Description

Acclaim Entertainment (AKLM) is the 5th largest US developer of video games for the video game console business (Playstation, Xbox and Gamecube). Acclaim is a company that is in transition from being capital constrained to having the ability to properly market and develop new titles. It has a stable of consistent titles, which produce free cash flow and two potential blockbuster titles (Turok and Vexx) coming out for the Christmas season. Acclaim is cheap relative to its peer group and provides an attractive way to play the coming explosion in video game sales globally. It is suffering primarily from a series of negative perceptions on the part of investors which are outlined here and discussed in detail below;
1. There is a going concern opinion on the company last audit.
2. Management’s reputation of being promotional.
3. There is an overhang of stock placed to repay $29MM of debt that matured in March 2002.
4. The company’s miss of q3 revenue and earnings and its bloated days sales outstanding.


INDUSTRY
The video game industry is now in the second year of what will probably be a five year growth cycle for the console business. UBS Warburg projects that the world wide installed base of next generation consoles will grow at 76% compounded from 2001 – 2004 to approximately 131 million machines. The tie ratio (games per console) of in excess of 10, implies over 1.3 billion video game titles will be sold from 2001 to 2004. Assuming Acclaim is able to hold its market share, there is tremendous upside potential in Acclaim shares.

HISTORY
Acclaim, founded in 1987, has been through the last three cycles of video game sales. It has managed to perform well during the up side of the cycle each time, only to falter each time as it matured. In the last cycle, Acclaim put too much debt on its books in the form of a $50 million convertible note. When this note came due in March of this year, Acclaim used private placements of stock and debt for equity swaps to allow it to pay off the note. The potential inability to repay this debt caused the company to receive a qualified opinion from its auditors KPMG. SINCE THE DEBT HAS BEEN PAID IN FULL, THE GOING CONCERN OPTION WILL BE REMOVED AT THE TIME OF THE NEXT AUDIT (FISCAL YEAR ENDS IN AUGUST).

PRODUCTS
Acclaim has some proven video franchises to go along with some potential hit titles. It main sports title, Derek Jeter All-Star Baseball, is the number 1 rated and best selling baseball title in the market. It augments its sports franchise with NBA Jam (mediocre seller), Legends of Wrestling (average seller), HBO Boxing and Punch King. In the alternative sports arena, it has Dave Mirra BMX (good seller), Jeremy McGrath Supercross (average seller), ATV Quad (good at Walmart and nowhere else) and the new hit Aggressive Inline. Aggressive Inline, a inline skating game, has sold well and adds another long term title to the arsenal.

In the action arena, Turok has historically been a top selling title on the old console platforms. It has consistently sold over two million copies per platform. With so many new consoles out, most analysts are looking for at least two million copies in this cycle. The other existing titles are Shadow Man (good title), Headhunter (good title) and Ecco the Dolphin (mediocre title). Both Headhunter and Ecco are titles produced by others that were adapted to a platform by Acclaim. On the new title front, Vexx is an exciting title due out for Christmas. It is any edgy game similar in character to Mario Brothers. It was well received at the E3 show in Los Angeles. It is hard to project sales of new titles, however the buzz surrounding it is very positive.

The company also has a number of racing titles that they produce or reformat. The major title in this area is Burnout (above average seller). It is a racing game that allows the cars to reflect the damage they receive. It is complemented by Crazy Taxi (mediocre), 18 Wheeler (OK), Extreme G Racing (mediocre) and Paris Dakar Rally (average).

The final category is girls’ video games. This is a very small part of the overall gaming market and Acclaim has the #1 brand in this niche with Mary Kate and Ashley (former child TV stars). They produce a number of SKU’s and do well with the brand.

FINANCIAL PERFORMANCE
Sales have been growing nicely over the last twelve months despite the lack of capital at Acclaim. For the three and nine months ended June 2, 2002 sales were $63MM and $215MM, respectively. These are increases of 63% and 42% over the prior year’s respective periods. Full year sales are projected to come in at $301MM, a 52% increase over fiscal 2001. For fiscal 2003 (August year end) the company is projecting $379MM, a 26% increase over 2002. IN CONVERSATIONS WITH MANAGEMENT, THEY HAVE INDICATED THAT BUDGETED SALES NEEDED TO MAKE THE COMPANY’S PROJECTIONS FOR FISCAL 2002 AND 2003 HAVE UNITS SALES NUMBERS FOR TUROK AND VEXX BUDGETED WELL BELOW STREET ESTIMATES.

Gross margins have been somewhat volatile and are currently in the high 50% to low 60% range, with management guiding to the low 60’s for future margins. On an operational and fully taxed earnings basis, Acclaim is profitable. The company is looking for $.39 EPS this year ($.30 already for 9 months) and $.67 EPS for 2003. Assuming Acclaim would be fully taxed (they have a $200MM NOL), EPS would be $.23 and $.40, respectively. Currently, the stock is trading for 8.7x and 5.1X 2002 and 2003 earnings, respectively.

For q3 2002 the company came in $2.1MM under plan for sales and $.01 under for EPS. The company claimed the miss was due to timing of revenues. However, margin was 5 points under plan too. Raising some questions of sales and earnings quality for the quarter. For q4, the company expects to make up the sales miss and to have margins comfortably in the low 60’s. WITH THE RELEASE OF TUROK DURING THE QUARTER AND CONTINUED ROLLOUT OF AGGRESSIVE INLINE, BOTH PREMIUM TITLES, I BELIEVE THIS RESULT IS ACHIEVABLE.

Acclaim’s balance sheet is relatively strong with cash of $40MM against $23MM of bank debt and capital leases. Acclaim also has $31.3MM outstanding under a factoring line with GMAC. DSO is at 59 net of factored receivables (103 days without factoring). This is troubling on the surface and could mean that Acclaim stuffed some channels. MANAGEMENT CLAIMS THAT IT RELATES TO THE BULK OF SALES COMING IN THE LAST MONTH OF THE QUARTER AND THAT THE DSO WILL RETURN TO NORMAL LEVELS NEXT QUARTER. The major off balance sheet asset is the $200MM net operating loss carry-forward that Acclaim can use to offset earning through 2011.


COMPARABLE COMPANY VALUATIONS:


P/E X AKLM AKLM MWY ERTS ATVI TTWO THQI
Taxed
2002 8.0 13.3 13.8 36.0 24.8 11.2 21.4
2003 4.5 7.7 9.3 27.5 21.9 9.8 17.4

EBIT X
LTM 9.0 NA 55.1 19.8 10.0 14.7

Sales X
LTM 1.2 2.6 5.0 2.0 1.1 2.1


P/E X Avg. Avg. Size AKLM
Excl. Excl. Discount
AKLM AKLM 20% Implied Value/Share*
& TTWO
2002 21.4 24 19.2 $4.50
2003 17.2 19 15.2 $6.10

EBIT X
LTM 24.9 29.9 23.9 $8.30

Sales X
LTM 2.6 2.9 2.3 $6.10



AKLM = Acclaim, MWY = Midway Games, ERTS = Electronic Arts, ATVI = Activision, TTWO = Take Two Interactive, THQI = THQ Interactive.
* Calculation uses 1) a taxed version of AKLM numbers, 2) group average excluding AKLM and TTWO 3) less a 20% to adjust for AKLM’s smaller size and market share.

I believe that the video game industry is one of the few true growth industries available to investors and will therefore tend to trade better than the overall market during the next year. Acclaim trades at a nice discount to all of its peers except Take Two. Take Two is largely a one-title (Grand Theft Auto) company and has recently had to restate numbers due to accounting problems.

Assuming Acclaim meets the street estimates and multiples don’t compress any further at its comparable companies, then shares of Acclaim could rise to between $4.50 and $8.30 per share based on a range of multiples. USING ’03 P/E AND LTM SALES MULTIPLES SUGGEST A VALUE AT THE MIDPOINT OF THIS RANGE AT $6.1/SHARE MORE THAN 100% ABOVE THE CURRENT PRICE. This analysis gives Acclaim no credit for its $200mm of NOL and assumes a 20% discount for size. If the NOL is valued at 40% (tax rate) then the cash value is $80mm or an additional $0.88/share. If no size discount is applied (with expected ’03 growth, Acclaim will approach the size of THQ and Activision) then the share price on a relative value basis could range from $5.40 to $10.00.

Catalyst

1. Sales – With robust industry sales expected for the next few years, Acclaim stands to improve earnings and cash flow by just keeping market share. If any of its titles become hits, then the upside could be multiples of today’s stock price.
2. Industry Consolidation – There are approximately 15 meaningful video game developers in the world. With the increased cost of creating games, there will be limited new entrants into the market and a higher emphasis on extending existing brands and titles.
3. Several large Japanese game makers trade at significantly higher multiples than their US counterparts and so the acquisition of a domestic player would be immediately accretive. Acclaim already has a history of working closely with Japanese companies as it has reworked several game titles for US distribution.