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Inventory Days Analysis
60.0 50.0 40.0 30.0 20.0 10.0 0 10.3
A/R Days Analysis
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
33.4 24.8 26.1 15.0 9.2
20.3 15.6 21.5
Finished Goods DoH
($s in millions) Inventory Days Analysis Raw Materials Inventory Finished Goods Inventory T otal Inventory Finished Goods, % of T otal Inventory Finished Goods DoH T otal Inventory DoH A/R Days Analysis BBY Revenue BBY % of T otal Revenue Non-BBY Revenue Non-BBY % of T otal Revenue Total Revenue % YoY Growth Gross A/R Allowance for Doubtful Accounts T otal Net A/R BBY % of T otal A/R Beginning BBY A/R Increase / (Decrease) BBY A/R Ending BBY A/R BBY A/R Days Ending Non-BBY A/R Non-BBY A/R Days
Finished Goods, % of Total Inventory
BBY A/R Days
Non-BBY A/R Days
Dec-31-2008 Mar-31-2009 Jun-30-2009 Sep-30-2009 Dec-31-2009 Mar-31-2010 Jun-30-2010 Sep-30-2010 Dec-31-2010 Mar-31-2011 $1.709 0.205 $1.913 11% 10.3 47.0 $2.750 0.379 $3.129 12% 9.2 79.2 $2.543 1.636 $4.179 39% 24.8 89.9 $2.531 0.957 $3.488 27% 26.1 77.2 $2.917 0.779 $3.696 21% 15.0 62.2 $3.522 0.927 $4.449 21% 20.3 96.7 $4.546 1.658 $6.204 27% 15.6 64.3 $7.029 3.761 $10.790 35% 21.5 67.4 $10.022 7.925 $17.947 44% 33.4 82.2 $12.446 8.747 $21.193 41% 56.9 133.6
$1.759 24% $5.571 76% $7.331 249% $3.813 (0.219) $3.594
$2.589 32% $5.502 68% $8.091 184% $4.547 (0.279) $4.268
$3.225 35% $5.990 65% $9.215 236% $5.368 (0.279) $5.088
$3.697 38% $6.032 62% $9.729 42% $6.184 (0.306) $5.878
$3.989 35% $7.408 65% $11.398 55% $6.136 (0.685) $5.451 67%
$2.984 34% $5.792 66% $8.776 8% $5.300 (0.685) $4.615 69% $3.652 (0.468) 3.184 104.3 $1.431 25.4
$5.873 39% $9.186 61% $15.059 63% $9.906 (0.685) $9.221 71% $3.184 3.362 6.547 75.4 $2.674 20.3
$9.683 42% $13.372 58% $23.056 137% $14.829 (0.685) $14.144 74% $6.547 3.920 10.467 79.9 $3.677 21.6
$12.579 43% $16.674 57% $29.253 157% $18.573 (0.904) $17.669 64% $10.467 0.841 11.308 78.8 $6.361 27.4
$7.284 27% $19.693 73% $26.976 207% $17.107 (0.904) $16.203 57% $11.308 (2.072) 9.235 128.3 $6.967 30.8
Approach: There are two primary concerns investors have over ZAGG‟s quality of earnings: its accounting for accounts receivable and inventory. Because the company‟s cash flow growth has been non-existent while its earnings have grown from $2MM to $10MM since 2008, all of its supposed earnings have piled into accounts receivable and inventory. In my analysis, I have attempted to analyze these balance sheet items further to assess the quality of these earnings. Inventory First, I looked at the composition of inventory over time because any major shift towards finished goods or raw materials should be attributable to seasonal factors (i.e. increasing finished goods during periods of peak demand). While ZAGG has historically built up finished goods in Q2 and Q3 in order to meet customer demand leading up to the holidays, there was no decline in Q4 2010 and Q1 2011 levels remain elevated. The company says it receives orders from its retailers 2-3 weeks before delivery so this would suggest overstocking of finished goods inventory that ZAGG was unable to unload to customers.
ZAGG Incorporated (“ZAGG”): Earnings Quality Analysis Some of this may be attributable to ZAGG‟s new relationship with Staples, which began in Q1 2010. As part of this arrangement, ZAGG consigns its product to Staples and maintains ownership over that inventory until the product is sold. Regardless of whether this trend is attributable to ZAGG‟s sale terms with Staples, it raises significant risk of future writedowns due to the high obsolescence of these products and upcoming new product launches which may render this inventory worthless. My analysis would suggest that at least $4MM-$5MM of its finished goods inventory is worthless and there is likely significant additional obsolescence in raw materials as the recent build up does not appear justified by ZAGG‟s revenue growth. Accounts Receivable The other area of concern is ZAGG‟s treatment of accounts receivable. To get a better sense for the payment terms ZAGG offers its large retail clients like Best Buy, I attempted to isolate Buy Buy‟s A/R and revenue from ZAGG‟s website, mall kiosk and shipping A/R and revenue because collection trends are very different for these sales channels. ZAGG provides sufficient information in its filings and earnings calls to do this although I had to make several assumptions. The company first started reporting A/R concentrations on a quarterly basis on 9/30/10 so I had to straightline the difference from 12/31/09 to come up with an estimate for 3/31/10 and 6/30/10. Also, the 3/31/11 financial statements reported A/R concentrations for ZAGG‟s top two customers in the aggregate rather than breaking out the detail between Best Buy and Target (see „Financial Statement Footnotes‟ below). I assumed Target represented a flat percentage quarter over quarter although my A/R days calculation was not very sensitive to this assumption. This analysis is important because ZAGG‟s non-retail A/R days are very low so looking at the aggregate collection trends for the company is misleading and masks the disturbing underlying collection trends at Best Buy, which are only getting more and more visible and disturbing with each passing quarter. According to my calculation, ZAGG‟s A/R days with Best Buy reached 128 days in Q1 2011, calling into question whether the company is recognizing revenue appropriately. “Accounts receivable for the quarter (Q4 2010) were $17.7 million, with 64% of the receivables related to one customer and 17% related to another customer. We are very comfortable with the creditworthiness of these customers…And, the second quarter is in a new customer but payments are being received in line with the terms that we have agreed to.” – Robert Pedersen (CEO), Q4 2010 Earnings Call ZAGG has made conflicting statements regarding its payment terms with Best Buy in the past (http://www.sec.gov/Archives/edgar/data/1296205/000101376210002947/form8k.htm). The statement above indicates that these extremely long payment terms are consistent with the terms ZAGG has agreed to. Mr. Pedersen notes that these customers are creditworthy but the issue is not whether these customers are creditworthy but whether they have the obligation to pay ZAGG for its product. If my estimates are even approximately accurate, ZAGG is failing to meet its revenue recognition requirements as described in the company‟s 10-K because collectability cannot be “reasonable assured”. I believe the company will be forced to write-down approximately $5MM-$6MM of its accounts receivable but even more importantly, restate prior financial statements to reflect a company that is growing far slower than it has been claiming to the investment community. Other Background Information While we continue to wait for more detail on the financing agreement entered into by ZAGG to execute the iFrogz acquisition, it is worth highlighting a couple details from its previous credit facility. ZAGG entered a Loan Agreement dated March 7, 2011 which provided for revolving loans up to $20MM but was limited by a borrowing base up to 80% of the company‟s eligible accounts receivable and 50% of eligible inventory. These terms are typical for a financing of this kind. In defining „eligibility‟, U.S. Bank excluded the following as eligible collateral: “Receivables that have been invoiced by Borrower and that are not more than sixty (60) days past due or not more than ninety (90) days past invoice date (except in the instance in which Best Buy is the account debtor, in which event the ninety (90) days past invoice benchmark shall be increased to one hundred twenty (120) days past invoice date).” While this loan is no longer effective, it is worth noting that a significant amount of ZAGG‟s accounts receivables would not have been considered eligible under its previous loan agreement. There is some seasonality in the business which
ZAGG Incorporated (“ZAGG”): Earnings Quality Analysis results in elevated A/R days in Q1, but nonetheless, I think this exclusion provides further evidence that collections of a meaningful portion of ZAGG‟s A/R cannot be reasonably assured as they were not recognized as valid collateral in ZAGG‟s Loan Agreement. Additionally, U.S. Bank reduced eligible inventories by an obsolescence reserve of $1.0MM and this reserve is above and beyond the 50% haircut already included in the definition of eligible inventory. There is no such obsolescence reserve anywhere on ZAGG‟s financial statements. Conclusion: I believe that within the next two quarters ZAGG will be forced to write off accounts receivable and inventory in substantial numbers. I suspect inventory may be overstated by $6MM-$8MM and accounts receivable may be overstated by $5MM-$6MM which would wipe out a significant portion of the company‟s historical earnings. Lastly, I think required changes to ZAGG‟s revenue recognition policies will present a significantly slower growth company with gross margins in the mid-30% and mid to high single digit operating margins. I believe a revaluation will occur which will drive the stock down to approximately $3-$5 per share. Financial Statement Footnotes: 12/31/09 Financials At December 31, 2009, approximately 67% of the balance of accounts receivable was due from one customer For the year ended December 31, 2009, one customer accounted for 35% of the Company‟s sales. For the year ended December 31, 2008, one customer accounted for 12% of the Company‟s sales 3/31/10 Financials No mention of A/R concentration; for the purposes of this analysis, I straightlined the difference between 12/31/09 and 9/30/10 For the three months ended March 31, 2010, Best Buy alone represented 34% of our revenue 6/30/10 Financials No mention of A/R concentration; for the purposes of this analysis, I straightlined the difference between 12/31/09 and 9/30/10 For the three months ended June 30, 2010, Best Buy alone represented 39% of our revenue 9/30/10 Financials One customer accounted for 74% and 52% of accounts receivable at September 30, 2010 and December 31, 2009, respectively. [Note that this is inconsistent with the 12/31/09 footnote which indicates 67% of accounts receivable was due from one customer, not 52%] The Company had one customer that accounted for 42% and 38% of revenue for the three months ended September 30, 2010 and 2009, respectively and 41% and 36% of revenue for the nine months ended September 30, 2010 and 2009, respectively. 12/31/10 Financials At December 31, 2010, approximately 64% and 17% of the balance of accounts receivable was due from two customers. At December 31, 2009, approximately 67%, of the balance of accounts receivable was due from one customer. [This is consistent with the 12/31/09 financials but inconsistent with the 9/30/10 financials] For the years ended December 31, 2010, 2009, and 2008, one customer accounted for 41%, 35%, and 12% of the Company‟s sales. 3/31/11 Financials At March 31, 2011, and December 31, 2010, approximately 74% and 64%, respectively, of the balance of accounts receivable was due from two customers [This statement is inconsistent with the 12/31/10 note which states that that top two customers represented 81% of receivables in the aggregate (64% + 17%). This typo could be interpreted one of two ways, either (i) these figures represent receivables just from the top customer (not top two), or (ii) it should read '74% and 81%'. On the Q1 earnings call, CEO Pedersen made
ZAGG Incorporated (“ZAGG”): Earnings Quality Analysis a statement suggesting the second alternative is accurate and the top two customers (BBY and TGT) represented 74% of receivables at 3/31/11. For the purposes of the analysis above, I have assumed the TGT percentage remained flat at 17% and therefore BBY represented 57% of receivables but had TGT grown to 20% of sales, A/R days would still have been 125.] One customer accounted for 27% and another customer accounted for 11% of the Company‟s sales.
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