Zagg (NASDAQ:ZAGG), a developer of accessories for mobile devices, including Apple's (NASDAQ:AAPL) iOS products and Android devices (generally Samsung's (OTC:SSNLF) as Samsung is the category leader in the Android device space at this time). While the firm rode high on the coattails of Apple's meteoric 2011 rise, a number of issues that I will address shortly have sent the shares to near all-time lows on extremely high short interest.
My view is that this is that this is the sort of opportunity that is incredibly appealing to contrarian investors, particularly as the current share price and valuation at 8.1x the current year's expected earnings reflects long-term pessimism for issues that can be unwound and addressed in the near-term. The thesis here is simple: the problems that the firm faces are likely to be addressed in short order, which suggests that shares are cheap at 8.1x CY2013E consensus EPS estimates of $0.69.
Apple Product Refresh Delay Is Short Term Problem
Zagg has traditionally benefited from a number of key Apple launches spread out over several quarters, which has allowed the firm to maintain fairly consistent sales growth. Unfortunately for Zagg, this threw off the firm's traditional sales pattern which means that investors are now in a "wait and see" mode. My view is that should new Apple products materialize, and should Apple manage to continue to grow its iPad sales (either iPad or iPad Mini; Apple's mix is not particularly important given the nature of Zagg's add-on products), while keeping its iPhone sales at least flat year-over-year (this should be attainable; the concern for Apple is mix of previous generation iPhones versus new iPhones, but this is not a concern for Zagg), then there is very little risk to consensus EPS estimates.
Interestingly, while gross margins are down Y/Y, management assured analysts on the call that this was due to a shift in mix (keyboards, which carry lower gross margins, now represent a larger portion of sales) and not to pricing pressure in the firm's core product lines, so I'm not particularly worried about Zagg seeing too much in the way of competitive pressure on the gross margin side of things.
From a broad market perspective, the primary headwind has been the delay in the Apple product refresh, which suggests that a successful set of product launches/refreshes from Apple should be enough to turn sentiment on this name (and indeed, many other firms that benefit from riding the coattails of the Apple ecosystem) and drive a higher multiple. Even a conservative expansion from 8.1x CY2013E to 10x CY2013E would drive 17% upside to the shares.
However, there are additional factors that could drive an even richer multiple going forward.
The Rest Of The Problems Are Fixable
While I believe that the firm could undergo modest multiple expansion should the Apple product refresh go as planned, there is additional opportunity for a richer valuation as the Street sees evidence that the "one time" problems were indeed temporary and that going forward they should not recur.
First, the firm took a $1M inventory write-down on its 9" keyboards for the iPad Mini (which negatively impacted gross margin). While this product saw strong critical reception, sales were an entirely different matter as evidenced by statements from management on the most recent call,
Despite great product reviews, the 9-inch keyboard turned out to be a retail disappointment as it became clear that consumers prefer keyboards that match the smaller form factor of the iPad Mini as opposed to our larger 9-inch keyboard. The 9-inch keyboard case was also very tight-fitting and made it cumbersome for consumers to install and remove their iPads. Ultimately, this product did not meet the market acceptance we had originally forecast.
While there is certainly risk that going forward a similar miscalculation happens, it is less likely as it should be clear at this point which accessories sell with which form factors; the risk only re-emerges with the introduction of a fundamentally new form factor/product category from Apple.
Next, the firm recalibrated its distribution strategy to one involving a smaller number of master distributors, which should help improve and regulate pricing in the channel. The transition, coupled with a consolidation of the firm's account management team, led to missed opportunities in the firm's iFrogz audio line. Going forward this shouldn't be a problem.
Finally, management has missed guidance several times over the last year, which has led to dramatic drops in the share price following those earnings reports. I believe this has created a credibility problem for the company's management team which further pressures multiple (as the multiple accounts for the nontrivial possibility of overly aggressive guidance from management). The upshot to this is that a few quarters of meeting/exceeding guidance should rebuild credibility and as a result should allow the Street to give the name a richer multiple, particularly as CY2014 should see the firm returning to much more robust growth.
The Bottom Line
At 8.1x CY2013E earnings coupled with multiple upside drivers and the potential for management to rebuild credibility with investors with a few quarters of improved execution, I believe that there is room for nontrivial multiple expansion. At a modest 10x CY2013E, we see 17% upside, but should the firm return to double-digit growth and successfully hit this year's EPS estimates, a quite modest valuation of 12x CY2014E EPS estimates (which currently stand at $0.80) would drive upside to $9.6/share, or 71% upside from current levels.
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.