On Monday May 7, 2012 The Grumpy Old Accountants blog published an article "Don't Gag on Zagg" in which the authors claim that Zagg's (NASDAQ:ZAGG) management is misleading auditors and investors and may even be "cooking the books." While many of the points brought up in the article are just a rehashing of the same old criticisms, there are a few new claims that are very serious in nature such as misreporting of cash balances and cash flows.
While I appreciate the type of accounting analysis performed by the authors as that type of analysis is rarely done, I did find the article to lack fairness and objectivity. It was written to sound as scary as possible without actually showing Zagg has been doing anything wrong in many of their claims. I want to address their claims and correct a major error.
Criticism - Zagg's cash is not what you think it is.
The authors claim:
- The Company includes accounts receivable from credit card processors in its reported cash balances. You know how we feel about this, right? Remember "What s Up with Cash Balances?" Anyway, the implications of this "accounting policy" are profound. Instead of the Company reporting a positive operating cash flow for 2011, it really "burned" cash. The below schedule calculates the amount of accounts receivable included in the balance sheet cash totals, and recomputes operating cash flows by treating the $23,024 increase in receivables (24,981-1,957) as a use or reduction in cash.
Cash reported on balance sheet
Less cash reported in fair value note
Receivables reported as cash
Operating cash flows reported.
Adjustment for receivable increase reported in cash
Adjusted operating cash flows
While it is true that Zagg does classify receivables from credit card processors as Cash Equivalents on its balance sheet, it is much smaller than the Grumpy Accountants claim. Zagg defines Cash Equivalents on page F-10 of the recent 10-K as
"The Company considers all highly liquid instruments purchased with a maturity of three months or less to be cash equivalents. Amounts receivable from credit card processors are also considered cash equivalents because they are both short-term and highly liquid in nature and are typically converted to cash within three days of the sales transaction. Cash equivalents as of December 31, 2011 and 2010, consisted primarily of money market fund investments and amounts receivable from credit card processors."
Under Fair Value Measurements on page F-26 Zagg reports the fair value of its Cash Equivalents at $1,452 for 2011 and $416 for 2010. These are the amounts of the receivables from the credit card processors. Please note that this is the fair value of Cash Equivalents, not Cash. There is no reason to report the fair value of cash as well… its cash. The authors confused these two. To correct their numbers:
Cash reported on balance sheet
Less fair value of cash equivalents (credit card receivables)
Equals actual cash
Operating cash flows reported
Adjustment for receivable increase reported in cash
Adjusted operating cash flows
As you can see Zagg was still cash flow positive for 2011. I notified the authors via their comment section on Monday at 4:30 pm eastern time of their error, but as of this writing late Monday night, my comment says "Your comment is awaiting moderation." This is despite other comments being published after mine. As of Tuesday at 4:30 pm my comment had been deleted and the authors did not correct their error. This leads me to believe this was not a mistake, but done intentionally to mislead.
As other commentators have pointed out the authors failed to include Zagg's most recent quarter in their analysis in which Zagg had cash flows from operations of $14 million and paid down $27 million in debt. It is really hard to fake repayment of debt if Zagg had not actually collected that cash.
Only 10% of Zagg's revenues come from its websites and 6% through its mall kiosks. These are the maximum amount of sales that are exposed to payments from credit card processors.
Criticism - Zagg's gross margins have been in decline
When adjusting for the iFrogz acquired inventory fair-value write-up of $4,506, gross margins for 2011 were 48.2%. Gross margins were 49.1% and 57.5% for 2010 and 2009 respectively and for the first quarter of 2012 they were 48.5%. So for the last two years the gross margins have been pretty stable. More details can be found in my last article. While the authors did disparagingly note the effect of the iFrogz acquisition, they failed to point out the two major reasons for the decline in gross margins from 2009 levels; the change in its product mix and the large growth in its wholesale business. The iFrogz product line and the ZaggMate/ZaggFolio have lower margins than the invisibleshield. The large sales growth for Zagg over the last two years has mainly come from Zagg getting into stores like Best Buy and AT&T. So yes these two factors carry lower margins, but Zagg would be nowhere near its current revenue levels had it stuck to mainly selling through its website and mall kiosks. There is a trade off, more sales but at lower margins. I will gladly take the additional sales.
Criticism - Management is pressured to make the numbers
Could this read anymore from a textbook? This line of reasoning can be applied to any management team of any public company. It does not mean that Zagg's management is doing anything improper.
As for the DuPont analysis, adjustments are needed for the one-time charges that occurred last year before this analysis can be meaningful in this situation. Zagg's margins suffered a lot from acquisition related charges from iFrogz, inventory write-ups, and the write-down of the Larry Harmer note receivable. It is highly unlikely to see similar charges in the future making the unadjusted DuPont analysis a poor predictor of the future.
In regards to a large portion of sales coming from a few customers I have to say yes this is a risk factor. But you have to remember that there is no way that Zagg could have achieved the success that it has without these customers. It is just the nature of this business. There is no reason to assume these relationships are at risk. There is also no indication that Zagg's financial performance is negatively affecting its customer relationships or that it is likely to in the future.
Criticism - The environment is ripe for material misstatement in the accounts
Yes, it is true that Zagg had to amend its 2010 10-K because its new auditor, KPMG, found a material weakness in regards to Zagg's accounting staff but no material errors in the financials were discovered. Also Zagg has remedied the situation buy hiring more qualified accountants last Fall. So the situation is actually "Zagg had a potential weakness, but it did not actually cause any problems or errors and then they fixed the weakness." Not something to worry about at this point in the game.
Zagg switched its auditors over a year ago. KPMG is a large and widely known firm that has a lot more at risk than the prior auditor Hansen, Barnett, and Maxwell for letting Zagg slide on anything. Was not KPMG the one that found the material weakness above and helped Zagg remedy it? While a last minute auditor switch can be a red flag in some cases, this is simply not the case here. It's been too long to raise this as a red flag and the switch to a more experienced well know firm is a positive thing for Zagg and its investors.
Last for this section is the criticism that management holds a large percentage of the outstanding shares. This is the first time I have ever heard this being a bad thing (except when they also hold a disproportionate share of the votes, which is not present in this situation). This is a good thing as management's long term success is tied to the long term success of the company. As for the related party transactions the authors refer to, I'm not sure exactly what they are referring to. I'm guessing HzO, but there is nothing fishy about that.
Criticism - Intangible assets and management estimates
Zagg acquired iFrogz in June of last year. Goodwill and intangible assets result when the acquirer pays more than book value for a firm. Is anything fishy going on with this? No. Zagg paid market value for iFrogz and goodwill is just a plug to make the accounting journal entry balance. While the iFrogz line is reporting an operating loss, this does not mean that it is losing money. Take out the amortization of the intangible assets relating to the iFrogz purchase and you will find that it is profitable. So is a goodwill impairment lurking? No. Why is all of the goodwill assigned to the iFrogz business unit? Because it is the only company that Zagg has acquired. Accounting rules do not let a company book its own goodwill i.e. marking its balance sheet to market value. If a company could book its own goodwill Zagg would add $170 million to its balance sheet.
The concern about the amortization period is purely academic. The only economic effect of how the amortization is handled is on taxes. The more Zagg gets to amortize now, the less taxes it pays now. Besides that it really does not matter. It's not depreciation and therefore does not represent the consumption of capital goods that need replacement. There are no other economic effects of how this is handled.
The authors are concerned about management's ability to estimate allowance for doubtful accounts and sales returns because Zagg is a young company. This is possible, but like other concerns of the authors this is a pretty generic criticism and so far there is no reason to assume this is likely to be occurring.
Criticism - Declining inventories
The authors report that for last year approximately $2.5 million of operating cash flows resulted from inventory liquidations. I find this one odd because if these authors had been following Zagg's history they would know that Zagg has been heavily criticized for having too much inventory. But I guess with 49% short interest it's damned if you do and damned if you don't. Zagg's inventories have been higher than I would like and have grown a little faster than revenues. Much of this was from the inventory acquired from iFrogz. Not that they are at red flag level or anything serious like that, but it has been something worth watching. Zagg was also heavily criticized for lack of operating cash flows prior to fourth quarter 2011. This was mainly because of growing inventory and accounts receivable to support its massive revenue growth consumed all its operating cash flows. I for one am glad to see that Zagg has been able to improve its inventory management and turn that excess inventory into cash.
Criticism - Use of variable interest entities
The Grumpy authors are referring to Zagg's investment in HzO. This is another case of applying generic criticisms from a textbook. The logic goes like this, "VIE's have been used by some companies to commit fraud. Therefore any company using a VIE is committing fraud." Again, no actual proof or details showing that Zagg is actually doing something inappropriate in how it is reporting its investment in HzO. My question to them is how, according to GAAP, should Zagg be reporting its interest in HzO?
Criticism - Zagg needs outside help to value note receivable
The note receivable referred to is from Zagg's past director Larry Harmer who made misleading statements about his involvement with the supplier of the ZaggBox. The ZaggBox has been Zagg's biggest black eye. It simply was a bad investment. But what I find odd is that the Grumpy authors think that hiring independent outside appraisers to value the note's security is a bad thing. The red flag would be Zagg never taking a valuation impairment and telling investors that they believe they can recover all that is due. Zagg has been conservative and responsible in how it has accounted for this.
Don't be fooled by the misinformation. Zagg has had two great quarters recently and this trend is likely to continue as market trends for this industry are still going strong. The stock is currently trading at a reasonable valuation. Its price is currently only about 10% higher than it was a year ago when its revenues were half as much. Short sellers have the strongest incentives to deceive investors as 49% of the float has been shorted and Zagg keeps outperforming expectations.
Disclosure: I am long ZAGG.