What Zagg Longs Can Do About The Stock's Shorts

| About: ZAGG Inc (ZAGG)

Zagg Inc. (NASDAQ:ZAGG) currently has the 10th highest short interest out of all the stocks listed on the NYSE, Nasdaq and AMEX. Everyone who follows Zagg knows that the shorts have been campaigning heavily against the stock for some time now. The short interest ratio is over 45% with 9.67 million shares of the 21.22 million float sold short.

Preparing for Zagg to release dismal earnings the shorts added 440,404 shares at the end of January and 908,240 shares during the first half of February to their short position. The shorts took a hit when Zagg released record earnings after hours on Monday and the stock jumped 10% the next day.

I've been wondering where the shorts stand with their massive bearish position, so the question I'm going to try to answer is "What is the basis of the shorts' position?"

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Top Ten Shorted StocksClick to enlarge

It would be nice if I had access to brokerage data to get precise position figures, but that information just isn't available, so I made an estimate of the shorts' position basis with three methods: Weighted average, FIFO and LIFO.

The first step was coming up with an estimated share price for each period. I did this by weighting the daily high price with the shares traded that day. I took the daily high as it keeps my numbers conservative and I can have more confidence in their values. Basically this assumes that the shorts got the best price when they opened their positions, but the counter is that it also assumes they got the worst price when closing their positions. This downside is minor as most the net transactions have been opening trades. I also looked at the average closing price, but decided to stick with the weighted average high.

Nasdaq only provides information going back 53 weeks, so that is my starting short interest position. This was 3.2 million shares on December 15, 2010. I assumed all of these short positions were opened between October 1, 2010 and December 15, 2010. This resulted in an average starting position of $7.77 per share. Zagg's price jumped from averaging $4 per share in September to the high $7's in October. These were all time highs for Zagg at the time.

The way to calculate the weighted average method is to take the average price for the period multiplied by the net change in the short position. Keep track of this on a cumulative basis going forward and then divide by the short interest to get the weighted average price.

WA FormulaClick to enlarge

As of February 15, 2012, the weighted average basis for the shorts was $8.95. With the closing price Tuesday of $11.02, the shorts would be sitting on a loss of $19.8 million with the current price of $11.

The FIFO method (First In First Out) is pretty straight forward. Whenever there was a net decrease in the short position I assumed that it was the closing of the very first positions opened. With this method the shorts would currently have a position basis of $11.03 and would be breaking even on their trade. This method is probably the least accurate of the three. Over the last 57 periods the net closings were 3.82 million. This means the starting open short interest of 3.2 million would be closed and two-thirds of the positions opened during the last half of December 2010. The shorts would have lost money every period that positions were closed under FIFO. That just isn't realistic.

The LIFO method (Last In First Out) is also straight forward. Unlike the FIFO method, LIFO is more realistic of the order positions were actually opened and closed in. Looking at the data you can see positions continually being opened as Zagg's stock price increased and the opposite occurring as the stock fell from its high. This method gives a position basis of $9.16 per share and the shorts sitting on a $17.8 million loss.

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Summary DataClick to enlarge

So which is it? What is the shorts' basis? It's really hard to say precisely considering the amount of averaging that went into the analysis. The data just isn't available to get a more accurate number. Also while this basis is an average, individual positions will vary. I think the average position basis is probably around $8-9 with a very confident interval of $7.50-10.00.

Either way the shorts are hurting. There is that starting short interest from December 2010 of $3.2 million shares accounting for one-third of the current short interest. That is a huge number considering the high for the period was $8.95 and was only above $8.50 for seven days in the quarter. They must have figured Zagg would have gone bust early in 2011, but its sales and earnings just kept growing as they doubled down. The shorts should have covered when the stock hit a low at the end of December 2011, but they got greedy thinking the stock was going to zero.

Conclusion

Zagg just had a record setting quarter as far as revenues, EBITDA, net income and cash flow. It has been growing revenues at over 100% for the last four years and it is currently trading at a multiple that is extremely low for its growth rate. Its P/E is 17.46 without adjusting for one-time charges and net income grew 80% last year compared to 2010 and its return on equity was 59%. That's a PEG of .30 (1.00 is considered fairly valued if you're unfamiliar with PEG). Apple (NASDAQ:AAPL) is expected to announce the release of the iPad 3 next week and the iPhone 5 is expected to come out this summer. Those two things alone are enough to keep Zagg going at the same pace for 2012.

So what can the longs do about all the shorts? With a 45% short interest, it isn't too difficult for a short squeeze to happen. I've called Ameritrade and had them make my accounts exempt from securities lending. That means my Zagg shares can't be lent and sold short. I suggest if you're long that you do the same and we put the squeeze on.

Disclosure: I am long ZAGG.