A Couple of Classic Value Traps

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

Don't always buy low, sometimes even beaten up stocks deserve to go lower.

As investors, we are always searching for undervalued stocks beaten up unfairly by the Street. However, the old adage of buy low, sell high, may get investors into trouble when multiple contraction starts to set in. Earlier this month, I stumbled upon a couple, once hyped, tech stocks whom as of late have seen weakness. Let's take a second and review another old investing adage, the value trap.

The basic definition of a value trap is any stock which appears to be trading at undervalued levels but unfortunately never improves due to slowing growth. I would like to highlight Skullcandy (NASDAQ: SKUL) and ZAGG (NASDAQ: ZAGG) as two potential value traps investors should consider carefully before entering a long position.

Broken buds

Let's first take a look at Skullcandy, an audio technology company which hit the market just a couple years ago. This highly anticipated IPO was welcomed to the market with open arms, priced at $20 per share, above the expected range of $17-$19 per share. Well, if you bought the IPO, you're hurting pretty bad, shares have moved lower by roughly 70%.

Trading at 8 times earnings, you may be inclined to pick up some shares at historically low valuations, right? Hold on, last month, the company reported a dismal quarter where it announced declining revenue, margins, and earnings. Skullcandy lost $9.8 million as revenue declined 30% and margins declined 3.6%. Management remained positive amid these struggles, the company is looking to change its reputation by upping its price point.

Currently, the company is known for a selling primarily inexpensive earbuds which are very similar to the technology available on eBay for only $0.99. Going forward, the company is looking to focus on higher priced products to stop the growth slowdown. Unfortunately, management doesn't realize Skullcandy isn't Bose, without a reputation for high quality merchandise, and I fully expect these products will see little success. Analysts are expecting the company to see earnings decline by 85% over the next year. I hate to see companies look to solve their problems by changing business models, it usually aggravates the problem. 

Damaged goods

Next up, ZAGG, a company which designs an array of consumer electronic accessories with a focus on mobile. ZAGG shareholders have had a tough couple of years, shares are down 27% this year alone. Trading at 6 times earnings, you may be inclined to pick up some shares at historically low valuations over here as well.

The company reported an awful quarter last month where it announced declining revenue, margins, and earnings. I'm not trying to be repetitive, but there are many similarities. Earnings declined 80% as a result of global weakness combined with slipping margins. 

ZAGG, like Skullcandy, operates in a very competitive market. The company competes with many competitors including Lifeproof, Otterbox, and an assortment of Chinese manufactures. I'm not sure ZAGG can ever maintain strong growth again. The thesis behind ZAGG is cemented in mobile technology growth. As we see this growth, new competitors will continue to enter the market, driving out economic gains over the long run. Additionally, new competitors like Lifeproof have simplified the protection process. Why buy a ZAGG case and screen protector when you can get the full package from Otterbox or Lifeproof?

Throughout the company's history, sales have been tied directly with the launch of additional Apple (NASDAQ: AAPL) products. ZAGG derives the majority of its revenue from the Apple customer which bodes well when Apple is innovating. As of late, however, Apple's products aren't seeing the same growth as before, in turn slowing ZAGG's sales. If there is a bright spot for ZAGG, it's that the Apple plans to launch a new iPhone later this year. Some analysts are expecting a lower priced iPhone to help expand Apple's customer base. The cheaper alternative is just speculation at this point, however, the option may be very beneficial for the company.

Apple's popularity in key developing markets, such as China and India, has been much lower than in the United States. If you give a greater number of consumers access to the ecosystem, in the future these consumers should have a greater sense of loyalty towards the brand. As incomes rise in these markets, I would expect consumers trade up to Apple's full ecosystem. At this point, the risk-reward is very good for investors.

The company is trading at 10 times forward earnings while paying investors a 3% dividend yield. Rising interest rates additionally bode well for Apple's dividend yield. As of the most recent quarter, Apple held $144.7 billion in interest generating capital, roughly 33% of the current market cap. If interest rates rise a measly 1%, the company would generate an additional $1.45 billion in returnable capital.

If a more affordable iPhone is indeed released, I feel ZAGG would stand in a decent position to capture this consumer as its basic products do tend to hit the lower end of the range. I would rather invest with Apple, however, as the company seems to be expanding into previously untouched industries such as mobile commerce.  

Foolish conclusion 

Both Skullcandy and ZAGG look inexpensive, but when you consider the terrible growth projections, it appears this may be a classic value trap. Skullcandy offers low quality products for relatively low prices, and I find it hard to believe consumers will choose Skullcandy should the company raise price drastically. ZAGG is no longer the best manufacturer in the industry, and don't expect anything to change.

When looking to invest in technology, pick companies with proprietary goods and strong pricing power. Apple fits this bill and at these levels, it is far greater value. Should Apple launch a lower priced, entry level iPhone, I would expect consumers in developing mobile markets to respond positively. 

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Nathaniel Matherson has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and SKULLCANDY INC. 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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