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The world of penny stocks is always worth a stroll because no matter what you come across, almost every company and its story ultimately follows the same script.

A maker of cellphone and computer accessories from Salt Lake City, Zagg (NASDAQ:ZAGG), is trying to buck that trend, and based on this chart, you could think it is pulling it off, managing to emerge from the primordial ooze of a reverse merger and walk upright in the sun.

Think again.

Barely four years from reorganizing out of a busted shell – its predecessor company, Amerasia Khan, folded after two years of trying to peddle “Academic Regalia,” without finding a single customer – Zagg has gone from just over $5 million in revenues in 2007 to more than $76 million last year.

With a growth trajectory like this, and the knowledge there is a first time for everything, the sky is traditionally the limit. In Zagg’s case, though, it’s a safer bet that things are likely to end up on a less lofty plateau.

Zagg’s major product, invisibleShield, is a cover protecting a cellphone’s (or handheld device’s) screens and buttons. That’s it. In fairness, it is an admittedly higher end offering than many of its competitors, albeit with a rather involved application, requiring a spray solution and a squeegee.

Despite holding three patents, marketwise, there is no conceivable barrier to entry for anyone who wants to grab market share, largely owing to it being made with polyurethane film; the only other thing needed to get into the protective cover business is a low-tech stamping machine and a website. Cellphone shields may rival Silly Bandz as the global economy’s most readily replicable product. There are at the very least dozens of different competitors selling products that are virtually identical at sharply lower prices.

Here is the Amazon page listing the best-selling cellphone shields. Zagg first pops up at number 21. Here is the Amazon page for invisibleShield, the anchor to Zagg’s product line, with about 77% of sales in the first quarter.

Despite its absurd reverse-merger origin–with revenues like these, Zagg could have had numerous options for traditional underwriters–is not a work of financial fiction. Financially speaking, Zagg seems at first pass to be like many fast-growing companies: Awe-inspiring sales growth parried with cash-flow worries. In the filings, it usually looks something like this–a big jumps in sales beget corresponding increases in Accounts Receivable while working capital expansion burns through cash. Despite the continued growth trajectory in sales, Zagg’s Accounts Receivable dropped 8% sequentially to $16.2 million in the first quarter.

Those (apparently) collected receivables aren’t being converted to cash quickly enough, however. Zagg used up $5 million in the first quarter and accessed its credit lines for $4 million. This is hardly unheard of, but that cash is going somewhere.

The growth of inventories is a good place to start looking for some answers.

At the end of the first quarter of 2010, inventories stood at $4.45 million; a year later, the figure was $21.19 million. It even continued to spike after a sharp revenue drop from the fourth quarter last year to this year’s first quarter, something that made no sense (then or now.) Some growth in inventory is naturally warranted as sales expand but this seems to defy logic. From an investors point of view, the “beauty” of this business is that it’s easy to rapidly produce a large volume of finished product, so maintaining large inventories of raw materials and work-in-progress is unnecessary. [Actually, large inventories are counterproductive for Zagg since the cellphone/mobile-device market is evolving so rapidly that models come and go, often in little more than a year, leaving older shield models virtually worthless. Moreover, polyurethane film is hardly a rare commodity, so storing a ton of it makes little sense.]

You might think the accountants would be all over Zagg seeking signs of inventory obsolescence but that hasn’t been the case, with around $1.5 million being the most it has ever written down, in the fourth quarter. In other words, most everything Zagg makes, it claims to sell.

This might be changing.

For most of its life, Zagg used Hansen, Barnett & Maxwell, a Salt Lake City-based accountantcy that was altogether too small and inexperienced to handle auditing a fast-growing public company, as this Public Company Accounting Oversight Board report makes brutally clear. In late January last year, Zagg took the unusual step of dismissing Hansen, Barnett a month into the yearend audit and hiring KPMG. A Zagg spokeswoman told The Financial Investigator the parting was due to “encouragement” from investors and the relationship “ended on good terms.”

Though the costs are going to be higher–KPMG charged $106,000 for 11 months of audit work versus $91,525 for a year’s worth of HBM’s audit and tax work–investors need to wonder if KPMG, with a full year’s familiarity, will force larger write-downs this year.

Still, Zagg’s management has embraced the growth-at-all-costs mantra. A few weeks ago, the company bought iFrogz, a maker of IPhone cases and Ear buds, for $105 million. There are several things that should raise eyebrows about this. The first is the purchase price of $105 million for a maker of the one product that is even more of a commodity–bordering on the realm of “novelty” gags and with even fewer barriers to entry–than cellphone shields. Moreover, the operating margins of iFrogz, at more than 20%, are remarkably high for a product that has zero value-added or complexity (oddly, Zagg has yet to produce financials for iFrogz.) This much can be guaranteed: If publicly traded companies can really make more than 20% operating profits selling cellphone cases then someone is going to put a lot of capital to work very soon in this space and build a competitor happy to accept 15%, begining the process of competing away the Zagg “franchise.”

Assurances that the deal is “accretive to earnings” had best prove true since it financed the deal with a Cerberus and PNC-led $45 million loan where the interest costs, at more than 6% currently, amount to $2.7 million a year–no small matter when it had to tap an existing credit facility for $4 million in the first quarter. [The credit facility also carries a prepayment penalty so doing a secondary offering to pay it down isn’t likely.]

Then there are the people.

Making an argument for Zagg would be much easier if its chief executive and chief financial officer weren’t shot through with so much Salt Lake penny stock vibe that you can virtually smell the copper (Salt Lake City’s penny stock culture of hype and promotion makes it essentially Boca Raton West.)

CEO Robert Pederson has repeatedly set up ventures with men who have truly run afoul of the law. These aren’t guys with a youthful indiscretion in their past, nor are they highly technical violations; they crossed the line and kept hauling as far as they could go before they were caught.

Evidence the first of this is his relationship with Robert Cord Beatty. Originally tasked with developing a superhero comic for movie and merchandising deals, a close reading of the Securities and Exchange Commission’s initial decision against Beatty shows him to have been a truly industrious, multidimensional scammer, both conscientious and enterprising in his violation of almost every known security regulation. At the time of his fund’s deal being struck with Zagg, the SEC’s decision was more than three years old. [The $500,000 loan is past due and collateralized by a corporate shell.] FI.com was unable to reach Beatty for comment.

The CEO also invested $3.2 million in something called hZo systems that claimed to have developed a “world class” waterproofing technology. The founder of the company, Scott B. Gordon, however, had been barred from the securities industry in 2008 when it was revealed that he had been using customer funds to pay the operating expenses of a private investment he had set up while a manager of a Lincoln Financial office in Salt Lake City (Gordon paid the capital back with interest.) A group of 20 investors later sued Lincoln Financial for failing to detect the fact that Gordon was running an independent software venture out of his office and were awarded $4.43 million.

A spokeswoman for Zagg, Amber Roberts of Lane PR, said that the board had not been aware of the FINRA issues when “Gordon was engaged” and that “He does not act in an officer role [nor] is he an employee of Zagg.” However, Gordon seems to have represented Zagg at a conference in Utah last year. FI.com called Zagg’s headquarters last week and asked to be connected to Gordon and was put right through to his secretary. A voice mail message for Gordon’s assistant was not returned. Roberts said she had called Zagg for additional clarification on Gordon’s role but had yet to hear back.

Pederson, the CFO Brandon O’Brien and board member Ed Eckstrom now own hZo and, per the spokeswoman, are trying “To further the technology and prepare it for mass-market.”

Pederson has also partnered up with one R. Matthew Tullis in Medical Payment Technologies, a company whose primary asset was an online payment system called Payteck. Notably, Tullis was a former senior portfolio manager at Zion’s Bank whom the Office of the Comptroller of the Currency ordered removed from his post in 2002 and fined. Though the charges are not detailed, the OCC barred him from the banking industry. A call to Tullis at his new employer was not returned.

The fur isn’t limited to the corner office.

A former board member, Lorence Harmer, even got into the act. As laid out in depth here (note that the article is written by a short-seller waging a running battle against the company,) Zagg loaned a company Harmer had a 25% stake in just under $4 million for a product that has never seen the light of day. [Zagg initially denied knowledge that Harmer had been involved with the company. It seems the company had not read its own filings.] The concern here isn’t that the company made a crummy loan, or even that Harmer collateralized the loan with a property that was heavily in hock and had dropped heavily in value, it’s the totality of the thing. It is not easy to decide what is more “penny”: the director screwing the company he oversees or the company that pretends they are shocked.

Frankly, being close to Zagg and not having at least some connection to the legal fallout from some current or past swindle would be news. Richard Durham, A Utah resident and private-equity player, recently took a 5% stake in Zagg. He is also a defendant in a case brought by the trustee of the Dreier note scandal, alleging he and trusts he controls profited unjustly from the $380 million fake promissory note scheme.

Lest any stone be left unturned in attempting to boost the stock price, Zagg hired promoters to tout the stock–this E-mail is a fine example of the type–long one of the surest signs of an impending disaster in an investor’s future. The allusion to Zagg as positioning itself as an early stages Google or Microsoft was a particularly dramatic flourish. The Zagg spokeswoman says “Mr. Cassel and Mr. Davidson provided investor relations advisory services in 2008 and 2009” and that the company no longer has any contact with them. Zagg disputes the description of them as “promoters.”

[You can read Zagg's full reply to FI.com's questions here.]

Zagg might pull it off. But risk is nothing if not a gimlet-eyed assessment of a likely outcome occurring over a certain time frame. Seen that way, adding debt and expanding scale in a business that has all the appearances of a fad points to only one result: a cruel reckoning with the cold, hard laws of economic gravity.

Because that which is pumped up always deflates.

Disclosure: I do not have any sort of investments in the securities of any company I write about, nor for that matter, in anything at all (save for my house).

Source: Zagg Might Pull It Off - But the Risks Are High