ZAGG Inc.: Restructuring Plan Can Unlock Value

Summary

• ZAGG reported Q1 earnings, which were significantly impacted by the COVID-19 pandemic, forcing an inventory write-down leading to a large loss.
• It has initiated a new restructuring plan, which includes exiting some categories to focus on higher-margin products and improve profitability.
• The company expects continued weakness through Q2 and the remainder of this year but has seen improving trends as retail channels reopen for business.
• We think the stock has value supported by the company's leadership position in core segments with products recognized for quality.
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ZAGG Inc. (NASDAQ:ZAGG) designs and distributes accessories for smartphones and tablets, best known for its cases and screen protectors marketed through several brands. The company reported its Q1 earnings highlighted by a significant impact from the COVID-19 pandemic as several retail channels closed amid global lockdown restrictions. Expected weakness in smartphone sales for the remainder of the year has further pressured the stock, which is down by over 50% in 2020. Recognizing the challenges, we think the ZAGG has value with a reset of expectations following the deep selloff. A recently announced restructuring plan to focus on the most profitable categories through a more streamlined product portfolio can help unlock value. The outlook has improved, and we're bullish on the stock.

(Source: Finviz)

ZAGG Q1 Earnings Recap

ZAGG reported its Q1 earnings on May 28 with a GAAP EPS loss of -$2.54, which missed by $2.22, or negative $76 million of income. This included an inventory writedown of $45 million and a $19 million goodwill impairment charge. Revenue in the quarter at $91 million increased by 15.5% year over year but missed expectations by $1.7 million. Management highlighted the revenue gain, explaining trends were strong through the first half of March before the deterioration of the coronavirus outbreak which forced the closure of retail stores where its products are sold.

(Source: Company IR)

With the inventory writedown recognized as a "cost of sale", the gross margin ended at negative 21% compared to 30% in the period last year. Excluding the writedown, the "adjusted gross margin" was 28%, pressured by COVID-19-related costs towards the end of the quarter. Favorably, operating cash flow was positive at $5.8 million.

Management observed a steep drop-off in sales in the final weeks of the quarter across both wholesale and direct-to-consumer channels. While not directly mentioned, a major factor was likely the temporary closures of Verizon Wireless (VZ) and Best Buy (BBY) brick-and-mortar stores. In the 10-Q filing, it was disclosed that both companies are major customers and together represent 33% of total receivable accounts. While these two companies continued to operate at some locations with curbside pickup and through online sales, the broader weakness was widespread and continued into Q2.

Management shifted its focus to reduce costs and support liquidity. Steps taken to stabilize the financial position included amending credit facilities, employee layoffs or furloughs, reduced executive compensation, general cost-reduction initiatives, and also, delaying inventory purchases aligned with adjusted demand forecasts.

The company ended the quarter with $14 million in cash on the balance sheet, against $100 million drawn in its credit line. A current ratio of 1.9x highlights relatively stable liquidity with no solvency concerns. After the quarter-end, the company amended its credit facility in April to increase the total amount available from $125 million to $145 million. ZAGG also received a $9 million loan from the Paycheck Protection Program of the CARES Act. Management believes that its current financial position, combined with cost-cutting initiatives, is sufficient to navigate the near-term environment.

ZAGG Restructuring Plan

The big development here was the announcement of several strategic changes in a new restructuring plan. ZAGG is exiting the battery case category and discontinuing the BRAVEN Audio brand. Going forward, the remaining iFrogz Audio brand, which includes headphones and speakers along with ZAGG branded mobile-keyboards, and mophie powerstation, is being simplified with fewer offerings. The goal here is to support higher operating margins and long-term profitability. The exit of the battery case category was justified by the high costs associated with engineering and development. From the conference call:

The focus going forward is on expanding within higher-margin categories where we believe we can further separate our sales from the competition through innovation, either developed internally or through licensing agreements like we’ve done with our partners, D3O, Kastus and Healthe.

In terms of simplifying certain categories, the goal is to reduce inventory risk by sourcing finished goods and move away from long lead time commitments and significantly reducing our number of SKUs in each of the remaining product categories. While we incur one-time charges this year in association to the restructuring, including inventory write-downs, which Taylor will review shortly, we expect our actions will result in higher operating margins, long-term and more nimble company that can better serve our retail partners and core consumers while generating increased value for our shareholders.

The company's strong points are in protective screens and cases, which represent over 50% of sales. The InvisibleShield brand was estimated to have 51% of the U.S. market share for mobile phone screen protection in 2018 and continues to present solid growth. Another growth area for the company is in external power, i.e., the mobile charge packs from the HALO brand. Wireless charging pads remain supported by greater penetration of smartphone devices that support the technology.

(Source: Company IR)

ZAGG continues to innovate, with the introduction of VisionGuard, which filters blue light to reduce eye strain. In response to the COVID-19 pandemic, the company is incorporating anti-microbial protection in all InvisibleShield and Gear4 product launches later this year. Another new product in the pipeline this year is a UV light phone sanitizer system for home and commercial use.

ZAGG Management Outlook

While management did not offer financial guidance for the remainder of the year, ZAGG expects significant weakness for the current Q2. There are some positives, including momentum in direct-to-consumer e-commerce. Still, the company has only seen a slow improvement in the weeks that retail channels have been open, with trends tracking about 50% below forecasts before the pandemic. From the conference call:

In terms of our direct-to-consumer performance, Q2 to date sales have outpaced 2019 by over 50% as we’re seeing very effective dotcom ad spend and improved conversion rates online. Overall, sales trends for the second quarter are slowly improving. We’re currently trying to be approximately 50% below our forecast in March of $120 million to $125 million.

With the amount of uncertainty created by COVID-19 in the near term and, potentially, longer term, the executive team and I took a deep dive into future profitability of all our brands, product lines, including review of the recoverability of inventory on hand due to the decline in demand brought on by the pandemic.

In terms of consensus estimates, the market expects full-year revenues to decline by 18% this year to $426 million. Going forward, considering the restructuring exits from several products, growth is estimated to just stabilize and increase 1% in 2021. ZAGG is expected to return to profitability next year, with EPS of $0.16 implying a 1-year forward P/E of 22.5x.

(Source: Seeking Alpha Premium)

Analysis and Forward-Looking Commentary

At the current share price of $3.64, ZAGG is trading with a market cap of just $107 million and an enterprise value of $202 million. Considering revenues of $534 million over the past year, and around $427 million estimated for 2020, the stock is trading at a depressed valuation with a forward P/S of 0.25x and forward EV-to-revenue of 0.47x.

Despite ZAGG being a "micro-cap" stock, the company has a real product that is used by millions of consumers and is recognized for quality. ZAGG has relationships with all the major phone manufacturers, including Apple Inc. (AAPL) and Samsung Electronics Co. (OTCPK:OTCPK:SSNLF), to gain early device specifications to produce the protective cases and screens in time for new product launches. The benefit for ZAGG is a lead time advantage compared to smaller companies that have more generic alternatives.

The other important aspect here is ZAGG's wide distribution across major retail channels. As these companies reopen stores, sales can normalize with improving underlying demand. Even if forecasts suggest a slowdown in new smartphone sales this year, consumers purchasing second-hand devices or refurbished units can still use cases and screen protection. ZAGG considers its products as part investment for the end-user that can help make a device last longer. Consumers also purchase cases and screens at the time when a phone breaks and is repaired, which has gained importance as the replacement cycle for new devices extends.

(Source: Company IR)

Verdict

We think the stock has value, supported by a more positive outlook with optimism over the restructuring plan. In our view, management's initiatives are a good move in the right direction that can help consolidate the company's core strengths and improve margins.

There is an upside to sales and earnings estimates, which can improve based on lower cost structure and an overall more efficient strategy. The higher value of new phones, along with a trend of maintaining a device for longer, supports the market for cases and screen protection. ZAGG wireless charging pads also benefit from market trends given the widespread retail distribution availability as the technology gains acceptance. We rate shares as a Buy, with a year-end price target of $5.00 per share representing ~50% upside and a 31x multiple of the current 2021.

The risk here is that the company losses its brand momentum, which forces revisions lower to estimates. A deterioration in the outlook could raise concerns about the balance sheet liquidity. The product categories are highly competitive, with several alternatives for consumers, often at lower prices. That being said, we think ZAGG's premium positioning and reputation of quality support a level of differentiation. To the downside, we think the lows for the stock in March, when ZAGG traded at $2.06, were a steal and should represent strong support in an environment of renewed volatility. Monitoring points for the company in the upcoming quarters include the evolution of financial margins along with trends in sales. This is a speculative stock, but we expect the company to survive this environment.

Analyst’s Disclosure: I am/we are long ZAGG. 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.