UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q








(Mark one)





[X]
Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended March 31, 2011, or





[   ]
Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ______________ to _____________.





Commission File No. 000-52211


ZAGG INCORPORATED


(Exact name of registrant as specified in its charter)





Nevada                                                                                                20-2559624


(State or other jurisdiction of incorporation or organization)(I.R.S. Employer Identification No.)





3855 South 500 West, Suite J


Salt Lake City, Utah 84115


(Address of principal executive offices with zip code)





(801) 263-0699


(Registrant's telephone number, including area code)





Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No[  ].





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


Yes [  ] No [X]





Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. [ ] Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X] Smaller reporting company





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-25 of the Exchange Act).


Yes [  ] No [X]





State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 24,477,211common shares as of May 6, 2011.





1





ZAGG INCORPORATED AND SUBSIDIARIES


FORM 10-Q





TABLE OF CONTENTS




PART I - FINANCIAL INFORMATIONPageItem 1.
Financial Statements (Unaudited)Condensed Consolidated Balance Sheets – As of March 31, 2011 and December 31, 2010
3Condensed Consolidated Statements of Operations for the Three Months EndedMarch 31, 2011 and 2010
4Condensed Consolidated Statements of Cash Flows for the Three Months EndedMarch 31, 2011 and 2010
5Notes to Condensed Consolidated Financial Statements
7Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
16Item 3.
Quantitative and Qualitative Disclosures About Market Risk
23Item 4.
Controls and Procedures
23PART II - OTHER INFORMATIONItem 1.
Legal Proceedings
23Item 1A.
Risk Factors
24Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
24Item 3.
Defaults Upon Senior Securities
25Item 4.
Submission of Matters to a Vote of Security Holders
25Item 5.
Other Information
25Item 6.
Exhibits
25


2


ZAGG INCORPORATED AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(Unaudited)




March 31,


December 31,2011


2010ASSETSCurrent assetsCash and cash equivalents

$
1,767,450


$
2,373,293Accounts receivable, net of allowances of $1,033,614 in 2011 and $904,296 in 2010


16,202,532



17,668,612Inventories


21,192,958



17,946,948Prepaid expenses and other current assets


500,472



2,620,308Related party other asset


-



3,899,910Deferred income tax assets


2,449,599



2,195,687Total current assets


42,113,011



46,704,758Property and equipment,net of accumulated depreciation at $978,117 in 2011 and $852,018 in 2010


1,546,128



1,496,532Related party note receivable


3,899,910



-Other assets


67,357



63,310Intangible assets, net of accumulated amortization of $78,175 in 2011 and $28,069 in 2010


9,134,858



9,167,466Total assets

$
56,761,264


$
57,432,066LIABILITIES AND EQUITYCurrent liabilitiesNotes payable

$
4,162,840


$
30,923Accounts payable


7,521,560



12,122,011Income taxes payable


2,791,251



8,030,719Accrued liabilities


702,366



240,454Accrued wages and wage related expenses


391,166



302,965Deferred revenue


337,952



294,931Sales returns liability


1,863,004



2,067,671Total current liabilities


17,770,139



23,089,674Deferred income tax liability


1,495,035



1,561,465Total liabilities


19,265,174



24,651,139EquityStockholders' equityCommon stock, $0.001 par value; 50,000,000 shares authorized;24,283,313  and 23,925,763 shares issued and outstanding, respectively


24,283



23,926Additional paid-in capital


16,976,143



15,494,836Cumulative translation adjustment


(84,758
)


(59,802
)Retained earnings


18,011,454



14,701,074Total stockholders' equity


34,927,122



30,160,034Noncontrolling interest


2,568,968



2,620,893Total equity


37,496,090



32,780,927Total liabilities and equity

$
56,761,264


$
57,432,066
  See accompanying notes to condensed consolidated financial statements.
 3
  ZAGG INCORPORATED AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)





Three Months Ended March 31,2011


2010Net sales

$
26,976,320


$
8,775,559Cost of sales


13,329,740



3,831,857Gross profit


13,646,580



4,943,702Operating expenses:Advertising and marketing


2,511,816



1,061,050Selling, general and administrative


6,270,478



2,550,860Total operating expenses


8,782,294



3,611,910Income from operations


4,864,286



1,331,792Other (expense) income:Interest expense


(11,341
)


(71,529
)Interest and other income


82



6,710Total other expense


(11,259
)


(64,819
)Income before provision for income taxes


4,853,027



1,266,973Income tax provision


(1,594,573
)


(475,897
)Net income


3,258,454



791,076Net loss attributable to noncontrolling interest


51,926



-Net income attributable to stockholders

$
3,310,380


$
791,076Earnings per share attributable to stockholders:Basic earnings per share

$
0.14


$
0.04Diluted earnings per share

$
0.13


$
0.03
  See accompanying notes to condensed consolidated financial statements.
 4




ZAGG INCORPORATED AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)




For the Three Months Ended March 31,2011


2010Cash flows from operating activitiesNet income

$
3,258,454


$
791,076Adjustments to reconcile net income to net cashprovided by (used in) operating activities:Stock-based compensation


303,778



242,070Excess tax benefits related to share-based payments


(203,430
)


-Depreciation and amortization


176,206



73,210Deferred income taxes


(320,342
)


-Expense related to issuance of warrants


376,751



30,548Expense related to issuance of stock for consulting


100,000



-Changes in operating assets and liabilitiesAccounts receivable


1,466,080



835,683Inventories


(3,246,010
)


(753,237
)Prepaid expenses and other current assets


2,119,836



(1,001,269
)Other assets


(4,047
)


(17,359
)Accounts payable


(4,450,449
)


(445,541
)Income taxes payable


(5,036,038
)


-Accrued liabilities


461,912



461,103Accrued wages and wage related expenses


88,201



(3,741
)Deferred revenues


43,021



16,852Sales return liability


(204,667
)


(32,809
)Net cash (used in) provided by operating activities


(5,070,744
)


196,586Cash flows from investing activitiesDeposits on and purchase of intangible assets


167,499



-Purchase of property and equipment


(175,695
)


(60,433
)Net cash used in investing activities


(343,194
)


(60,433
)Cash flows from financing activitiesPayments on debt


(2,917
)


-Proceeds from notes payable


4,134,834



-Proceeds from exercise of warrants and options


497,704



24,567Excess tax benefits related to share-based payments


203,430



-Net cash provided by financing activities


4,833,051



24,567Effect of foreign current exchange rates on cash and cash equivalents


(24,956
)


1,963Net (decrease) increase in cash and cash equivalents


(605,843
)


162,683Cash and cash equivalents at beginning of the period


2,373,293



4,970,756Cash and cash equivalents at end of the period

$
1,767,450


$
5,133,439Supplemental disclosure of cash flow informationCash paid during the period for interest

$
11,341


$
71,529Cash paid during the period for taxes


6,944,539



205,000


See accompanying notes to condensed consolidated financial statements.
 5


ZAGG INCORPORATED AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


(Unaudited)








Supplemental schedule of noncash investing and financing activities





For the Three Months Ended March 31, 2011:





Issued 50,000 warrants.





Issued 10,439 shares of common stock to consultant.





Conversion of related party other asset to related party note receivable of $3,899,910.





For the Three Months Ended March 31, 2010:





Issued 100,000 warrants.














See accompanying notes to condensed consolidated financial statements.
 6
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)








NOTE 1–NATURE OF OPERATIONS AND BASIS OF PRESENTATION





ZAGG Incorporated (collectively, the “Company”, or “ZAGG”) provides innovative consumer products like films, skins, audio and power solutions that protect, personalize and enhance the mobile experience.  ZAGG's products are distributed worldwide under the following brands: invisibleSHIELD®, ZAGGskinsTM, ZAGGsparqTM, ZAGGbudsTM, ZAGG LEATHERskinsTM and ZAGGmateTM.





The accompanying unaudited condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations.  These condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary to present fairly the financial position, the results of operations and cash flows of the Company for the periods presented.  The Company suggests that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s 2010 Annual Report on Form 10-K.  Operating results for the three months ended March 31, 2011, are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.





Use of estimates–The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.





Principles of consolidation–The condensed consolidated financial statements include the accounts of ZAGG Incorporated and its wholly owned subsidiaries ZAGG Europe Limited, ZAGG International and ZAGG Intellectual Property Holding Co, Inc., and HzO, Inc., which is a variable interest entity.  All intercompany transactions and balances have been eliminated in consolidation.





NOTE 2 – ACCOUNTS RECEIVABLE





On May 13, 2009, the Company entered into an accounts receivable financing agreement with Faunus Group International, Inc. (“FGI”).  Under the agreement, the Company could offer to sell its accounts receivable to FGI each month during the term of the Agreement, up to a maximum amount outstanding at any time of $4,000,000.  The Company could sell accounts receivable to FGI on either a credit approved or full recourse basis.  Credit approved invoices were sold to FGI with no recourse, and FGI accepted all credit default risk on invoices sold under the credit approved terms.  The Company accounted for the sale of the credit approved invoices as a reduction to accounts receivable.  Under the terms of the agreement, the Company was charged a monthly collateral management fee of 0.87% of the average monthly outstanding balance and interest at 7% per annum.  The term of the agreement was for a period of four years.  Amounts sold under the financing agreement during the three months ended March 31, 2010, were $4,554,000.  However, effective May 12, 2010, the Company terminated the receivable financing agreement with FGI.





7
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)








NOTE 3 – PREPAID EXPENSES AND OTHER CURRENT ASSETS





Prepaid expenses and other current assets are summarized in the table below:





March 31, 2011


December 31, 2010Interest and other receivables

$
95,523


$
97,719Inventory deposits


97,905



2,277,615Other


307,044



244,974Total prepaid expenses and other current assets

$
500,472


$
2,620,308





NOTE 4 – INVENTORIES





At March 31, 2011, and December 31, 2010, inventories consisted of the following:





March 31, 2011


December 31, 2010Finished goods

$
8,747,324


$
7,925,387Raw materials


12,445,634



10,021,561Total inventory

$
21,192,958


$
17,946,948





NOTE 5 – LINE OF CREDIT





Effective May 13, 2010, the Company entered into a Loan Agreement (the “Loan Agreement”) with U.S. Bank National Association (“US Bank”).  The Loan Agreement provided for revolving loans and other financial accommodations to or for the benefit of the Company of up to $5 million, to be used for working capital and other corporate purposes.  The Company’s obligations under the Loan Agreement and all related agreements were secured by all or substantially all of the Company’s assets.  The obligation of U.S. Bank to make advances under the Loan Agreement was subject to the conditions set forth in the Loan Agreement.  The Loan Agreement and the credit facility were to mature on May 13, 2011.





On March 8, 2011, the Company entered into an Amended and Restated Loan Agreement (the “Amended and Restated Loan Agreement”) with U.S. Bank which provides for revolving loans and other financial accommodations to or for the benefit of the Company of a principal amount not to exceed $20 million.  Advances under the Amended and Restated Loan Agreement bear interest at LIBOR plus 1.75%.  The Amended and Restated Loan Agreement requires the Company to maintain a fixed charge coverage ratio of no less than 1.25 to 1.00 measured quarterly on a trailing twelve month basis and a leverage ratio of no greater than 2.5 to 1.0 measured quarterly on a trailing twelve month basis.  As of March 31, 2011, the Company was in compliance with all covenants under the Loan Agreement and $4,120,334 had been drawn against the credit facility.  The Amended and Restated Loan Agreement and the credit facility mature on March 15, 2012.





NOTE 6 – COMMON STOCK AND NONCONTROLLING INTEREST





Common stock





During the three months ended March 31, 2011, the Company issued 357,550 shares of its common stock.  Of such shares, 195,234 were issued in connection with the exercise of stock options, 151,877 were issued in connection with the exercise of warrants and 10,439 were issued in connection with consulting services received.  The Company received proceeds of $300,114 related to the option exercises, $197,590 related to the exercise of the warrants and recognized consulting expense of $100,000 related to the issuance of 10,439 shares of its common stock.





8
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)








Noncontrolling interest





Noncontrolling interests are classified in the consolidated statements of operations as part of net income attributable to stockholders and the accumulated amount of noncontrolling interests is included in the consolidated balance sheets as part of equity. If a change in ownership of a consolidated subsidiary results in loss of control and deconsolidation, any retained ownership interests are remeasured with the gain or loss reported in net earnings.





The value of the noncontrolling interest in the consolidated financial statements primarily represents the Series A Preferred Stock in HzO Inc. (“HzO”) issued to Northeast Maritime Institute, Inc. (“NMI”) as part of the HzO technology purchase.  The Series A Preferred Stock in HzO has the same voting rights as HzO Common Stock and has one vote for each share of Series A Preferred Stock.  The Series A Preferred Stock is convertible into Common Stock, at the option of the holder, at a fixed conversion ratio of 1 share of Series A Preferred Stock to 1 share of Common Stock.  All outstanding Series A Preferred Stock shares are redeemable at any time after August 21, 2014 at the election of at least two-thirds of the Series A Preferred Stock holders.  As the Company holds at least one-third of the HzO Series A Preferred Stock, it can control the redemption of the HzO Series A Preferred Stock and therefore the associated noncontrolling interest is recorded within permanent equity.  The Series A Preferred Stock is redeemable at the fixed price of $0.4752 per share.  As of March 31, 2011, the Company and NMI hold 6.6 million and 11.1 million shares of HzO Series A Preferred Stock, respectively.  However, 2.1 million shares of the 11.1 million shares of HzO Series A Preferred Stock issued to NMI are held in escrow pending a future event.  HzO Series A Preferred Stock holders are entitled to receive dividends annually at a stated dividend rate of $0.038 per share when, as, and if declared by the Board of Directors of HzO.  No dividends had been declared as of March 31, 2011.  The Company holds a call option to acquire all of NMI’s equity interests and rights in HzO for $2,500,000 which is exercisable at any time through May 27, 2011 and thereafter for $3,000,000 which is exercisable any time through October 1, 2013.  The Company also has the right of first refusal if NMI has an offer to purchase its interests in HzO.  The call option does not meet the definition of a derivative, and therefore it is not marked to fair value at each period end.





Noncontrolling interest consists of a 47% equity interest in the HzO subsidiary held by third parties, excluding shares of HzO Series A Preferred Stock held in escrow.  The Company is consolidating HzO because it is a variable interest entity for which the Company is the primary beneficiary.





NOTE 7 – COMPREHENSIVE INCOME





The following table summarizes the components of comprehensive income for the three months ended March 31, 2011 and 2010:





Three Months EndedMarch 31, 2011


March 31, 2010Net income

$
3,258,454


$
791,076Other comprehensive income:Foreign currency translation gain (loss)


(24,956
)


1,963Comprehensive income


3,233,498



793,039Comprehensive income attributable to noncontrolling interest


51,926



—Comprehensive income attributable to stockholders

$
3,285,424


$
793,039





9
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)








NOTE 8 – STOCK OPTIONS, WARRANTS AND RESTRICTED STOCK





Common Stock Options - The Company granted 92,541 and 771,500 stock option awards during the three months ended March 31, 2011 and 2010, respectively. The stock awards granted were estimated to have a weighted-average fair value per unit of $4.98 and $1.62 for the three months ended March 31, 2011 and 2010, respectively. The fair value for stock options granted is calculated using the Black-Scholes option-pricing model on the date of grant. For the three months ended March 31, 2011 and 2010, the following assumptions were used in determining the fair value:





3 Months Ended March 31, 2011


3 Months Ended March 31, 2010Expected dividend yield


0.0
%


0.0
%Risk-free interest rate


1.21
%


1.28
%Expected term (years)

3.5 years


3.5 yearsExpected volatility


90.59
%


96.21
%





The Company recorded share-based compensation expense only for those options that are expected to vest.  The estimated fair value of the stock options is recognized on a straight-line basis over the requisite service period of the award, which is generally the vesting term of the award.  During the three months ended March 31, 2011 and 2010, the Company recorded equity-based compensation expense of $262,876 and $242,070, respectively, which is included as a component of selling, general and administrative expense.





Warrants - During the three months ended March 31, 2011, the Company issued warrants for investor relations consulting services for 50,000 common shares exercisable at $9.05 per share expiring in 5 years and which vested upon issuance.  The warrant grant was valued using the Black-Scholes option pricing model based on the fair value of the Company’s common stock on the date of grant, expected term equal to the contractual term, expected volatility weighted between the Company’s historical volatility and the average historical volatility of similar entities with publicly traded shares over the expected term, and risk-free rate for the expected term based on the U.S. Treasury yield curve on the grant date.  For the three months ended March 31, 2011, the Company recorded expense of $318,239 for these warrants.  The Company had also issued warrants for investor relations consulting services during the three months ended March 31, 2010 for 100,000 common shares exercisable at $2.58 per share expiring in 5 years and vesting equally over the 12 month period from the grant date.  Each vesting tranche of the warrants was independently valued using the Black-Scholes option pricing model with separate assumptions for each tranche based on the fair value of the Company’s common stock on each vesting date, expected term equal to the remaining contractual term on each vesting date, expected volatility weighted between the Company’s historical volatility and the average historical volatility of similar entities with publicly traded shares over the expected term for each vesting date, and risk-free rate for the expected term based on the U.S. Treasury yield curve in effect with a period that approximates the remaining contractual term for each vesting date.  For the three months ended March 31, 2011 and 2010, the Company recorded expense of $58,512 and $30,854 for these warrants.





The fair value of warrants has been estimated as of the vesting date using the Black-Scholes option pricing model.  For the three months ended March 31, 2011, the following assumptions were used in determining the fair value:





Three months ended March 31, 2011


Three months ended March 31, 2010Expected dividend yield


0.0
%


0.0
%Risk-free interest rate


2.02
%


2.49
%Expected term (years)

4.9 years


4.9 yearsExpected volatility


90.71
%


82.51
%





Restricted Stock- The Company granted 237,800 shares of restricted stock during the three months ended March 31, 2011. There were no shares of restricted stock granted during the three months ended March 31, 2010. The restricted stock was estimated to have a weighted-average fair value per unit of $7.11 for the three months ended March 31, 2011. The fair value of the restricted stock granted is based on the closing share price of the Company’s common stock on the date of grant.  The shares of restricted stock vest annually on a straight-line basis over a 3 year vesting term.




10
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)





The Company recorded share-based compensation expense only for those shares of restricted stock that are expected to vest.  The estimated fair value of the restricted stock is recognized on a straight-line basis over the requisite service period of the award, which is generally the vesting term of the award.  During the three months ended March 31, 2011, the Company recorded equity-based compensation expense of $40,902, which is included as a component of selling, general and administrative expense.





NOTE 9 – INCOME TAXES





The Company’s effective tax rate was 32.9% and 37.5% for the three months ended March 31, 2011 and 2010, respectively.  The Company’s effective tax rate will generally differ from the U.S. Federal Statutory rate of 35%, due to state taxes, permanent items and favorable tax rates associated with certain earnings from the Company’s operations in Ireland.





NOTE 10 – EARNINGS PER SHARE





Basic earnings per common share excludes dilution and is computed by dividing net income attributable to stockholders by weighted average number of shares of common stock outstanding during the period.  Diluted earnings per common share reflect the potential dilution that could occur if stock options or other common stock equivalents were exercised or converted into common stock. The dilutive effect of stock options or other common stock equivalents is calculated using the treasury stock method.





The following is a reconciliation of the numerator and denominator used to calculate basic earnings per share and diluted earnings per share for the three months ended March 31, 2011 and 2010:





March 31, 2011


March 31, 2010Net income attributable to stockholders

$
3,310,380


$
791,076Weighted average shares outstanding


24,095,788



21,719,274Dilutive effect of warrants, restricted stock

and stock options


2,120,402



1,651,336Diluted shares


26,216,190



23,370,610Earnings per share attributable to stockholders:Basic

$
0.14


$
0.04Dilutive

$
0.13


$
0.03





For the three months ended March 31, 2011 and 2010, warrants, restricted stock, and stock options to purchase 156,541, and 1,396,500, respectively,were not considered in calculating diluted earnings per share because the warrant or stock option exercise prices or the total expected proceeds under the treasury stock method for the warrants, restricted stock, or stock options was greater than the average market price of common shares during the period and, therefore, the effect would be anti-dilutive.





NOTE 11 – FAIR VALUE MEASURES





Fair Value of Financial Instruments -At March 31, 2011, and December 31, 2010, the Company’s financial instruments included cash and cash equivalents, accounts receivable, accounts payable, related party receivable and a line of credit. The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable approximate fair value due to the short-term maturities of these financial instruments.  The Company recently entered into the related party receivable transaction and Amended and Restated Loan agreement, and the carrying amounts of these items approximates fair value because the interest rates approximate current market rates.




11
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)





Fair Value Measures - The Company measures at fair value certain financial and non-financial assets by using a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, essentially an exit price, based on the highest and best use of the asset or liability. The levels of the fair value hierarchy are:





Level 1 — Quoted market prices in active markets for identical assets or liabilities;





Level 2 — Significant other observable inputs (e.g., quoted prices for similar items in active markets, quoted prices for identical or similar items in markets that are not active, inputs other than quoted prices that are observable such as interest rate and yield curves, and market-corroborated inputs); and





Level 3 — Unobservable inputs in which there is little or no market data, which require the reporting unit to develop its own assumptions.





At March 31, 2011, and December 31, 2010, the following financial assets and liabilities were measured at fair value on a recurring basis using the type of inputs shown:





Fair Value Measurements Using:March 31, 2011


Level 1 Inputs


Level 2 Inputs


Level 3 InputsCash equivalents


—



—



—



—





Fair Value Measurements Using:December 31, 2010


Level 1 Inputs


Level 2 Inputs


Level 3 InputsCash equivalents

$
416,312


$
416,312



—



—





The majority of the Company’s non-financial instruments, which include intangible assets, inventories, and property and equipment, are not required to be carried at fair value on a recurring basis. However, if certain triggering events occur such that a non-financial instrument is required to be evaluated for impairment, based upon a comparison of the non-financial instrument’s fair value to its carrying value, an impairment is recorded to reduce the carrying value to the fair value, if the carrying value exceeds the fair value.





At March 31, 2011 and December 31, 2010, there were no non-financial instruments measured at fair value.





NOTE 12 – CONCENTRATIONS





Concentration of credit risk





Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and accounts receivable.  The Company places its cash with high credit quality financial institutions.  The Company maintains its cash in bank deposit accounts, which, at times, exceed federally insured limits. The Company has not experienced any losses in such accounts through March 31, 2011.





At March 31, 2011, and December 31, 2010, approximately 74% and 64%, respectively, of the balance of accounts receivable was due from two customers.  No other customer account balances were more that 10% of accounts receivable.If one or more of the Company’s significant customers were to become insolvent or were otherwise unable to pay for the products provided, it would have a material adverse effect on the Company’s financial condition and results of operations.





Concentration of supplier





The Company purchases its raw materials related to the invisibleSHIELD product line primarily from one source.   Management is aware of similar raw materials that would be available from other sources if required and has current plans to immediately engage such resources if necessary.  A change in supplier, however, could cause a delay in manufacturing and a possible loss of sales, which could adversely affect operating results.




12
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)





Concentration of sales





For the three months ended March 31, 2011, one customer accounted for 27% and another customer accounted for 11% of the Company’s sales.   No other customer account balances were more that 10% of sales.  For the three months ended March 31, 2010, one customer accounted for 34% of the Company’s sales.  If the Company loses one or more of the Company’s significant customers, it would have a material adverse effect on the Company’s financial condition and results of operations.





The percentage of sales by geographic region for the three months ended March 31, 2011 and 2010, was approximately:





Three months ended March 31, 2011


Three months ended March 31, 2010United States


95
%


83
%Europe


4
%


12
%Other


1
%


5
%





NOTE 13 – COMMITMENTS AND CONTINGENCIES





Legal matters





The Company’s wholly owned subsidiary, ZAGG Intellectual Property Holding Company, Inc. (“ZAGG IP”), is engaged as the plaintiff in patent infringement litigation pending in California and in Utah that seeks to enforce rights under United States Patent No. 7,784,610.  The defendants in these cases have raised defenses and, in some cases, asserted counterclaims against ZAGG IP, that seek declarations of unenforceability or non-infringement of the patent.  These counterclaims do not assert any claims for affirmative relief apart from a request for an award of costs and attorney’s fees to the prevailing party.  There are no claims asserted in these actions against the Company.   In the opinion of management, the ultimate disposition of these patent infringement claims, including disposition of the counterclaims, will not have a material adverse effect on the Company’s consolidated financial position, results of operations, or liquidity.





The Company is not a party to any litigation or other claims at this time.  However, from time to time the Company may become subject to lawsuits and other claims in the ordinary course of business.  Such matters are subject to many uncertainties, and most outcomes are not predictable with assurance.





Patents





On August 31, 2010, Andrew Mason (“Mason”) filed a complaint against the Company claiming patent infringement as a result of the Company’s invisibleSHIELD installation kits.  On September 4, 2010, the Company filed a counter complaint against Mason and his company, eShields LLC (“eShields”).  On November 9, 2010, before either party had responded on the merits to the claims asserted, the Company, Mason and eShields entered into an Asset Purchase Agreement (“Purchase Agreement”) under which a wholly owned subsidiary of the Company, ZAGG Intellectual Property Holding Co., Inc., a Nevada corporation, acquired all of the rights of Mason in the (i) patents which are the subject of the litigation, (ii) patent application filed on August 13, 2010 (the “CIP Application”) and (iii) rights to sue for infringement of the patents.




In consideration for the conveyance of Mason’s assets described above, the Company agreed to pay or convey to Mason the following:





(a)
a first payment of $200,000 by November 11, 2010, and a second payment of $150,000 after December 31, 2010;


(b)
issue to Mason five-year warrants (the “Warrant”) to purchase 750,000 shares of the Company’s restricted Common Stock at an exercise price equal to the closing bid price on November 9, 2010 ($8.53); provided that 500,000 of the 750,000 warrant shares are exercisable only upon the issuance of a patent from the CIP Application with at least one claim that satisfies the Claim Conditions (as defined below);


(c)
issue to Mason 70,000 shares of the Company’s restricted Common Stock; and


(d)
grant eShields a fully paid-up, perpetual, non-exclusive license, with limited rights to transfer or sublicense, for the patents and CIP Applications.




13
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)





The Company also agreed to dismiss the claims asserted against Mason and eShields, and to make additional payments to Mason if the US Patent and Trademark Office (“USPTO”) issues a U.S. patent on the CIP Application that includes at least one claim that broadly encompasses any protective kit that includes a package, as well as a squeegee and an adhesive-coated protective film for a consumer electronic device with a peel-away backing within the package (collectively, the “Claim Conditions”).  If the Claim Conditions are met, the Company will:





(a)
pay Mason the sum of $500,000; and


(b)
issue to Mason 430,000 shares of the Company’s restricted Common Stock.





If the Claim Conditions are not met, the Company has no obligation to make the payment or issue the shares described in the preceding paragraph and Mason will not be able to exercise 500,000 of the Warrants.  There can be no assurance that the USPTO will issue a patent on the CIP Application that meets the requirements of the Claim Conditions.





NOTE 14 – RELATED PARTY RECEIVABLE





In June 2008, a former member of the board of directors, Lorance Harmer, introduced the Company to a potential consumer electronics product, which became known as the ZAGGbox.  The ZAGGbox aggregates digital content such as music, pictures, videos and movies in a single location and allows the user to share the content with most other networked media players, including mobile devices.  After investigating the market opportunity for the ZAGGbox, the Company determined in June 2009 to license certain rights for the development and sale of the ZAGGbox in North America.  Thereafter, the Company entered into a Distribution and License Agreement with Teleportall, LLC (“Teleportall”), the owner of the technology used in the ZAGGbox, under which Teleportall agreed to manufacture and deliver ZAGGboxes to the Company and the Company was appointed the exclusive distributor for the ZAGGbox in North American.  On June 17, 2009, the Company issued its initial purchase order for 15,000 ZAGGbox units and advanced to Teleportall a total of $1,152,500 representing a $200,000 NRE fee and $952,500 in payment of 30% of the total purchase price for the 15,000 units ordered by the Company.





Teleportall proceeded to develop and test prototypes of the ZAGGbox and provided periodic progress reports to the Company.  The Company continued to conduct market analysis for the product and requested several changes to the functions and features of the ZAGGbox.  Teleportall did not deliver the product in time for the 2009 Christmas selling season.





Development of the product continued in 2010 with the expectation that the product would be delivered in time for the 2010 Christmas selling season.  The Company made additional payments for long lead-time parts to Teleportall in the aggregate amount of $2,747,410.  When it became obvious to the Company that the product would not be ready to market and sell during the 2010 Christmas season, the Company commenced discussions to restructure the Distribution and License Agreement with Teleportall.  During the course of those discussions, the Company learned in January 2011 that Mr. Harmer had an indirect interest of 25% in Teleportall.  As a result, on March 23, 2011, the Company entered into a settlement agreement with Teleportall, Mr. Harmer and several entities owned or controlled by Mr. Harmer, pursuant to which the parties agreed to terminate the Distribution and License Agreement on the following terms:





●
Mr. Harmer, Teleportall, and certain of their affiliates delivered a promissory note (the “Note”) dated March 23, 2011 to the Company in the original principal amount of $4,125,902 which accrues interest at the rate of LIBOR plus 4% per annum (adjusted quarterly) payable as follows: (i) interest only payments (a) on September 23, 2011, and (b) thereafter on or before the last day of each calendar quarter, (ii) 50% of the net profits of each ZAGGbox sale by Teleportall and its affiliates to be applied, first, to accrued interest and, second, to the principal balance of the Note, and (iii) the unpaid balance of principal and interest due in full on March 23, 2013. The principal amount of the Note is the aggregate amount of the payments made by the Company to Teleportall plus the internal cost of the ZAGGbox project incurred by the Company.  The Note is secured by certain real property, interests in entities that own real property and restricted securities.





●
Teleportall and the Company entered into a License Agreement on March 23, 2011 under which the Company licensed to Teleportall the use of certain ZAGG names and marks to sell and distribute the ZAGGbox product.  Teleportall will pay ZAGG a 10% royalty on net sales of ZAGGboxes per calendar quarter.




14
 ZAGG INCORPORATED AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)


●
Teleportall and ZAGG entered into a non-exclusive Commission Agreement on March 23, 2011, under which Teleportall may make introductions of many ZAGG products in all countries where ZAGG does not currently have exclusive dealing agreements in respect of the marketing, distribution or sale of its products.  The Commission Agreement is for a term of two (2) years; provided that the Commission Agreement shall (a) automatically terminate concurrent with any uncured default under the Note, and (b) the term may be extended for an additional time period on reasonable terms if Teleportall’s introductions during the initial term result in the purchase of no less than $25,000,000 of ZAGG products during the initial term.  Payment terms of the Commission Agreement are as follows:




●
10.0% commission payments on orders received by the Company from retailers and distributors first introduced to the Company by Teleportall during the first 60 days after the introduction is made (the “Load-in Period”) to be split 50/50 between cash to Teleportall and principal payments on the Note. However, all commission payments will be paid to ZAGG if Teleportall is in breach of the terms of the Note or any other agreements between the parties;





●
3.0% commission on all orders within the first 24 months after the Load-in Period, and 2.0% thereafter, from retailers and distributors first introduced to the Company as described under the terms set forth in the preceding bullet point.  The 3.0% and 2.0% commissions will be split 50/50 between cash to Teleportall and principal payments on the Note; and





●
3.0% commission on all orders generated in countries where Teleportall is paid commission under the terms of the preceding two bullet points (excluding the United States), regardless of Teleportall’s involvement in ZAGG’s receipt of the order until the first to occur of (i) payment in full of the Note, (ii) termination of the Commission Agreement or (iii) 24 months after the applicable Load-in Period.





No revenue was recognized from Teleportall during the three months ended March 31, 2011.





NOTE 15 – SUBSEQUENT EVENTS





On April 7, 2011, the Company partnered with Logitech on the ZAGGmate product and renamed it the Logitech Keyboard Case by ZAGG.  Under the partnership with Logitech, the Company receives a royalty for all units sold by Logitech.


15


ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS




Certain statements, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.   These forward-looking statements generally are identified by the words “believes,” “project,” “expects,” “anticipates,” “estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions.  We intend such forward-looking statements to be covered by the safe-harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and are including this statement for purposes of complying with those safe-harbor provisions.  Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain.  Factors which could have a material adverse affect on our operations and future prospects include, but are not limited to: changes in economic conditions, legislative/regulatory changes, availability of capital, interest rates, competition, and generally accepted accounting principles. These risks and uncertainties should also be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.  We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.  Further information concerning our business, including additional factors that could materially affect our financial results, is included herein and in our other filings with the SEC.




Our Business





Headquartered in Salt Lake City, Utah, ZAGG Incorporated designs, manufactures and distributes protective coverings, audio accessories and power solutions for consumer electronic and hand-held devices under the brand names invisibleSHIELD®, ZAGGskinsTM, ZAGGbudsTM, ZAGGsparqTM, and ZAGGmateTM.





Our flagship product, the invisibleSHIELD, is made from a protective film covering that was developed originally to protect the leading edges of rotary blades of military helicopters. We determined that this same film product could be configured to fit onto the surface of electronic devices and marketed to consumers for use in protecting such devices from every day wear and tear, including scratches, scrapes, debris and other surface blemishes. The film also permits touch sensitivity, meaning it can be used on devices that have a touch-screen interface. The invisibleSHIELD film material is highly reliable and durable because it was originally developed for use in a high friction, high velocity context within the aerospace industry. The film provides long lasting protection for the surface of electronic devices subject to normal wear and tear. The film is a form of polyurethane substance, akin to a very thin, pliable, flexible and durable clear plastic that adheres to the surface and shape of the object it is applied to.





The invisibleSHIELD is designed specifically for iPods®, iPads®, laptops, cell phones, digital cameras, watch faces, GPS systems, gaming devices, and other items.  The product is “cut” to fit specific devices and packaged together with a moisture activating solution which makes the invisibleSHIELD adhere to the surface of the device, literally “like a second skin,” and virtually invisible to the eye.  The patent-pending invisibleSHIELD is the first scratch protection solution of its kind on the market.  The invisibleSHIELD is not ornamental, but rather provides a long lasting barrier to preserve the brand new look of the surface of an electronic device.  In early 2010 we introduced the invisibleSHIELD DRY through retail partners, which is a protective film made from the same material as the original invisibleSHIELD, and engineered to be clearer, smoother to the touch, and apply without the need for fluid.  In the beginning of 2011 we added the invisibleSHIELD Smudge-Proof to our line, which also incorporates the invisibleSHIELD film with added features that eliminate smudges, fingerprints, and glare from the device display.





Currently, ZAGG offers over 5,000 precision pre-cut invisibleSHIELD designs with a lifetime replacement warranty through online channels, big-box retailers, electronics specialty stores, resellers, college bookstores, Mac stores, and mall kiosks.  We plan to increase our product lines to offer new electronic accessories to our tech-savvy customer base, as well as an expanded array of invisibleSHIELD products for other industries.  Given the amazing success of the invisibleSHIELD, ZAGG has the unique opportunity to offer additional accessories from a trusted source to gadget enthusiasts worldwide.






16





The ZAGGaudio brand of electronics accessories and products were first released in late 2008, and continue to focus on innovation and superior value.  The flagship product within ZAGGaudio is the award winning ZAGGsmartbudsTM line, which includes ZAGGaquabuds, a water-resistant earbud introduced in late 2010.  A previous winner of the coveted CES Design and Innovation award, the ZAGGsmartbuds line has been very well received by professional reviewers, experts and the consumer base. On January 12, 2010, we were awarded patent number US D 607,875 by the U.S. Patent and Trademark Office, covering design elements of ZAGGsmartbuds in-ear headphones.





ZAGGskins were introduced in November 2009, and combine customizable, high-resolution images with the scratch protection of ZAGG’s invisibleSHIELD.  To create a ZAGGskin, consumers select from a library of professional designs or upload their own high-resolution personal photos or images.  The printed image, custom designed for their device, is then merged with the exclusive, ultra-tough, patented invisibleSHIELD film, which allows customers to both protect and individualize their gadgets with a single product.





In early 2009 we introduced the ZAGGsparq, a small, powerful, portable battery that can recharge a power-hungry smartphone up to four times before the ZAGGsparq itself needs to be recharged.  Featuring a 6000ma lithium polymer cell, the ZAGGsparq plugs into a wall outlet and provides two USB ports for charging mobile devices.  An adapter is also included that fits many international standards.  The ZAGGsparq is compatible with any USB-charged device, including the Apple® iPad and iPhone®, as well as cell phones, handheld gaming systems, and digital cameras.





We also introduced ZAGG LEATHERskins in early 2010.  ZAGG LEATHERskins are thin, pliable cases that apply directly to personal electronics like a film, and are created from genuine leather.  Available in typical leather shades and premium animal patterns, ZAGG LEATHERskins use an adhesive that holds the skin firmly in place on the device, but can be removed if necessary.  Later in 2010, we broadened the line to include ZAGG sportLEATHER, which are also created from genuine leather and feature authentic recreations of baseball, football and basketball textures.  ZAGG LEATHERskins and sportLEATHERS are available for the most popular personal electronics.





We introduced the ZAGGmate on November 26, 2010, – “Black Friday” – in select national retailers.  The ZAGGmate is a protective and functional companion to the Apple iPad that accentuates both the appearance and utility of Apple's innovative device. Made from aircraft-grade aluminum with a high quality finish, the patent-pending ZAGGmate matches the design, look and feel of the iPad.  The ZAGGmate line features two models, one with a simple, innovative stand and built-in wireless Bluetooth® keyboard that allows for fast, responsive typing, and interaction with the iPad's features.  The second model replaces the keyboard with a more versatile stand that provides multiple angles for use.  On April 7, 2011, we partnered with Logitech on the ZAGGmate product and renamed it the Logitech Keyboard Case by ZAGG.  Under the partnership with Logitech, we receive a royalty for all units sold.





We maintain our corporate offices and operational facility at 3855 South 500 West, Suites B, C, I, J, K, L, M, N. O and R, Salt Lake City, Utah, 84115. The telephone number of the Company is 801-263-0699.  Our website address is www.ZAGG.com.  Information contained on, or accessible through, our website is not a part of, and is not incorporated by reference into, this report.





Critical Accounting Policies





The discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.  Significant estimates include the allowance for doubtful accounts, inventory valuation allowances, sales returns and warranty liability, the useful life of property and equipment, stock-based compensation expense and income taxes.




17





An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably may have been used, or if changes in the estimate that are reasonably likely to occur may materially impact the financial statements.  Management believes the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.





Revenue recognition





We record revenue when persuasive evidence of an arrangement exists, product delivery has occurred, the sales price to the customer is fixed or determinable, and collectability is reasonably assured.  Our revenue is derived from sales of our products through our indirect channel including retailers and distributors and through our direct channel including www.ZAGG.com and our corporate-owned and third-party-owned mall kiosks, and from the fees derived from the sale of exclusive independent distributor licenses related to the kiosk program.  For sales of product, our standard shipping terms are FOB shipping point, and we record revenue when the product is shipped, net of estimated returns and discounts.  For some customers, the contractual shipping terms are FOB destination.  For these shipments, we record revenue when the product is delivered, net of estimated returns and discounts.  For license fees, we recognize revenue on a straight-line basis over the life of the license term.





Promotional products given to customers or potential customers are recognized as a cost of sales. Cash incentives provided to our customers are recognized as a reduction of the related sale price, and, therefore, are a reduction in sales.





Reserve for sales returns and warranty liability





For product sales, the Company records revenue, net of estimated returns and discounts, when products are shipped and the customer takes ownership and assumes risk of loss, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Our return policy generally allows its end users and retailers to return purchased products for refund or in exchange for new products within 45 days of end user purchase.  In addition, the Company generally provides the ultimate consumer a warranty with each product.  Due to the nature of the invisibleSHIELD product line, returns are generally not salvageable and are not included in inventory.  We estimate a reserve for sales returns and warranty and record the estimated reserve amount as a reduction of sales and as a sales return reserve liability.  The estimate for sales returns and warranty requires management to make significant estimates regarding return rates for sales and warranty returns.  Historical experience, actual claims, and customer return rights are the key factors used in determining the estimated sales return and warranty reserve.





Allowance for Doubtful Accounts





We provide customary credit terms to our customers. We perform ongoing credit evaluations of the financial condition of our customers and maintain an allowance for doubtful accounts based upon historical collections experience and judgments as to expected collectability of accounts. Our actual bad debts may differ from our estimates.





Inventories





In assessing the realization of inventories, we are required to make judgments as to future demand requirements and to compare these with current inventory levels. When the market value of inventory is less than the carrying value, the inventory cost is written down to the estimated net realizable value thereby establishing a new cost basis. Our inventory requirements may change based on our projected customer demand, market conditions, technological and product life cycle changes, longer or shorter than expected usage periods, and other factors that could affect the valuation of our inventories.





Income taxes





Deferred income tax assets are reviewed for recoverability, and valuation allowances are provided, when necessary, to reduce deferred income tax assets to the amounts that are more likely than not to be realized based on our estimate of future taxable income. Should our expectations of taxable income change in future periods, it may be necessary to establish a valuation allowance, which could affect our results of operations in the period such a determination is made. We record income tax provision or benefit during interim periods at a rate that is based on expected results for the full year. If future changes in market conditions cause actual results for the year to be more or less favorable than those expected, adjustments to the effective income tax rate could be required.




18





The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. The determination of the realization of certain income tax positions is subject to significant estimates based upon the facts and circumstances of each position.





Long-lived Assets





We have significant long-lived tangible and intangible assets consisting of property, plant and equipment and definite-lived intangibles. We review these assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. When indicators of impairment exist related to our long lived tangible assets and definite-lived intangible assets, we use an estimate of the undiscounted net cash flows in measuring whether the carrying amount of the assets is recoverable.  Measurement of the amount of impairment, if any, is based upon the difference between the asset’s carrying value and estimated fair value. Fair value is determined through various valuation techniques, including market and income approaches as considered necessary which involves judgment related to future cash flows and the application of the appropriate   valuation model.  If forecasts and assumptions used to support the realizability of our long-lived assets change in the future, significant impairment charges could result that would adversely affect our results of operations and financial condition.





Stock-based compensation





The Company recognizes stock-based compensation expense in its consolidated financial statements for awards granted to employees and non-employees under its stock incentive plan, which include restricted stock and stock options.  Equity-classified awards are measured at the grant date fair value of the award. The fair value of stock options is measured on the grant date using the Black-Scholes option pricing model (BSM), which involves the use of assumptions such as expected volatility, expected term, dividend rate, and risk-free rate.  Volatility is a key factor used to determine the fair value of stock options in the BSM.  The Company does not have sufficient historical data or implied volatility information to determine volatility based upon its own information.  Therefore the Company uses significant judgment to identify a peer group and determine the appropriate weighting in order to estimate a volatility rate for use in the BSM.





Results of Operations





THREE MONTHS ENDED MARCH 31, 2011 AND 2010





Net sales





Net sales for the quarter ended March 31, 2011, were $26,976,320 as compared to net sales of $8,775,559 for the quarter ended March 31, 2010, an increase of $18,200,761 or 207%.





For the quarter ended March 31, 2011, sales of our invisibleSHIELD product line accounted for approximately 77% of our revenues.  We have experienced significant growth in our indirect channel to big-box retailers such as Best Buy, Target and Radio Shack, wireless carriers such as AT&T, Verizon, The Carphone Warehouse and Cricket, and both domestic and foreign electronics accessory distributors.  We are still focused on distribution through our mall kiosk program and through our website www.ZAGG.com, but the significant growth for 2010 was through our indirect channel as we began selling through additional customers and expanded our SKU count in our current customers.  For the quarter ended March 31, 2011, approximately 70% of our overall net sales were through our indirect channel, 22% was through our website, 6% was through our mall cart and kiosk programs and 2% was from shipping and handling charges.


19


Cost of sales





Cost of sales includes raw materials, packing materials and shipping and fulfillment costs.  For the quarter ended March 31, 2011, cost of sales amounted to $13,329,740 or approximately 49% of net sales compared to cost of sales of $3,831,857 or 44% of net sales for the quarter ended March 31, 2010.  The increase in cost of sales as a percentage of net revenues for the quarter ended March 31, 2011, as compared to the quarter ended March 31, 2010, is attributable to the continued shift towards our indirect channel and the product mix shift from our film products towards hardware products like the ZAGGmate.





Gross profit





Gross profit for the quarter ended March 31, 2011, was $13,646,580 or approximately 51% of net sales, as compared to $4,934,702 or approximately 56% of net sales for the quarter ended March 31, 2010.  The decrease in gross profit percentage is due to the sales mix shift from direct internet sales to indirect customers which have a lower average selling price and increased costs of expediting our ZAGGmate products from China.  As we continue to grow our business, we will have increased sales to our indirect customers which will continue to put pressure on our gross profit margins.  There are no assurances that we will continue to recognize similar gross profit margins in the future.





Operating expenses





Total operating expenses for the quarter ended March 31, 2011, were $8,782,294, an increase of $5,170,384 from total operating expenses for the quarter ended March 31, 2010, of $3,611,910. The increases are primarily attributable to the following:





●
For the quarter ended March 31, 2011, salaries and related taxes increased by $782,874 to $2,152,703 from $1,369,829 for the quarter ended March 31, 2010.  The increase is due to the increase in our staff as we continue to build the people infrastructure to meet the demand for our product and continue to develop new products and offerings, and non-cash compensation expense related to our stock based compensation plan of $303,778.





●
For the quarter ended March 31, 2011, marketing, advertising and promotion expenses were $2,511,816, an increase of $1,450,766 as compared to $1,061,050 for the quarter ended March 31, 2010.  We invested heavily in advertising for the ZAGGmate product line during the quarter ended March 31, 2011.  We expect our marketing and advertising expenses to continue to be a significant expenditure as our revenues increase and expect to spend increased funds on advertising and promotion of our products as well as sales training.  During the fiscal year 2011, we intend to continue to expand our marketing efforts related to our products.





●
For the quarter ended March 31, 2011, other selling, general and administrative expenses, net of salaries and related taxes described above, were $4,117,775 as compared to $1,181,031 for the quarter ended March 31, 2010.  The changes by category are summarized in the table below:





Three Months

Ended

March 31, 2011


Three Months

Ended

March 31, 2010Professional fees

$
750,998


$
62,409Rent


139,869



146,796Credit card and bank fees


356,419



156,325Commissions


749,546



208,395Other


2,120,943



607,106Total

$
4,117,775


$
1,181,031





The increase in professional fees is due to legal expenses incurred related to the defense of our patents, legal work incurred in connection with negotiating the Logitech agreement and accounting fees incurred related to our change of auditors.  Commissions were also up on a comparison basis due to the strong sales of the ZAGGmate product online and continued growth through indirect accounts that we utilize a third-party sales company.




20





Income from operations





We reported income from operations of $4,864,286 for the quarter ended March 31, 2011 as compared to income from operations of $1,331,792 for the quarter ended March 31, 2010, an increase of $3,532,494.  The increase in income from operations for the quarter ended March 31, 2011 as compared to the quarter ended March 31, 2010 is primarily attributable to continued strong sales of our invisibleSHIELD product line successes primarily with the ZAGGmate product line.





Other income





For the quarter ended March 31, 2011, total other expense was $11,259 as compared to other expense of $64,819 for the quarter ended March 31, 2010.  The decrease is primarily attributed to interest expense associated with our credit facility and decreased interest income related to short-term loans.





Income taxes





We recognized an income tax expense of $1,594,573 for the quarter ended March 31, 2011, compared to income tax expense of $475,897 for the quarter ended March 31, 2010.





Our effective tax rate was 32.9% and 37.5% for the three months ended March 31, 2011 and 2010, respectively.  Our effective tax rate will generally differ from the U.S. Federal Statutory rate of 35%, due to state taxes, permanent items and favorable tax rates associated with certain earnings from our operations in Ireland.





Net income





As a result of these factors, we reported net income of $3,310,380 or $0.13 per share on a fully diluted basis for the quarter ended March 31, 2011 as compared to net income of $791,076 or $0.03 per share on a fully diluted basis for the quarter ended March 31, 2010.





Liquidity and Capital Resources





Three Months Ended

March 31, 2011


Increase (Decrease)


Year Ended December 31, 2010Cash used in operating activities

$
(5,070,744
)

$
(1,916,902
)

$
(3,153,842
)Cash (used in) provided by investing activities


(343,194
)


2,592,877



(2,936,071
)Cash provided by financing activities


4,833,051



1,392,838



3,440,213





March 31, 2011


(Decrease)

Increase


December 31, 2010Cash

$
1,767,450


$
(605,843
)

$
2,373,293Working capital


24,342,872



727,788



23,615,084





Net cash used in operating activities for the three months ended March 31, 2011 was $5,070,744, compared to cash provided by operating activities of $196,586 during the three months ended March 31, 2010.  The overall decrease in cash flows from operating activities is due to decreased income taxes payable of $5,036,038 due to payments made on accrued taxes, payments against outstanding accounts payable of $4,450,449, increased inventory of $3,246,010, decreased deferred income taxes of $320,342, excess tax benefits related to share-based payments of $203,430 and decreased sales return liability of $204,667; and were partially offset by decreased prepaid expenses and other current assets of $2,119,836, decreased accounts receivable of $1,466,080, increased accrued liabilities of $461,912, non-cash expense related to the issuance of warrants of $376,751, non-cash stock-based compensation expense of $303,778, depreciation and amortization of $176,206, non-cash expense related to the issuance of shares for consulting services of $100,000, increased accrued wages and wage related expenses of $88,201 and increased deferred revenues of $43,021.




21





Net cash used in investing activities during the three months ended March 31, 2011 was $343,194, compared to cash used in investing activities of $60,433 during the three months ended March 31, 2010.  The increase in cash used for investing activities was due to purchases of property and equipment of $175,695 and payments for intangible assets of $167,499.




Net cash provided by financing activities was $4,833,051 during the three months ended March 31, 2011 compared to $24,567 for the three months ended March 31, 2010.  Proceeds from notes payable were $4,134,834, proceeds for warrant and option exercises were $497,704 and excess tax benefits related to share-based payments of $203,430; partially offset by payments on debt of $2,917.




We reported a net decrease in cash for the three months ended March 31, 2011 of $605,843.





For the three months ended March 31, 2011 and 2010, we generated revenues of $26,976,320 and $8,775,559, respectively, had net income attributable to stockholders of $3,310,380 and $791,076, respectively, and had negative cash flow from operations of $5,070,744 and cash flow from operating activities of $196,586, respectively.  As of March 31, 2011, we had total equity of $37,496,090, retained earnings of $18,011,454, working capital of $24,342,872, accounts payable of $7,521,560, income taxes payable of $2,791,251, sales returns liability of $1,863,004, accrued wages and wage related expenses of $391,166, deferred revenues of $337,952, accrued liabilities of $702,366 and notes payable of $4,162,840.  Management believes that existing cash, along with cash generated from the collection of accounts receivable, our line of credit with U.S. Bank and the sale of products will be sufficient to meet the Company’s cash requirements during the next twelve months.





On March 8, 2011, the Company entered into (i) an Amended and Restated Loan Agreement dated March 7, 2011 (the “A&R Loan Agreement”), with U.S. Bank National Association (“U.S. Bank”), and (ii) a Security Agreement dated March 7, 2011, with U.S. Bank (the “Security Agreement”) and related agreements described in the Loan Agreement and Security Agreement.  The A&R Loan Agreement amends certain terms from a prior Loan Agreement between the Company and U.S Bank dated May 13, 2010.





The A&R Loan Agreement provides for revolving loans and other financial accommodations to or for the benefit of the Company of a principal amount not to exceed the lesser of (a) the “Borrowing Base” (defined below) or (b) Twenty Million Dollars ($20,000,000) and in accordance with the terms of the A&R Loan Agreement and other related documents (the “Loan Documents”).  The Borrowing Base is defined as the sum of (a) eighty percent (80%) of Borrower’s eligible accounts receivable (with eligibility determined pursuant to the A&R Loan Agreement terms) plus (b) fifty percent (50%) of Borrower’s eligible inventory (with eligibility determined pursuant to the A&R Loan Agreement terms), although in no event may the eligible inventory portion exceeds fifty percent (50%) of the total Borrowing Base.  The proceeds under the A&R Loan Agreement may be used for working capital and other corporate purposes.





The A&R Loan Agreement and the credit facility mature on March 15, 2012.





Advances under the A&R Loan Agreement bear interest at LIBOR plus 1.75%.  The default rate of interest is 3% per annum over the otherwise applicable interest rate.  In addition to the accrual of interest at the default rate, in the event a payment is more than fifteen days past due, the Company shall pay a late fee equal to five percent of the missed payment.  Monthly payments of accrued interest shall be due and payable on the fifth day of each month, commencing with April 5, 2011, and continuing on the fifth day of each month thereafter.  At maturity, the entire outstanding principal balance, all remaining accrued and unpaid interest and all other amounts outstanding are due and payable in full to U.S. Bank.





In connection with the A&R Loan Agreement, the Company also entered into a Security Agreement, a Patent Security Agreement, and a Trademark Security Agreement, all of which have been disclosed in more detail in a Current Report on Form 8-K filed by the Company on March 14, 2011.




22





Based on our current level of operations, we believe that cash generated from operations, cash on hand, and available borrowings under our existing credit arrangements will be adequate to meet our currently expected capital expenditures and working capital needs for the next 12 months and beyond.





Off Balance Sheet Arrangements





As of March 31, 2011, there were no off balance sheet arrangements.





Item 3.              Quantitative and Qualitative Disclosures About Market Risk





We are exposed to certain market risks in the ordinary course of our business. These risks result primarily from changes in foreign currency exchange rates and interest rates.  In addition, our international operations are subject to risks related to differing economic conditions, changes in political climate, differing tax structures and other regulations and restrictions.





To date, we have not utilized derivative financial instruments or derivative commodity instruments.  We do not expect to employ these or other strategies to hedge market risk in the foreseeable future.  We invest our cash in money market funds, which we believe are subject to minimal credit and market risk.  We believe that the market risks associated with these financial instruments are immaterial.





Item 4.              Controls and Procedures





Our Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15b under the Securities Exchange Act of 1934 as of the end of the period covered by this Report.  Based on their review of our disclosure controls and procedures, they have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us that is required to be included in our periodic SEC filings.





Changes in Internal Controls over Financial Reporting





We have made no changes in our internal controls over financial reporting in the most recent quarterly reporting period that have materially affected, or are reasonably likely to affect, our internal controls over financial reporting.





Limitations on the Effectiveness of Internal Controls





An internal control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the internal control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.





PART II - OTHER INFORMATION





Item 1.              Legal Proceedings





Our wholly owned subsidiary, ZAGG Intellectual Property Holding Company, Inc. (“ZAGG IP”), is engaged as the plaintiff in patent infringement litigation pending in California and in Utah that seeks to enforce rights under United States Patent No. 7,784,610.  The defendants in these cases have raised defenses and, in some cases, asserted counterclaims against ZAGG IP, that seek declarations of unenforceability or non-infringement of the patent.  These counterclaims do not assert any claims for affirmative relief apart from a request for an award of costs and attorney’s fees to the prevailing party.  There are no claims asserted in these actions against us.   In the opinion of management, the ultimate disposition of these patent infringement claims, including disposition of the counterclaims, will not have a material adverse effect on our consolidated financial position, results of operations, or liquidity.




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We are not a party to any litigation or other claims at this time.  However, from time to time we may become subject to lawsuits and other claims in the ordinary course of business.  Such matters are subject to many uncertainties, and most outcomes are not predictable with assurance.





Item 1A.           Risk Factors





In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I. “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Form 10-K”), which could materially affect our business, financial condition or future results.  The following information updates certain of our risk factors and should be read in conjunction with the risk factors disclosed in the 2010 Form 10-K.  These risk factors should be read carefully in connection with evaluating our business and in connection with the forward-looking statements contained in this Quarterly Report on Form 10-Q.  Any of the risks described below or in the 2010 Form 10-K could materially adversely affect our business, financial condition or future results and the actual outcome of matters as to which forward-looking statements are made.  These are not the only risks we face.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.





We depend on large purchases from a significant customer, Best Buy, and any loss, cancellation or delay in purchases by this customer could cause a shortfall in revenue, excess inventory and inventory holding or obsolescence charges.





For the three months ended March 31, 2011, Best Buy alone represented 27% of our revenue.  Best Buy does not have minimum purchase requirements and can stop purchasing our products at any time or with very short notice.  In addition, including Best Buy, most of our customer agreements are short term and non-exclusive and provide for purchases on a purchase order basis.  We expect that Best Buy will continue to represent a substantial percentage of our sales.  If Best Buy reduces, delays or cancels orders with us, and we are not able to sell our products to new customers at comparable levels, our revenue could decline significantly and could result in excess inventory and inventory holding or obsolescence charges.  In addition, any difficulty in collecting amounts due from Best Buy would negatively impact our result of operations.





Item 2.              Unregistered Sales of Equity Securities and Use of Proceeds





During the three months ended March 31, 2011, we issued the following securities:





We issued 10,439 shares of common stock valued at $100,000, to a consultant.





We issued 92,541 stock options as shown in the table below:





Options Granted

Date Granted

Exercise Price


Price at Grant Date

Expected Life

Volatility*


Risk Free Rate


Fair Value92,541

3/9/2011

$
8.14


$
8.14

3.5 years


90.59
%


1.21
%

$
460,671*Expected volatility is calculated by weighting the Company’s historical stock price to calculate expected volatility over the expected term of each grant.





We issued 195,234 shares of common stock in exercise of options to purchase 195,234 shares.  We received proceeds of $300,114.





We also issued 151,877 shares of common stock in exercise of warrants to purchase 151,877 shares.  We received proceeds of $197,590 related to the exercise of the warrants.





These securities were issued pursuant to Section 4(2) of the Securities Act of 1933, as amended, and rules promulgated thereunder.




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Item 3.              Defaults Upon Senior Securities





None.





Item 4.              Submission of Matters to a Vote of Security Holders





None.





Item 5.              Other Information





None.





Item 6.              Exhibits





a.
Exhibits: The following Exhibits are filed with this Form 10-Q pursuant to Item 601(a) of Regulation S-K:





Exhibit No.
Description of Exhibit





31.1
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 302 of the Sarbanes-Oxley Act of 2002.31.2
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 302 of the Sarbanes-Oxley Act of 2002.32.1
Certification of Chief Executive Officer pursuant to 18 U.S. C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002.32.2
Certification of Chief Financial Officer pursuant to 18 U.S. C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002.








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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.




ZAGG INCORPORATEDDate: May 10, 2011

/s/ ROBERT G. PEDERSEN IIRobert G. Pedersen II,President and Chief Executive Officer(Principal executive officer)




Date: May 10, 2011

/s/ BRANDON T. O’BRIENBrandon T. O’Brien,Chief Financial Officer(Principal financial officer)