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The most exciting part of a portfolio can be the speculation play, the lottery pick. Many of these securities are falling knives. The key is not to try and catch all that you see, but examine for the knife with the dullest blade and the longest handle, effectively shifting the odds in your favor and minimizing the potential cut. You want to find the type of stock which if it disappoints at earnings, people collectively sigh and say "….figures" and allow it to roam free in the land of flat trading. But, if it manages even a weak pulse, the death certificate is sent through the shredder, and the company starts a climb up, up and away. ZAGG just may be that stock with the right risk/reward profile to be worth a bite.

For being such a small company, it has done remarkably well with brand recognition and product leadership in the past three years, primarily in screen protection with its invisibleSHIELD line which serves just about all lines of smartphones and tablets. However, it is spreading into other segments which are becoming a more meaningful piece of revenue, such as tablet keyboards, which will be shown later.

ZAGG was first punished by showing up to earnings in May and severely disappointing analysts with a huge miss, sending the stock into a tail spin. Trimming guidance did not do anything to help its cause either. However, the past two quarters have been nice surprises but did not do anything to win back the respect of investors as shown by the depressed stock price. An obvious concern from the most recent financials is the decrease in revenue and the lowered full year 2013 guidance. After growing revenue almost 50% from 2011 to 2012, ZAGG is expected to decrease revenue from 2012 to 2013 by about 19%. Additionally, as sales decline, inventory is actually rising by roughly 8% for the past few quarters.

While all that is clearly negative, I believe it is baked into the current price. Let's look at some of the positive things we can glean from the recent quarter. Its main product, invisbleSHIELD, dropped by 4 percentage points of total revenue from Q3'12 to Q3'13. This was offset by its keyboard product line increasing by 9 percentage points of the total revenue in the same period, as shown in the in the 10-Q. This is a very positive sign of product diversification. Another point which should not be overlooked is that ZAGG managed to remain profitable by slightly expanding both gross and operating margins in recent quarters and generating free cash flow, despite lower revenues. ZAGG is displaying the desire to be profitable.

ZAGG fessed up at the LD Micro Conference that it needs to work on the following:

  • Sales execution (Domestic and International)
  • Inventory management
  • Detailed sales forecasting
  • Reliance on Apple (NASDAQ:AAPL) product launches
  • Two delayed product launches in FY13
  • Inconsistent timing of product launches

This is an honest admission which can be clearly seen in the financial statements, ZAGG is not trying to hide anything. Following the confession it laid out a plan to address each point, which shows it wants to do right by shareholders.

Other than net income, some of the biggest drivers of operating cash flow for ZAGG are accounts receivable and inventory. The graph below shows the movement of Days Sales Outstanding (-DSO-) and Days Inventory Outstanding (-DIO-) over the past ten quarters, which I created using the Income Statement and Balance Sheet. Although there are websites available which do the calculation for you.

ZAGG has been able to manage its Days Sales Outstanding (DSO) fairly well relative to historical performance, however its DIO has spiked to extreme levels. Which is why I am sure ZAGG acknowledges inventory is a problem and it is taking the necessary steps to fix it. Decreasing the DIO will be essential for ZAGG to have a successful quarter. While higher inventory is necessary to support a more diversified product line, it in no way merits the inventory spike. The table below shows the impact to operating cash flow if it sees a 10 day, 20 day, or 30 day reduction in DIO:

The above table was created by backing out the inventory in the DIO equation based on each level of reduction specified. Once the inventory is calculated to support a given DIO, the impact to operating cash flow can be shown by subtracting the calculated inventory from the prior quarter's ending inventory. I believe that a 30 day reduction in DIO is reasonable which will significantly reduce the negative impact to operating cash flow, implying a more effective management of inventory to support revenue.

If we assume that the net income comes in at the average analyst's expectation, DSO remains flat, and we see the 30 day reduction in DIO, this would lead to an estimated free cash flow of $4.8 million for the quarter, assuming that capital expenditures is equal to the average quarterly capital expenditure of 2012. This would land ZAGG at a free cash flow total of $29.2 million for the 2013 fiscal year, representing a growth of 100% compared to 2012.

I calculated a WACC of 12.65% and used it to build the below table:

This table represents the implied equity, and therefore stock price, if ZAGG improves DIO by 30, 20, 10, 0, or increases it by 10 or 20 days. The assumed growth rate of FCF is inflation (2%). As a final price floor scenario, in the same table, I used the NCAV valuation method which is Current Assets - Total Liabilities, this represents near liquidation value. Essentially to hit NCAV, ZAGG would need to screw everything up at earnings, miss badly on revenue, income, accelerate inventory growth relative to revenue, all while presenting no plan of how to fix it.

The numbering in the title of the table is shown below to reference the thoughts of investors about the earnings announcement if each were to play out.

(1) "You are almost who we thought you once were!"

(2) "You said you cared, and now you are actually showing it!"

(3) "Improvement takes time, but we love you for trying!"

(4) "It moved a finger, someone check its pulse!"

(5) "….figures"

(6) "Do you even care?"

(7) "Someone file the bankruptcy papers"

Of course this analysis does not represent all possible scenarios. It also does not mean if DIO decreases by 30 that the stock will immediately shoot up 115%. It represents the most important thing ZAGG needs to show improvement in - the earnings announcement - for the stock price to once again appreciate, while ideally seeing a pop on earnings day. Inventory control is critical as ZAGG acknowledged it as one of the most crucial areas for improvement. I believe it will take necessary strides to get back on track. I am a fan of the risk/reward profile and look forward to earnings.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ZAGG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: ZAGG When Others Zig