As a hobby, I rebuild pre-1970 Hamilton mechanical watches. These old time-pieces are interesting and fun to rebuild but weren’t always made with the best parts (certainly nothing like sapphire glass). If you used to wear one of those watches, or have ever seen the movie Platoon, you know one of the big issues with watches from those days was that they aren’t sealed very well and the crystal over the face will scratch very easily.
These problems can be solved with better waterproofing techniques and the use of sapphire glass on the face of the watch. Sapphire can only be scratched by a few other materials including diamond and special silicone abrasives. Sapphire is so hard it is used in bullet proof windows, solar panels, and it covers the laser scanner at the grocery store.
I was an early adopter of smart phones and I don’t think I made it home from the store before my first iPhone had a scratch on it. Even my cheapest watch has sapphire glass and remains virtually scratch-free despite daily use. Why cell-phone makers weren’t using sapphire glass for screens was a complete mystery to me. Within a couple of days, I bought my first Zagg screen protector to prevent more scratches. In fact, Zagg, Inc. (ZAGG), a leading manufacturer of “screen protectors” once had a market capitalization of $500 million based on solving the problem of fragile smart phone screens.
ZAGG’s most recent investor presentation has a picture of screen protection film being applied to an iPhone 5S as the first product featured. Screen protectors are still the largest product category for ZAGG in 2013-2014 despite heroic diversification efforts. I have used Zagg screen protectors, and they seem very effective, but if I didn’t need it, I wouldn’t want it on the phone.
Screens as Hard as Diamonds
What if cell phone makers caught up with the technology of watchmakers? If my iPhone had sapphire glass, would I still want to place a tacky film of plastic over it, or would its near-diamond hardness be enough protection? I can only speak for myself, but the excitement around the upcoming sapphire screens indicates that other smartphone users would agree that a harder screen is better than a piece of plastic that is expensive and difficult to apply.
Expected demand for sapphire screens has sent stocks like GT Advanced Technologies (GTAT) up nearly 200% over the last 12 months. This sapphire glass manufacturer has a contract with Apple and on very little additional information, analysts expect GTAT to increase earnings per share several hundred percent in 2015.
This leaves ZAGG in a difficult position. Falling earnings and revenues over the last few years due to competition has already hurt the company significantly. If the market’s demand for screen protection begins to evaporate because screen technology has changed, ZAGG will likely take another big hit. ZAGG sells other products as well, but the margins and market share for wireless keyboards, cases, and battery packs is shrinking in the face of low-cost competition blooming all over Amazon and eBay.
ZAGG’s Multiples Should Come Down
I am not suggesting that ZAGG will go out of business, however, it seems extremely unlikely that they will be able to turn around a trend that is accelerating and may be out of their control. Currently, the stock trades at a multiple that is double the average for the S&P 500, which seems unreasonable for a company with declining top and bottom lines.
On Aug. 5, ZAGG reported revenue and earnings (down on a year over year basis) and the stock initially popped 8%. Part of the rally can be attributed to the fact that keyboard sales are up, which is definitely a good thing, but it’s a much lower margin product and still faces the competition problems I mentioned above. Despite some progress in the hardware business, net margins were down 20% and I can’t see that improving in the near term.
The real issue is that ZAGG’s success is largely tied to the release of new tablets and smart phones. Keyboards are fine, but the company still depends on consumer demand for its screen protection products when they buy a new phone. If new product launches from Apple (AAPL) and Samsung don’t need add-on protection then this quarter’s report is likely to represent the new norm for ZAGG rather than a new beginning.
The company also received an “upgrade” from the analysts at Northland Securities. Northland (lead by the former president of a dot-com brokerage implosion known as “Stockwalk”) does not have the best track-record for the stocks they cover so the bounce today looks pretty fragile. I think the stock is going to drop as investors and non-Northland analysts digest the meat of the earnings report. That presents opportunities for traders willing to take a risk on a short position as the stock bumps up against resistance in the $5.50 to $6.00 range.
More conservative traders may want to wait for a break below $5.00 per share before opening a short position, but the move could be quick. In my opinion, the stock isn’t insolvent, but an average market multiple applied to the last 12 months of earnings places its value near $2.88 per share, which is a reasonable target. I think this is appropriate considering the fact that earnings and margins are on the decline. If margins continue to decline in the third quarter, even $2.88 may turn out to be a premium.
John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.
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