We believe that ZAGG is a little powder keg with a potential return of 60-80¢ on the dollar invested over the next 6-9 months.

The Company

ZAGG designs, manufactures and distributes branded protective coverings, audio accessories and power solutions for consumer electronic and hand-held devices. ZAGG's primary product is the popular invisibleSHIELD ("IS") and is based on a technology to which ZAGG has exclusive worldwide rights from its materials source. ZAGG sells the IS and other products through its website, major retailers including Best Buy, Radio Shack and Staples, mall kiosks and recently announced a carrier exclusive distribution agreement with AT&T for the iPhone4.

ZAGG was founded in '05 to sell screen protection products based on military grade film. The film had been developed to coat the propeller blades of Apaches and Blackhawks operating in the Mid-East. The expensive graphite blades were being shredded by sand and debris in the desert theater. The IS is a malleable polyurethane with some regenerative qualities. Here are some links that can give you a good idea for the invisibleSHIELD:

iPhone4 Scratch Test

iPhone4 "Death Grip" issue solved by invisibleShield

Why the Stock is Cheap

From its launch as a public company in 2007 ZAGG had grown sales and earnings rapidly via their website. When ZAGG launched product at Best Buy the top line exploded. However, by the first quarter of 2010 there were no large product launches (e.g. new iPhones, etc.) and there were no large retail customer additions. Therefore, while ZAGG grew 8.5% year over year, revenue experienced a sequential decline; in-line with seasonality typically associated with discretionary consumer products. Believing the growth story was broken investors sold shares down hard.  We believe however, that the growth story is in-tact and overlooked providing a significant near-term opportunity.

New Handset Launches

Since the end of the first quarter, the iPhone4, iPad and HTC Droid "Incredible" have been introduced. We believe that the street is significantly underestimating the positive impact on ZAGG. We have been following zagg.com and found that the number of website hits and unique visitors has literally exploded in the past three months (visits increased roughly 4x y/y in June):

http://siteanalytics.compete.com/zagg.com/

                                Uniques Visits

5/31/2009             160.3      205.5

6/30/2009             156.0      215.6

7/31/2009             151.8      194.5

8/31/2009             114.4      143.3

9/30/2009             112.3      146.8

10/31/2009           117.4      164.4

11/30/2009           153.3      224.2

12/31/2009           223.9      335.8

1/31/2010             149.6      240.1

2/28/2010             128.7      202.4

3/31/2010             142.7      320.8

4/30/2010             308.4      571.9

5/31/2010             356.1      606.9

6/30/2010             482.8      809.6

We take this as strong evidence that ZAGG will experience a significant positive impact just from these new launches. Additionally, web sales are ZAGG's highest margin business.

New Retailers Announced

Staples - 5/10/2010

ZAGG announced that they've expanded distribution of invisibleSHIELD into all of Staples' 1,550 stores as Staples focuses on expanding their dedicated wireless accessories areas within their store base. June 1st was the target date to begin rolling out. ZAGG began with a 30 store trial and in a short period were given the opportunity to be in all Staples stores and replace existing similar products.

Staples is a sell-through arrangement, unlike Best Buy, but gives ZAGG the opportunity to manage merchandising at the store level which, as you'll see in the case of Best Buy and AT&T, can lead to better results more quickly.

AT&T - 6/28/2010

ZAGG announced a short-term (we believe 3-6 months) carrier exclusive with AT&T stores nationwide for the IS on iPhone4 handsets from Apple, Inc. For many quarters management mentioned carriers as the holy grail with substantial retail store networks and handset sales volume. Initially holding carriers back was the method by which the IS is applied: by spraying a solution and placing the protective cover. Carriers were worried about voiding the phone warranties despite ZAGG having sold over 7m units with no reported problems. ZAGG came up with invisibleSHIELD "Dry" to address concerns and signed AT&T.

In speaking with management it appears that AT&T decided to go with ZAGG 13 days before the iPhone4 rollout. AT&T placed an initial order for an amount they figured would be one month's supply despite ZAGG management's advice that they order way more. AT&T sold out of the IS across their store base in 4 days and contacted ZAGG to reorder.

Existing Large Retailers

Best Buy

Best Buy represents roughly 1/3 of ZAGG's sales. It took ZAGG over a year to get into Best Buy and launched in just a handful of US stores in August, 2008. The pushback from Best Buy was that ZAGG was asking too much. ZAGG wanted the IS to retail at $14.99 and Best Buy was already selling a screen protector for $12.99. What's more, the install charge was $8-$11 to have it put on in-store. ZAGG  insisted on their price point. Data that came back over the next 3-4 caused Best Buy to roll out to all 1,100 stores and increase the price to $21.99 for the screen only.

The invisibleSHIELD is now the best selling mobile handset accessory at Best Buy next to power adapters. If you have a chance to go into a Best Buy you will see how much space throughout the entire store is dedicated to the invisibleSHIELD.

Carphone Warehouse

Carphone Warehouse in the UK / Europe is one of the largest latent opportunities within ZAGG's portfolio of customers. Carphone Warehouse carries the invisibleSHIELD but barely sells any of them. Interestingly however, Carphone Warehouse is 50% owned by Best Buy and does 4x the handset volume. Just as they spent time educating Best Buy's management and associates on the IS opportunity, ZAGG's management recently spent a week in the UK educating Carphone Warehouse operatives with the results from Best Buy US in-hand. We believe that external and internal champions of the invisibleSHIELD at Carphone Warehouse could cause this to be a very large opportunity.

Radio Shack

ZAGG is in 6,000+ Radio Shack stores throughout the US. They've been in these stores for 3/4 of a year but the growth has been lackluster. Management believes that this is a training issue as well and plan to address this in the coming months.

Others

Other retailers include Cricket Wireless, CinciBell, college bookstores, Mac Stores and online retailers.

Other Positives

We believe the trend toward Smartphone adoption works in ZAGG's favor as new handsets have larger and touch sensitive screens which are fragile. Also, we believe that the invisibleSHIELD becomes somewhat of an annuity as satisfied customers continually upgrade and switch phones. Further, international growth potential is significant for ZAGG as the majority of mobile handsets are sold outside of the US while the majority of ZAGG's current sales are within the US.

Management

We believe that management's execution on the business side has been excellent. ZAGG has been able to perfect and ship a new SKU for a new handset in as little as a day. They've been able to ramp significant volumes at new retail customers in less than a week. Solid reliability and execution are a significant competitive advantage in this market; especially when dealing with national and multi-national distribution channels.   

Financials and Valuation

ZAGG's sales are broken down roughly by the following: Indirect (Retailers and Distributors) are 60%, Website is 25%, Kiosk is 10% and Shipping & Handling (for website) is 5%. We figure that ZAGG's product cost is $2.50 - $3.00 per unit and their blended ASP is between $8 and $10 which will decline by 10-15% as the model shifts more heavily toward indirect sales. This excludes S&H which typically accounts for almost 1/3 of overall COGS and is a money loser.

ZAGG has a $67m market cap and 62m enterprise value. We conservatively model 2010 sales of $51m; slightly above management's guidance which excluded the recent AT&T announcement. We expect 2010 gross margins to decline 420bps to 53% and ultimately bottom-out at 50%. Meanwhile, we expect operating margins to grow to the high teens for the full-year and remain in that range going forward.

We believe shares of ZAGG are worth $4.50 based on conservative assumptions.

As ZAGG is an early / mid-stage growth story, we put a 15x multiple on next year's EPS of 31¢ = $4.65, a discount to a loose comp group of accessories companies and in-line with their historical multiple. We also look at a 10-year DCF assuming a 7.5% CAGR (most of the growth coming in front years), op margin averaging 17%, 3% terminal growth and 11.5% WACC which gets us to $4.56. Finally, we believe a business growing sales at low double digits with a high-teens op margin over the next couple of years should command a roughly 2x EV/S multiple putting the value at $4.81. We average these together and give it a haircut. As such, we're comfortable with a $4.50 price target and believe there's plenty of cushion for upside from there.

Concerns

While ZAGG has developed other products and signed additional customers, it's virtually a one product, one customer company until management can really drive diversification. New customer announcements are a big step in the right direction, however. Also, ZAGG is attempting to get a utility patent for IS. It's been 5 years. While the technology is less important than the strength of the Zagg brand, this could be seen as a weakness and presents headline risk if the patent is rejected. In addition, ZAGG's growth strategy outside of IS is questionable. ZAGG introduced several other mobile accessories (Budz, Sparq) which are in line with their core market. ZAGG is however, introducing the ZaggBox which is a $999 price point media aggregator which makes no sense whatsoever but will worst case break even. Further, management is new to running a public company and whiffed a couple of quarters taking down guidance. Street will likely discount until performance consistently meets/exceeds guidance. Finally, as the retail channel becomes a larger part of ZAGG's overall sales, gross margins will likely come down. We believe however, that ZAGG can realize significant scale on their operating expenses as sales ramp going forward.

Conclusion

ZAGG is a small, overlooked growth story. Despite several positive developments over the past few months, the stock really hasn't moved. We believe that the website hits are a harbinger for good things to come in the next few quarters and that ZAGG's opportunity just in their portfolio of announced customers is enough to drive significant growth in the near to mid-term. While third quarter may or may not be a blowout (as many of the new announcements wont hit until late in the quarter) we believe that full-year numbers will have to increase. 

Near-Term

-Possibly a beat in the second quarter. If not, at least increased guidance for the full year (currently guidance calls for 30% full-year growth but did not include the AT&T deal or significant expectations for the iPhone4).

-Early results from Staples

Mid-Term

-Solid numbers for the second half of the year.

-AT&T exclusive coming off and potential new carrier partners announced

-Carphone Warehouse and RSH ramping up sell-through