Description

Gigamedia Limited (GIGM). Gigamedia is the third largest broadband ISP in Taiwan. The attractions for value investors are extremely strong financial condition (debt free and holding over $3.60 per share in cash and fixed income investments) and conservative financial management (low cash burn turning to positive EBITDA and cash flow in 2003).

SUBSEQUENT EVENT

After I prepared this analysis in January, Gigamedia announced 2 acquisitions, but will not release financial information about the deals and revised financial projections until March 14th. I believe the current share price is extremely attractive so I am submitting the idea now. I will post updates as additional information becomes available.

My acquisition comments and expectations are at the end of this write-up.

CASH & FIXED INCOME INVESTMENTS

The most attractive value characteristic is the large cash equivalents balance (my 12/01 estimate is US$180mm) remaining from the 2000 IPO (at $27 per share). My reference to cash equivalents includes amounts shown on the balance sheet as “Cash,” “Short-term investments,” and an additional $15mm in long-term fixed income investments included in the “Investments” line. Shareholders recently approved a special return of capital distribution of US$2 per share. The press releases refer to a distribution in the first half of 2002 following approval by the High Court of Singapore. The company says that approval is just a formality expected to be complete in 4-8 weeks and it is reasonable to expect the distribution within 3 months.

I believe investors should analyze the share price and valuation on an “ex-dividend” basis. In recent days the stock has traded around $2.40 so the “ex-dividend” price is around $0.40. As the distribution date nears I believe that some of the value and potential remaining after the cash distribution will begin to be reflected in the share price. Following this distribution the company will still retain cash equivalents of $80mm or $1.56 per share. I estimate that the company’s broadband business will use $15mm of cash in 2002 and generate positive cash flow of $1mm in 2003 leaving a balance of $66mm in 4Q/03. That would be $1.22 per share assuming that outstanding shares increase to 54mm. Some of these cash balances will be applied to the recently announced acquisitions (see final section).

The company has no significant off-balance sheet capital commitments. Capital expenditure requirements in 2002 are very moderate.

BUSINESS DESCRIPTION

Taiwan had an estimated 800,000 broadband internet customers at 12/01 and is projected to have 1,750,000 customers at 12/02. The market is very competitive and margins on access service are expected to remain thin. GIGM is the third largest broadband ISP and tries to distinguish itself from competitors by offering better service (e.g. standard 786k DSL service vs 512k offered by the largest ISP) and by specialized content offerings.

CONTENT PARTNERSHIPS & ALLIANCES

Gigamedia has been very successful at forming partnerships and alliances that bring specialized content to its customers and in some cases offer potential for expansion via other service providers in Taiwan and the Greater China region. GIGM offers packages combining access with one or more premium offerings. These partnerships and alliances include:

1) Gamania. This company is Taiwan’s largest subscription based on-line gaming service (1.4 million members). Gamania also offers services in Hong Kong and Korea. GIGM purchased 10% of Gamania in 2001 for $11mm. The company is profitable and generated about US$35 million in revenue last year. An IPO is expected in 03/02.
2) ALFY. A US-based children’s education service. GIGM partnered with ALFY to develop a Chinese language service that has excellent potential in a market where parents value education.
3) Gigamusic. An online distribution service for Chinese language music. Partners include Rock Music (the largest Taiwan-based Chinese popular music label) and EMI. Gigamedia also has a separate partnership with Singapore One.
4) Microsoft. Currently MSFT owns 8% of GIGM stock and appoints one board member. Cooperation to date has been primarily through GIGM use of MSFT technology, but interesting potential will come when on-line gaming features are released for the XBOX platform.

Gigamedia’s goal is to form partnerships that do not require significant capital investment or expenditure. Partners provide content, Gigamedia provides distribution, and revenues are shared.

OWNERSHIP & CORPORATE STRUCTURE

Gigamedia is an affiliate of the Koos Group, one of Taiwan’s largest private business groups. Among the most important Koos Group businesses are ChinaTrust Commercial Bank and KG Telecom. The group includes 16 cable service providers that provided the initial basis for GIGM’s access business. GIGM is the exclusive broadband provider on these systems (plus 6 more operated by unaffiliated cable companies.) Koos Group companies own approximately 60% of GIGM common shares and therefore Koos Group interests are aligned with those of other GIGM shareholders.

GIGM is incorporated in Singapore in order to avoid restrictions on foreign purchase and sale of shares in Taiwan companies. The Singapore parent company owns 100% of the Taiwan operating company (Hoshin Gigamedia Center Ltd.) Financial statements are prepared on a consolidated basis in accordance with US GAAP.

GIGM’s only listing is on Nasdaq. This must have seemed like a brilliant idea at the time of the IPO, but now GIGM is orphaned with no analyst or media coverage and little investor awareness of the company. The company has considered an additional listing on either the Singapore or Hong Kong exchange but a combination of legal complications and additional expenses has so far prevented any change. The company has considered a roadshow for US investors, but will probably not travel in 2002 because its primary focus is on expense reduction.

Gigamedia makes 20-F and 6–K filings with the US SEC, but they cannot be accessed via the EDGAR electronic retrieval system. 13D/G filings from the Koos Group entities that own 60% of GIGM are not on EDGAR, but the company confirms that KG ownership has not changed. The 20-F reports and other interesting information are stored in the investor relations section of the Gigamedia web-site: http://ir.giga.net.tw/

Further information is available from Brad Miller, Director of Investor Relations:
bradley_miller@corp.giga.net.tw
886-2-8770-7966 ext. 1107


FINANCIAL PERFORMANCE & CASH BURN

Revenues. Growth has been rapid. Subscriber count increased from 60,000 at 12/00 to approximately 120,000 at 12/01 and is projected to reach 200,000 at 12/02. Revenues are shown net of fees shared with cable and telephone service providers. The key to future profits will be the ability to expand revenues from premium content offerings. The subscriber forecast appears conservative and the company should have 250,000 subscribers by 12/02 simply by maintaining its current market share.

Expenses. Even as revenues climb, expenses have fallen significantly due to 1) aggressive cost-cutting, 2) declining long-distance telecommunication expense, 3) reduced cost of customer acquisition, and 4) exit from money-losing modem sales and rental business. Note that non-cash depreciation and amortization of $4.3mm per quarter is not broken out as a separate line item. A restructuring was announced 01/29; I believe the expense savings were already implied in the company’s 2003 forecasts.

The company forecasts that continuation of these trends can generate positive EBITDA by 1Q03. Cash flow will turn positive ahead of EBITDA because of interest income. I believe the company may slightly delay these expectations at the next conference call and my projections assume reaching positive cash flow and EBITDA by 3Q/03. I estimate that the company will use $15mm of cash in 2002 and generate positive cash flow (after capex) of $1mm in 2003 leaving a cash equivalents balance of $66mm in 4Q/03. Some of this will be applied to the recently announced acquisitions (see final section).

Intense competition among service providers in Taiwan is expected to result in some industry consolidation. Gigamedia has said that it would only make an acquisition if it brought an immediate financial benefit. The terms of the recent acquisitions have not yet been disclosed, but the company says that they will immediately increase cash flow and profitability.


COMPS & VALUATION

An interesting comparison can be made with Korea Thrunet (KOREA), the largest broadband access provider in Korea with 1.2mm broadband access customers. KOREA’s heavy debt represents most of its enterprise value of $773mm. Assigning 78% of the EV to the access business (based on revenue split) leads to an EV for the access business of $603mm or $502 per subscriber.

Another reference point is Earthlink (ELNK) whose access business (94% of revs) has an enterprise value of $362 per customer.

GIGM’s large cash balance currently implies a negative value for GIGM’s access business and a negative value per customer.

Prior to the recently announced acquisitions I estimated that GIGM would have about $1.22 per share in cash and fixed income investments at YE 2003. Assuming a conservative valuation of $250 per subscriber and 375,000 subscribers at that time then the access business will have a value of about $1.73 per share. If Gamania at least retains its value of $11mm then it would be worth an additional $0.20 per share. The combined value of $3.15 compares to a current ex-dividend valuation of around $0.40. The heavy insider (Koos Group) ownership and conservative management to date suggest that GIGM is committed to creating value for common shareholders.

IMPACT OF RECENTLY ANNOUNCED ACQUISITIONS

On 2/2/2, Gigamedia announced that it would acquire the two largest record store chains in Taiwan, but has not yet disclosed the terms of the acquisitions or released revised financial projections. Potential GIGM investors are left with a dilemma of whether to purchase shares at a very low price with imperfect information, or to wait one month for clearer information about the terms of the acquisition and the timing of the $2 distribution with the risk that complete information would make it impossible to purchase shares at current prices.

Considering Gigamedia’s conservative financial management and control by insiders, I am willing to assume that the information released next month will be satisfactory and will increase the company’s attractiveness. Some factors to keep in mind:

The purchase price has not been disclosed. The only pure play music retailer in the US is TransWorld Entertainment (TWMC) valued at about 0.25 times annual sales. I mentioned this figure to Gigamedia and my concern that the company would want to retain significant financial flexibility. I was told that my numbers were on the right track (the chains had total sales of about $85mm last year so 25% would be $21mm) and they shared my conservative financial outlook, but they could not give me any specific numbers until there had been a formal announcement. My own assumption is that the acquisition cost will turn out to be less than 50% of the company’s YE2002 cash, or less than $33mm. That price would leave a YE2003 cash projection of at least $0.61, plus whatever cash the chains generate up to that point. I feel that still provides more than adequate support for an investment at the current share price.

The acquisition increases the operating leverage. If the retail business becomes a cash drain then the safety provided by the cash reserves will be lost. Retail music sales in the US are a poor business due to intense competition, but in Taiwan the situation is more favorable. Aside from the two chains being acquired by Gigamedia, the country has no other large national music retailers. If the retail business can continue to generate cash and can be integrated with the on-line business then Gigamedia has an excellent opportunity to develop a unique identity in the marketplace with close ties to content producers and a strong retail image.

I will post an update as soon as new information is available.

Catalyst

1) $2 per share special cash distribution within 3 months
2) Reaching positive cash flow by 3Q/03
3) Long-term business growth potential