Description

Gemstar, the former high-flying gateway to the interactive TV world, has been left for dead. Talk about a CWI (company with issues), this one has them all: accounting issues, value-destroying management, potentially worthless patents, tardy SEC filings, possible NASDAQ delisting and the list goes on. So why is it interesting? The inherent value in the shares has become secondary to all the other noise going on with GMSTE. In addition, there are near-term catalysts that could unlock that value.

Background

Without going into great detail about Gemstar’s less-than-impressive past, here are a few key background items:

GMSTE promised to be the “gateway” to the interactive TV world through its patented interactive programming assets (IPG). Basically, this technology allows digital cable users to navigate programming (e.g., TV listings) through their set-top boxes. The technology had great promise of ad sales and other revenue sources. The stock sold for $100. So why does the stock now sell for $4? Read on.

GMSTE is currently run by Henry Yeun—a controversial figure to say the least. Yuen is a former-patent attorney who is known for his arrogance. In fact, when Scientific-Atlanta (SFA) and Echostar introduced competing technologies, Yuen sued them for patent infringement. Yuen was so confident of his case against the two companies, he (unbeknownst to Wall Street) continued to accrue royalties from them.

GMSTE first disclosed the SFA accruals when it filed its 10-K for FY2001 in March 2002. Needless to say, Wall Street wasn’t happy. The disgust was furthered by the disclosure of $20mm of barter income. Stock went from $20 to $15.

In June 2002, GMSTE lost the patent cases against SFA and Echostar. Stock went from $10 to $5. GMSTE has appealed the decision and the court’s decision whether or not to hear the appeal is expected this week.

On August 14, 2002, GMSTE announced that it would not be certifying its results. Basically, GMSTE plans to reverse the SFA accruals, expense legal fees that had been capitalized with respect to the patent cases and is in discussions with KPMG regarding the proper treatment of the $20mm of barter income.

In addition—and more importantly, GMSTE announced that it had a preliminary proposal to “restructure” its management but did not provide any further details. One important fact: News Corp (NWS), controlled by Rupert Murdoch, owns 42% of GMSTE. Murdoch and Yuen aren’t exactly the best friends. You can read some recent WSJ articles on this subject by searching the WSJ archives. Although not publicly disclosed by the company, the general thinking is that Yuen and his CFO will be paid a large sum of money (maybe $50mm) to assume non-executive roles at GMSTE. NWS would then assume operating control GMSTE—and that’s a good thing.

Investment Thesis

So where is all this heading? GMSTE owns several media assets that have been lost in the shuffle with all the IPG hoopla in recent past. The non-IPG assets are as follows:

-->TV Guide magazine
-->TV Guide channel (cable channel that scrolls TV listings)
-->VCR+
-->C-Band satellite programming company
-->TV Games cable channel
-->SkyMall

Combined, these assets generate approximately $255mm in EBITDA. None of these assets have significant capex associated with them. I think these assets are worth at least $1.5B, or $3.55 per share based on the EBITDA multiples in the table below. You can make your own judgment but I think the multiples above are fairly conservative--especially considering that I ascribed no value to TV Games channel or SkyMall. In addition, I think it’s safe to assume that these non-IPG assets have been largely ignored/under-managed during Yuen’s reign and that some TLC could enhance the cash flow from these assets.

Asset_______________________Proj. EBITDA______________EBITDA Multiple
TV Guide magazine______________$70mm_____________________6x
TV Guide channel______________ $50mm_____________________12x
VCR+___________________________$50mm_____________________3x
C-Band satellite business______$85mm_____________________3x
TV Games cable channel_________$0________________________0x
SkyMall________________________$0________________________0x

Most Wall Street analysts peg the value of these non-IPG assets at $5-7/share vs. my $3.55/share value.

In addition, GMSTE had net cash of $.60 per share at March 31. So the total value of the non-IPG assets is at least $4.15 per share.

What are the IPG assets worth? It is hard to say with certainty but the upside is significant. At this price, you’re not paying anything for them anyway. The IPG segment currently generates a royalty-like cash flow stream from customers such as Comcast, AT&T Broadband, Charter and some others. The run-rate on that cash flow is approximately $100mm annually. Without a lock on the patents, the competition may increase in the future and pricing to GMSTE may decrease. Nevertheless, the potential customer base continues to grow with further digital cable penetration. One thing we can say with certainty: the IPG assets are worth a lot more if NWS is in control rather than Yuen. For starters, GMSTE could win the BSkyB business--an entity controlled by NWS--and provide the IPG product to BSkyB’s 6mm subscribers.

Potential Outcomes/Catalysts

Several near-term events are on the plate:

Resolution of the management issue. NWS assuming operating control would be a huge positive.

Actually reporting 2Q results, filing SEC docs, restating 2001 results and avoiding a delisting would be a positive.

A decision by the ITC as to whether or not to allow an appeal of the initial ITC patent determination is expected any day now. My impression is that most people think the ITC will not allow an appeal of the case and, therefore, the initial negative ruling will stand. If the ITC decides to review the case, it could be a positive.

Potential negative outcomes: Yuen stays in control. Further material accounting issues are disclosed. NWS finds a way to benefit itself at the expense of GMSTE shareholders. It's possible that NWS offers to buy the 58% of GMSTE that it does not own.

At this stage of the game, I think Yeun has been discredited enough and has destroyed enough value that he will not be allowed to stay. He will not go down without a fight however.

Catalyst

Several noted above.