ZAGG: Is it in the covers business, or covering up its real business?

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Next month, August 2011, marks the 10th anniversary of Citron Research researching and publishing on the topic of stock fraud.  China aside, Citron has uncovered and published more actionable stories of stock fraud in the US markets among domestic companies than any other research journal or column online. 

 

   Lie with Dogs, Get Fleas

What really drew Citron's attention to ZAGG was the 10-K of 3/25/2011, in which Randall Hales is appointed head of ZAGG's audit committee.  This is a move so egregious it absolutely made our eyes pop out.

Indeed, Mr. Hales is well known to Citron… 

 

Introducing Randall Hales, audit committee chairman of ZAGG

Mr. Hales is the former CEO, President, and Chairman of the board of First Scientific.  The claim to fame of First Scientific is that after the post-September 11 anthrax scare, (FSFI) claimed to be in the middle of testing “an anti-anthrax bacterial crème”. 

http://www.stockpatrol.com/article/key/anthrax2

What makes the anti-anthrax scam even crazier is that according to the SEC the company’s principal operating subsidiary was sold at foreclosure just six months before they even pulled the anthrax stunt…. and it was never disclosed.

This is the chosen new head of ZAGG's audit committee? 

In uncovering fraud, one of our key indicators has always been the pedigree and credibility of management.   It is our study of management that leads us to believe that ZAGG is committing fraud on the investing public.  Go ahead and sue, ZAGG, you will lose.   We continue our discussion of management credibility below…but its not off to a very promising start…

 

ZAGG is presenting an intentionally distorted financial picture of its current business, playing word games while flirting with outright fraud.  Citron predicts that ZAGG will not experience the explosive growth that management and the analysts project for the future, and the retail investors piling in now as its enterprise value approaches $500 million will take huge losses as a consequence. 

 

In the first Citron report on ZAGG, we focused on cash flows, pointing out how real cash flow has been declining while inventory has been growing disproportionately to reported revenues.   These metrics come from ZAGG’s reported financials to date, revealing the company is not generating cash, but rather burning it in increasing amounts.  Their investment premise, parroted uncritically by analysts, projects a glowing picture of the future.  But this picture is directly contradicted by the competitive factors inherent in ZAGG’s core business.   

 

The heart of the issue therefore goes to management credibility.   Therefore this report covers three main points:

 

  • Reliability of reported revenues in ZAGG’s core business, in light of adverse competitive factors
  • Analyst track record, and whether they are worthy of investors’ trust in their recommendations
  • Management credibility

   ZAGG’s revenues:  Can you take them to the bank ?

ZAGG’s protective covers for cell phones and iPads are sold through a variety of channels, but the largest one by far is Best Buy.   Any Citron reader can in fact wander into their local Best Buy and observe a whole rack of SKU’s for ZAGG’s covers for dozens of cell phone models.  These include hot selling models as well as dozens of “last year’s models” that have gone dormant, which is simply the nature of the business.

 

If you ask a sales rep, you’ll find out, unsurprisingly, that ZAGG sells some products for the current “hot models”, and the rest are dead. 

 

Analysts and skeptics have focused on the status of ZAGG’s revenues because of the huge number of “dead” SKU’s on display at Best Buy.  Big box retailers are notorious for highly one-sided, vendor adverse return policies for inventory they carry.  For example, Staples has an “open return” policy on ZAGG’s products.  Yet ZAGG has steadfastly insisted that Best Buy purchases are final and cannot be returned.  This would imply vendor market power for ZAGG which is available only to Apple, and would be highly unusual for a gadget accessory vendor. 

 

Speaking of Apple, Citron has no doubt that ZAGG is selling some amount of covers for the currently hot model: iPhone 2, plus accessories for the iPad.   But it is clear from industry commentary about Apple that it is selling huge quantities of its own cover, and there are literally hundreds of competitors for iPhone covers.

http://blogs.barrons.com/techtraderdaily/2011/07/11/apple-bachman-ups-ipad-estimates-those-covers-make-money-too/?mod=BOLBlog

 

Comparative data points keep popping up to increase the concern.   For example, just last week, on 7/6, Skullcandy filed their S-1 to go public.  As most ZAGG investors know, Skullcandy is “the brand” in the headphone and phone case market.   (Recent ZAGG acquisition Ifrogz can be considered a generic competitor to Skullcandy.)  In Skullcandy’s S-1, we read an interesting disclosure:

 

"……….We have executed an open return program with a major retailer allowing for an unlimited amount of returns. Estimates for these items are based on actual experience and are recorded as a reduction of revenue at the time of recognition or when circumstances change resulting in a change in estimated returns."

 

It is the opinion of Citron that Skullcandy sells its products subject to an open return policy because it is simply required to do business with the big box stores.

 

This relationship description is consistent with the experience of numerous product vendors’ when dealing with major chain retailers.   Yet ZAGG claimed it could sell the same category of products to Best Buy without any return contingency….until they were forced to insert some more wiggle words. 

 

Has ZAGG really orchestrated a better deal at the major retailers than Skullcandy, a deal unique in all the world of big box retail?  Or is management not being forthright about its terms?  Remember, this issue is large enough to trigger an accounting restatement, and/or to wipe out all of ZAGG’s reported profits.

 

Citron advises that investors assess the risks here based on the company’s own words (from their 11/10/2010 conf call) :

 

http://www.sec.gov/Archives/edgar/data/1296205/000101376210002774/ex993.htm

 

“Q:  Okay and then just one last question and I don’t want to be rude here or anything but would you please address one more time your contract with Best Buy and what their opportunity is to return product to you or not.  Could you lay that out on the table one more time?

 

Brandon O’Brien – ZAGG Incorporated – CFO

Sure, as we have reiterated in the past.  Our contract with Best Buy does not allow for any type of return.  We do not have the ability to send products to Best Buy more than they order.  So there is no way for us to stuff that channel.  We are fulfilling the orders that Best Buy sends to us on a weekly basis.  They get that product.  That product is theirs then and there’s no return rights on that.

 

Just three weeks later, the company was obliged to issue an 8-K, backpedaling on that claim, having gotten so much flak that the claim simply wasn’t credible.

 

http://www.sec.gov/Archives/edgar/data/1296205/000101376210002947/form8k.htm

 

On November 9, 2010, the Company conducted its Third Quarter Earnings conference call.  Robert G. Pedersen II, the Company’s Chief Executive Officer, and Brandon T. O’Brien, the Company’s Chief Financial Officer, participated in the call on behalf of the Company.  During the question and answer portion of the conference call, Mr. O’Brien was asked questions about Best Buy’s right to return products sold by the Company to Best Buy.  In response, Mr. O’Brien stated that the Best Buy contract did not allow Best Buy to return products to the Company.  As clarification to Mr. O’Brien’s statement, the Company notes that Best Buy can return products to the Company under limited circumstances, including where products are defective or for other similar customary reasons.

 

That wasn’t the only forced “clarification” either.  In the same release, they were forced to “clarify” statements made at the Merriman Investor Summit Conference, reducing the claim of “millions of dollars” of orders to just $1.5 million.

Merriman Investor Summit Comments

On November 15, 2010, Robert G. Pedersen II, the Company’s Chief Executive Officer, and Brandon T. O’Brien, the Company Chief Financial Officer, participated in the Merriman Investor Summit 2010 in New York, New York.  Mr. Pedersen gave a presentation regarding the Company and its prospects.  In the course of the presentation, Mr. Pedersen discussed the introduction of a new product, the ZAGGmate, for protection of the iPad device.  Mr. Pedersen described the ZAGGmate product and its features, its anticipated introduction date and pricing.  Mr. Pedersen further stated that the Company had received orders for “tens of thousands” of the ZAGGmate product and that companies “like a Best Buy” had ordered “millions of dollars” of the ZAGGmate product.  It has now come to the attention of the Company that some participants at the Merriman Investor Summit 2010 and others who have listened to a recording of the conference might have understood Mr. Pedersen to say that Best Buy had ordered “millions of dollars” of the ZAGGmate product.  As clarification to Mr. Pedersen’s remarks, the Company notes that as of November 15, 2010 it had received initial stocking orders for $1,500,000 of the ZAGGmate product from large, national indirect channel partners.  In addition, as of November 15, 2010 the Company had also received ZAGGmate product orders from other retail outlets, including on-line retailers.

 

The company has been very evasive about the details of their relationship with Best Buy.  The funny thing is that Citron does not fundamentally disagree with the company, we believe that Best Buy only has the right to return product under certain conditions.   So whether its a matter of credits against future orders, expense deferred forward, or whatever, there is a shell game being played in here with loose language.  If ZAGG really wanted to clarify this question, they should have made their entire sales relationship with Best Buy transparent.  It is Citron’s belief that they can’t – it would force them into a financial restatement.

 

These restatements should be red-flag concerns all investors.  It is Citron’s opinion that they inevitably foreshadow another kind of restatement – the bad kind.

 

   Analysts or Puppets?  Uncritical Analysts Just Parroting Management Claims

 

Two analysts cover ZAGG:  Northland Securities and the new kid on the block, Jon Hickman, at Ladenberg Thalmann. 

 

Northland, whose now notorious anointment of CCME (now delisted) as its “Top Pick of 2011”, has been very vocal about ZAGG, feeling the need to issue a note and a reiteration every time anything critical is stated in public about ZAGG.  But their justification is just a hollow echo of management’s claims.   They don’t say a word or provide any independent assessment of the risk factors and the troubling red flags surrounding management’s actions and statements.  

 

It would be no surprise that Citron places zero credibility in the work product that comes out of Northland.  Recommending that investors buy ZAGG at these levels, without even acknowledging the major risk factors in the details of their sales contracts or the quality and credibility of their management, is malpractice.

 

Hickman just came over from a small firm MDB Capital Group.  His 15 minutes of fame came in an interview just 7 months ago, in which he delivered more dogs than the Humane Society.  http://finance.yahoo.com/news/Semiconductor-Company-Rated-1-twst-556849794.html?mod=pf-real-estate&x=0

 

Let’s review the quality of his thought:

 

Ticker

Nov 4, 2010 Price

Current Price

Pct Change

Comments

SATC

4.00

2.00

– 50%

His top pick

HEV

3.75

.80

– 75%

Citron covered this stock in 2008l stock was 7.00 at the time

QTWW

9.50

5.43

– 40%

 

VLNC

1.30

1.08

– 20%

 

ALTI

2.00

1.02

– 50%

 

 

Honestly, these outcomes are exactly representative of what Citron’s expects from ZAGG.

At its core, the ZAGG pro-and-con argument breaks down like this:  The bullish analysts take their projections straight from the company’s guidance.  The optimistic view is that revenues will rocket higher — and all of the paper profits plowed into inventory stockpiles so far have been built up to prepare for this future.  The bull case also stands on the premise that all sales to Best Buy (by far their largest single customer) are final sales with no refund or credit overhang.  Therefore its posted revenues are clean, and its revenue growth projects into a future which can be relied upon. 

 

The bear case, as reflected in the opinion of Citron, is that the company is operating a terminal business model and has not been forthright with Wall St. on either revenues, inventory accounting, or future business prospects. 

 

If you’re going to buy this stock, you are banking on the bright future story, not its current assets or current cash flows.  Therefore, the safety of your capital will be entrusted to ZAGG’s management team. 

 

   Introducing the ZAGG team

 

Top Dog

Let’s start from the top down.  The CEO of the ZAGG is Robert Pedersen. As mentioned in the widely read Worthless Pennies report, CEO Pedersen was involved in many penny stocks over the years.  Yet, Citron wants it noted that he was not just passively involved, but while the CEO of ZAGG was supposed completely fully dedicated to his position with the company, he was moonlighting orchestrating dodgy reverse merger deals.  Below are the list of stocks and the relevant dates he appears at the center of reverse merger deals while he was the acting CEO of ZAGG. 

 

         

Ticker

Company  

Merger Filing  

Date 

Recent price

AMBS

Amarantus Biosciences

6/3/2011

1.05

ADSYQ

Ad Systems Communications

2/12/2010

.0014

PMOZ

PrismOne

6/22/2009

.0027

BESN

Blue Earth Solutions

5/20/2008

.0011

GNAU

General Automotive

2/28/2008

.05

WSGF

World Series of Golf

2/1/2008

.01

ZNOM

Znomics

11/08/2007

.0255

 

The Face of Fraud

The public’s last line of protection in the soundness of companies it invests in is the auditor.  It is the audit committee that is responsible for all aspects of the audit relationship.  Because of the red flags regarding ZAGG’s inventory and sales policies, the auditor and the integrity of audited financials going forward is the fulcrum of the investment’s safety and soundness. 

 

As mentioned in the previous report but cannot be understated, late last year ZAGG committed blatant securities fraud by not disclosing the dismissal of the former head of its audit committee Lorence Harmer until four months after the event.  Clearly there were shenanigans involved; ZAGG appears to have eaten a substantial loss after having advanced $4 million in a related party deal with the Chairman of its own audit committee.  

 

On November 5, 2010, he resigned from ZAGG but the company never filed a required 8-K announcing the event.  To make maters worse, the company then issued a 10-Q just four days later, but made no mention of the resignation or a replacement.

 

What were they hiding?  Why did they not want the investing public, or their new auditors to know the new head of the audit committee?  Here is why.

That all becomes a little more clear once you realize his replacement is the abovementioned Randall Hales.  This choice is unspeakable from a corporate governance standpoint.  And note that is he works hand-in-hand with CFO Brandon O’Brien, whose last public company went into liquidation while he was CFO, with annual revenues barely more than $1 million.

So these are the horses you are betting on when you bet on ZAGG. 

 

   Hello Skullcandy, and a comment on valuation.

 

Once public, Skullcandy will have 27.5 million shares outstanding with management selling half of their equity at IPO.  With a brand that is growing over 100% a year and ttm revs of 160 mil and strong management, Skullcandy would have the same enterprise valuation as cash strapped ZAGG…but who cares about valuation when your business will eventually implode?

   Conclusion

Buyer beware.

 

Cautious investing to all.