011, as diversification increased, operating-cost growth started to outstrip sales growth. The company increased sales by 135%, but costs grew 155%. Instead of being able to focus on the strong-margined but competitively weak invisibleSHIELD, the company has had to look to thinner-margin products.

Accounts-receivable growth: ZAGG products are specifically designed for each device. A cover that fits an iPhone is distinct from a cover that fits a Windows phone. That's why I worry when the company's accounts receivable grows 125% from Q1 2011 to Q1 2012. Revenue grew 106% over the same period.

ZAGG is increasing the speed and volume at which it's shipping, but as the lifecycle of a smartphone shortens, it's likely to start receiving more returns of unsold products that no longer fit the newest phones. With $37 million waiting to be collected, there's a big hole just waiting to open up under ZAGG's feet, if demand drops off.

The bottom line
There is certainly a temptation to play ZAGG as an indirect way of getting into Apple. I don't think the company is poorly run, nor do I think it makes bad products. The problem is that ZAGG doesn't seem to be in control of its own destiny. If it does well, it will only be because no one comes along to compete. However, I believe the market is large enough for a meaningful competitor to come along and drive margins even further down as it cuts into ZAGG's market position.

As my colleague Austin Smith has said, the next few months could continue to be strong for ZAGG. It's the long-term future that's unknown. If I had invested in ZAGG and made a nice return up to this point, I'd sell out and get into Corning. I think the future of Gorilla Glass is going to keep it in handhelds for years to come. Obviously, individual investors should take their time before making those sorts of decisions and do all of their own research before making any moves.

ZAGG's strength came from its ability to see the niche market that no one else had seen. As more people see the market, their advantage will slowly fade. Luckily, the Fool has created a free report detailing the business behind The Next Rule-Breaking Multibagger. This one has a moat the size of an ocean, and investors are going to happy they got in early. Get the all the details from our report today.

Fool contributor Andrew Marder owns none of the stocks covered in this report. The Motley Fool owns shares of Corning and Apple. Motley Fool newsletter services have recommended buying shares of Corning and Apple, creating a bull call spread position in Apple, and writing naked calls on ZAGG. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (0)

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 July 09, 2012, at 3:24 PM, shadowlesstruth wrote:

    First you say a lack of product diversification is a bad thing, then you blame them for diversifying because it doesn't have quite as high margins. Then you go on to argue a shorter product cycle is a bad thing for Zagg, in fact this is a major positive. Next, you lie about Zagg not having any rights to the film in InvisibleShield. While writing about superior products, you mention gorillaglass, which is not even close to as protective. Then you mention the market is large enough for competitors like that's a bad thing. How did get by with day to day life using such horrible logic.

  • Report this Comment On July 09, 2012, at 4:00 PM, loosecannon102 wrote:

    This is the same "analyst" who recommended Facebook stock. What business school helped him hone his acumen that leads to quotes like "It's the long-term future that's unknown" that apply to any company that's not heading towards bankruptcy. Looks like anyone can become a Fool commentator! Useless...

  • Report this Comment On July 09, 2012, at 4:05 PM, mikecart1 wrote:

    ZAGG reminds me of SMT which I annihilated in 2010 constantly despite others saying how it was going to soar to new heights. The only thing that soared was the bank accounts of whoever shorted SMT - the maker of SMART boards aka white boards with projectors connected and marked up in $$$.

  • Report this Comment On July 09, 2012, at 4:46 PM, loosecannon102 wrote:

    Okay, well make your case as to why ZAGG and SMT are similar situations.

  • Report this Comment On July 09, 2012, at 7:11 PM, analystinCA wrote:

    Single product reliance:

    While Gorilla Glass is a good product, it has been in the iPhone since the very beginning. Its not new and won't suddenly be a serious competitor to screen protectors and cases. How many cracked iPhone and Android phone screens have you seen the last three years? Guess what, they all were made with Gorilla Glass. No matter how strong Gorilla Glass is, as long as it still breaks and scratches there will be a need for screen protectors and cases. A $15 screen protector is a pretty good insurance policy for a $600 device.

    GLW has not been a great performer and its a poor AAPl play. Gorilla Glass makes up less than 15% of GLW revenues. If you want to play on AAPL, just buy AAPL. Really.

    Margin erosion:

    Here is a lesson on financial statement analysis for you: Margin erosion occurs when a firm has rising costs that it can't pass on to customers or the competitive climate has intensified resulting in lower prices and revenues. These are bad signs for a company, but this is NOT what has been happening at Zagg.

    Zagg's margins have been decreasing because it has changed its product mix. What this means is that Zagg could have focused solely on the Invisible Shield and been proud of itself for not letting its gross margins decrease, but it would not have had nearly as many sales. Heck, it could have kept its margins really nice by never selling wholesale and staying in mall karts. But it would have never gotten over $100 million in sales that way. So there is a trade off, more sales of more products but at lower margins. I will gladly take all of the addition sales that came through selling addition products and through more channels. In case this didn't sink in let me summarize, Zagg would have been no where near $180 million in revenues last year if it stayed in high margin mall kart retail. Zagg's competitive advantage is that it is available in major retailers. None of its competitors are near the level of distribution of Zagg.

    Also, by diversifying its product mix it will keep Zagg relevant in the long term.

    Accounts-receivable growth:

    The most likely explanation for the higher rate of receivables vs sales growth is from Zagg's customers having more power to dictate payment terms. Best Buy and Walmart are big fish. Zagg's impressive growth has come from getting distribution in big retailers. Its not ideal to have a 50+ days receivable, but its worth it for the additional sales. Besides these are credit worthy customers. Zagg hasn't had any bad debt expense the last two quarters.

    Zagg had $18 million in finished goods as of last quarter. (This has been falling each quarter over the past year.) That is about 30 days worth of product. Zagg knows when new products are launched by Apple and Samsung. It not too difficult to manage production in this industry. Besides, old models are still for sale such as the iPhone 4, just at a lower price.

    This is hardly a risk.

  • Report this Comment On July 10, 2012, at 9:46 AM, loosecannon102 wrote:

    Two new reasons not to sell ZAGG -- impressive new directors just added to the board. They must be doing something right.

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