Zagg ( Nasdaq - ZAGG ) -- Breakneck Expansion Elevates Risk

Zagg (ZAGG $16.00) reported excellent Q2 results, above our expectation.  Excluding nonrecurring costs associated with a recent acquisition income advanced 111% to $.19 a share.  Sales climbed 158% to $38.8 million.  The i-Frogz acquisition boosted performance by a modest amount since that contribution was included for only two weeks.  The Invisible Shield line represented 63% of total revenue.  Most of the rest was provided by keyboard and related accessories for the Apple iPad.  That line will be outsourced to Logitech in upcoming periods in exchange for a volume based royalty.  Zagg will continue to sell the iPad edition on its website, and will recognize the full revenue amount on those sales.  The i-Frogz accessory line will amplify revenue performance in upcoming periods.  Greater penetration of Europe should provide further leverage.  And Zagg recently expanded its U.S. distribution system for its bread and butter mobile phone covers, which could generate further momentum.  We've raised our 2011 earnings estimate by a nickel to $.75 a share.

Risk has increased.  The company added $62 million in debt so far this year to purchase i-Frogz, buy patents related to the Invisible Shield, invest in an unrelated technology (HZO), and expand fulfillment capacity.  Those deals lifted intangible assets to $90 million, an amount equal to shareholders equity.  Tangible equity was reset to zero.  The proliferation of Android mobile phones has forced Zagg to produce a more diversified inventory, moreover, creating greater potential for write-offs on slow selling models.  The debt load constrains future manoeuvrability, as well.

Zagg could continue growing at above average rates.  The mobile device industry is expanding at a 35% pace and could remain vibrant well into the decade.  Zagg is trading at a higher P/E multiple than Apple Computer and Google, though, the two industry leaders which have stronger balance sheets and better control of their futures.  Our advice to investors seeking exposure to the mobile phone industry is to switch into those stocks.  Zagg is coming off a smaller base and could deliver higher appreciation if the company doesn't slip along the way.  But downside risk is significantly greater.

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