ZAGG is Slipping Off the Shoulders of Giants

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There was a time when ZAGG’s (NASDAQ: ZAGG) simple business of protective cases and skins for mobile devices seemed brilliant. ZAGG rode on the coattails of the success of Apple (NASDAQ: AAPL) and Google (NASDAQ: GOOG) Android devices, while peddling high-margin protective gear and accessories.

Although the South Salt Lake, Utah-based company started out creating thin protective coverings, branded as invisibleSHIELDs, it began offering headphones in 2008, followed by a hybrid case that includes a Bluetooth keyboard in 2011. That same year, ZAGG acquired its industry peer iFrogz, which also sell cases and headphones.

From its market debut in November 2009 to its all-time high of $16 in July 2011, it was smooth sailing for ZAGG.

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But then the reality of rising competition and declining margins started to set in, and things fell apart quickly. Profit margin started to slide in the second half of 2010 into the holiday season, and operating margin began dropping at the start of 2011. This was a direct result of ZAGG lowering its prices to remain competitive in an increasingly crowded market.

For those investors who didn’t read the writing on the wall, revenue growth started outpacing earnings growth by the middle of the year. What happened next wasn’t pretty.

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Although ZAGG’s revenue continues to rise, its margins are still plunging, to the point that profit margins are barely above the breakeven point. Over the past twelve months, revenue has risen 14.7% but diluted earnings per share have declined 37.8%. If this trend continues, the company will soon be unprofitable. Is there any hope left for this former darling of Wall Street?

We make SHIELDs, not barriers...

The simplicity of ZAGG’s business is also its greatest weakness. ZAGG has absolutely no competitive barriers to keep its competitors at bay. As long as Apple and Google mobile devices are popular, then nothing will deter other companies from producing similar protective products.

That weakness has allowed companies such as OtterBox, which produces cases for most iOS and Android smartphones and tablets, to easily steal market share from ZAGG. Research firm NPD Group ranks OtterBox as the number one smartphone case maker in America, based on February 2013 figures.

Another competitor, LifeProof, has gone one step further and manufactured waterproof, snow-proof and dirt-proof cases for mobile devices, making them an ideal choice for outdoor activities.

In the lower-end market, consumers can easily find cheaper alternative skins and cases online on Amazon and eBay, often imported from Asia. Meanwhile, higher-end consumers with more discerning tastes are buying more fashionable tablet and smartphone cases from affordable luxury brands Coach and Michael Kors.

Meanwhile, the headphone market is an extremely crowded one, where ZAGG runs into another cluster of competitors, such as Sony, Panasonic, Philips and Apple. Even Skullcandy, which creates large, fashionable headphones, has chomped into ZAGG’s share of the audio market.

Tougher phones and tablets

To top off all this misery in its two main markets, ZAGG faces technological advances from Corning (NYSE: GLW) that could render its invisibleSHIELD protective film completely obsolete.

Corning is the creator of Gorilla Glass, the tough scratch-proof glass that covers most modern smartphones and tablets. A second generation, Gorilla Glass 2, was released last year, and is now considered the industry standard. Last year, Corning reported that more than a billion mobile devices worldwide were protected by Gorilla Glass.

What’s more, Corning is creating a bendable glass called Willow Glass, which many analysts believe will be used in next-generation wearable technology products. Corning has already shipped samples of Willow Glass to smartphone, tablet and television manufacturers to see how the product can be implemented in new products.

In my opinion, the increasing toughness of Corning’s Gorilla Glass will cause consumers to completely ignore ZAGG’s products. However, they could still be interested in buying novelty cases as a fashion statement, and not for protective purposes.

I also believe that market aesthetics will change, especially considering the recent rumors of a transparent, scratch-resistant iPhone 6. Skins and cases might just end up looking tacky on these tough, futuristic devices.

Desperate times call for desperate measures

With its flagship products getting squeezed out of their primary market, and technological innovations threatening to break its core business model, what does ZAGG do? It gets very, very desperate.

As I noted earlier, ZAGG’s solution to keep up with its competitors is to lower prices. In other words, it hopes that a prolonged pricing war will halt the advance of its rivals, allowing it to grow revenue at the expense of declining margins and profits. That’s a very risky tactic, that runs the risk of bleeding its cash reserves and free cash flow dry.

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From the chart, we can see that ZAGG’s expenses have risen 138.6% year-on-year since its market debut, but free cash flow has declined 25.8%.

Looking forward, ZAGG’s current strategies point to lower margins and negative earnings down the road. The company has an aggressive reseller and affiliate program, which allows merchants to sell its products at a 20% discount. The reseller program does not have clear eligibility requirements and is open to anyone. That means anyone could buy these products at the steep discount and simply set up an eBay shop.

This is a reckless strategy that suggests that ZAGG desperately wants to grow its market share, whatever the cost to its margins.

The Foolish Bottom Line

Although ZAGG appears to be a fundamentally cheap stock, trading at 5.5 times forward earnings with a 5-year PEG ratio of 0.32, don’t be fooled. This is a company facing an existential crisis. More innovative competitors will continue to chip away at its market share, and technological advances such as Gorilla Glass and transparent iPhones may render its core business useless.

For now, lower demand, lower margins and possibly negative earnings all await ZAGG investors in 2013. I guess that’s the price to pay for riding high off the success of heavy lifting innovators such as Apple and Google.

ZAGG would be wise to remember the words of Sir Isaac Newton, “If I have seen further, it is by standing on the shoulders of giants.”

The problem is that those shoulders are now getting awfully crowded, and the giants are starting to sprint. That means ZAGG is about to get pushed off - and it’s a long, long way down.

Leo Sun owns shares of Apple. The Motley Fool recommends Apple, Corning, and Google. The Motley Fool owns shares of Apple, Corning, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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