ZAGG: Undervalued And Forgotten

| About: ZAGG Inc (ZAGG)
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Sometimes a great company can be buried in wave of negative headlines, and once the news passes the stock is left beaten down and forgotten. This phenomenon is an opportunity for a patient investor. The key to dissecting which companies will overcome the spurt of bad publicity is always the underlying fundamentals. As long as the balance sheet remains solid, it only takes one or two good earnings reports to reinvigorate the bulls. I believe ZAGG (NASDAQ:ZAGG) Inc. to be a company that fits this profile perfectly.

ZAGG is a leading mobile device accessories and technology company with products that protect, personalize and enhance a consumer's mobile experience. ZAGG's product line focuses on smartphones and tablets, and therefore the company has been rapidly expanding during the past 3 years. In 2010 and 2011, revenue grew by 98% and 135% respectively. ZAGG concludes their 2012 fiscal year on February 25th, and analysts predict that revenue will grow another 45% YoY. Income before taxes has been expanding at an even faster rate. In 2010 ZAGG's income before taxes grew 112% to $5.51 million dollars, followed by $16.58 million in 2011 (200.7% growth YoY). Analysts expect 2012 income before taxes to grow 62.8% YoY to $27 million. With such a rapid increase in revenue and income, you might expect to find a lofty valuation. But shares of ZAGG Inc. sit only 11.87% off their 52-week low, and sport a P/E of 9.42.

In addition to substantial organic growth, there have been a couple of positive announcements in recent months that have failed to move the share price. In mid-December, ZAGG was able to refinance all $46 million of existing debt on the balance sheet. They entered into a $84 million dollar credit facility with Wells Fargo Bank, consisting of a $24 million 2 year note and a $60 million revolving line of credit. This move will save them around $2 million in interest charges a year and provide them with liquidity needed for ramp up periods during large product releases. ZAGG also announced in December a $10 million dollar share repurchase program that will return capital to shareholders over the coming 12 months. So why have investors driven shares down so far?

The Meltdown

There are a variety of factors that play into recent lackluster performance. On August 3rd, 2012 ZAGG reported Q2 EPS of 0.18 (in-line) and revenue of $61.6M (beat by $2.3M). At that time the company raised full year revenue guidance from $250M to $256M, but the street was expecting $261.3M. The next day, ZAGG was clobbered in response to the weaker than expected full year guidance and lost 25% of its value. Only 14 days later, the CEO and co-founder Robert Pedersen resigned from the company. Pedersen had been buying ZAGG on margin. On August 14th, Pedersen was forced to sell 512,240 shares "to meet margin calls" at an average price of $8.22. As you might guess, the market reacted negatively to the news and by August 20th the share price had fallen to $6.90. Since then, ZAGG has done little to regain investor confidence. Q3 results were reported on November 1st, and ZAGG missed estimates for the first time in 5 quarters. EPS of 0.11 missed by 0.05 and revenue of $59.8M (+30.3% YoY) missed by $1M. Full year revenue guidance was raised again to $259M - $262M, but this was not enough to combat heavy shorts. The share price continued to fall until November 19th when it reached a low of $6.48. Shares have fallen a long way from $10.80 in early August, but the overall value proposition remains intact.

If you are a believer in traditional valuations, the current $7.25 share price couldn't get much juicier. ZAGG has a trailing P/E of 9.42 and a forward P/E of 7.40, both of which are far below their 5 year historical lows of 20 and 15 respectively. Valuations at this level are typically reserved for stalwarts with modest growth prospects. No matter how you look at it, ZAGG does not belong in this category. On February 25th, management expects revenue between $259M - $262M which represents growth of approximately 45%. Analysts expect EPS for 2012 between 0.71 - 0.78 (growth of 13% - 24%). For 2013, revenue is expected to grow by 18% to $308M and EPS by 32% to 0.98. Companies that expect such significant growth in the future rarely have a P/E below 15, so there must be an explanation for why the shorts have been in control since August.

The pessimistic attitude towards ZAGG on the street can be attributed to three main factors. First, the debacle with former CEO Pederson earlier in the year left a bitter taste in everyone's mouths. The new management team is unproven and only has one quarter under their belt during which they missed the street's expectations. Second, many believe that market penetration has nearly peaked. From Target (NYSE:TGT) to Best Buy (NYSE:BBY), ZAGG products such as invisibleSHIELD and ZAGGKeys are carried by almost every major retailer. There aren't many avenues left in which ZAGG can expand its customer base in the US. Third, ZAGG is up against increasing market saturation. As Apple (NASDAQ:AAPL) products have been flying off the shelves at record paces in recent years, new cases, keyboards, and screen protectors have been filling up the aisle end caps just as rapidly. This will likely cause margins to compress as the various accessory dealers compete for market share.

The Big Picture

Even though ZAGG has fallen out of favor over the past 6 months, the macro environment that the company operates in is overwhelmingly bullish. The IDC projects that smartphone shipments in 2012 grew 33.5% to 659.8 million units, and that growth will continue during the next four years at a rate of 18.6%. It is reasonable to expect that cell phone accessory companies will grow consistently for the next few years as the customer base continues to expand. ZAGG's most successful product is the invisibleSHIELD, which accounted for 48% of their revenue YTD. invisibleSHIELD is available for almost every smartphone, so as the number of consumers with smartphones increases, so will the potential customer base. ZAGG's other brand name iFrogz offers cell phone cases for nearly every make and model on the market in many different styles and colors. If ZAGG is able to maintain market share during the next few years, revenue growth will continue alongside. Management believes that they can increase market share, but this isn't necessary for continued growth.

The second largest chunk of ZAGG's revenue comes from a much more exciting growth category: tablets. ZAGG is a leading manufacturer of keyboards for the iPad and other successful android tablets. Tablet sales growth in 2012 has been rampant, and it doesn't look like it will be slowing down anytime soon. The IDC raised its 2012 tablet shipments projection to 122.3 million in December, and they anticipate growth of 40.1% in 2013. By 2016, the IDC projects that there will be 282.7 million tablets shipped to retailers which is more than double the 2012 figure. While keyboards are not a necessity for any tablet owner, they are a luxury that many people will continue to want. Tablets are replacing laptops for many consumers. Even though auto-correct features continue to improve on touch screens, they will always be less efficient than a physical keyboard. ZAGG's keyboard sales have grown considerably; management reported YoY growth in Q3 of 300%. Apple reported an increase of 48.7% in iPad sales in their most recent quarter, which is a positive leading indicator for ZAGG keyboard sales.

The Outlook

Even if competition in the accessories market picks up considerably, ZAGG has two advantages that ensure continued success. ZAGG already has well developed distribution channels and relationships with retailers. ZAGG products can be found in Target, Walmart, Office Depot, Best Buy, Radio Shack, and all 4 major cell phone providers' stores. They have the ability to put accessories in stores all across the nation the day of the new product release. It took a considerable amount of time and a series of high quality products to build up their reputation. Even if others can make products similar to theirs, they have a long ways to go in order to get the market exposure that ZAGG currently benefits from. Retailers prefer to work with fewer vendors rather than more. If ZAGG can continue to expand their product offerings and pricing points in coming years, there is a good chance that retailers will choose to consolidate. This will provide ZAGG with more shelf space and more consumer exposure. Also through the acquisition of iFrogz in June of 2011, ZAGG has been able to reach a larger customer base. The company has chosen to position ZAGG as the upscale brand focused on the working professional, while iFrogz products are directed at teens and young adults and are generally lower in cost. By selling products under two names, ZAGG has been able to maintain brand integrity and reach both spectrums of the market.

ZAGG is well positioned for continued double digit revenue growth in the smartphone and tablet market, and deserves a serious look from investors. It isn't every day that you come across a company that operates in a high growth category (revenue growth of 45% in 2012) and is already profitable with a P/E of 9.66. There are a few other concerns that a diligent investor should not over look such as the continued improvement of Gorilla Glass from Corning (NYSE:GLW), but at the moment I believe ZAGG is an undervalued and forgotten stock. Be on the lookout for a full year revenue figure of $261.3M on February 25th. If revenue surpasses $262M, ZAGG shares could begin the journey back to $10.80 from where the meltdown began.

Disclosure: I am long ZAGG, GLW, AAPL. 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.