Description

Mad Catz Interactive (MCZ) was written up on VIC in May 2002 by pokey351. We want to take the opportunity to present this idea again, since MCZ appears to be a timely opportunity right now. MCZ is at about $0.75. The stock has been fairly volatile within a range of $0.60 to $1.30 in the last year. Yet we think it’s poised for a sustainable upturn that should begin soon. While the company has only done $0.02 to $0.04 of EPS in each of the last few fiscal years and our best guess is that they will report a similar, marginally positive amount in the fiscal year ended 3/31/04, we believe the stars have lined up for MCZ to do much better in the FY ended 3/31/05, and to continue to do well beyond that. We believe MCZ could generate EPS of $0.15 or more in FY 2005 (the next 12 months), based on a confluence of industry and company-specific factors that have not yet been recognized in MCZ’s price. If MCZ does $0.15 EPS and the market gives the stock a multiple of 15-20 times, you get a $2.25 to $3.00 stock price – potentially a triple or quadruple.

Over the last few years, a number of key events have taken place which have positioned MCZ as the leader in its industry. A major competitor left the market in early 2003, and MCZ made an interesting acquisition in early 2003. Additionally MCZ has “the wind at its back” in terms of overall industry trends which should support MCZ’s growth in 2004 and 2005. Although MCZ is a small cap company, the stock is surprisingly liquid (average 450,000 shares traded daily during the last 3 months on the American Stock Exchange). (The stock also trades on the Toronto exchange – however, note that all numbers in this report are in US dollars.)

MCZ is the leading third party developer and marketer of video game accessories. They make hardware accessories such as controllers, steering wheels, and adaptors, as well as “cheat” software, which are used with the current generation of video game consoles – Sony Playstation2, Microsoft Xbox, Nintendo GameCube, and hand-held games such as Gameboy and Gameboy Advance. They also continue to sell accessories for the prior generation of consoles. Here is some data that provides some perspective on the role of accessories in the overall video game market: Of the roughly $10.0 billion in US industry-wide video game industry sales at retail in 2003 – about 12% or $1.2 billion was from accessories. Of this $1.2 billion accessory market, roughly 50-60% is met through the first party manufacturers – Sony, Nintendo, Microsoft – who sell controllers and other accessories in addition to the gaming consoles – while about 40-50% is met through third party manufacturers such as MCZ. Retailers tend to carry both the first party accessories and the third party accessories, with the first party accessories setting the “price umbrella”, and the third party accessories priced 30-40% lower. Hence the third party accessories tend to attract the more price conscious consumers, and thus become more important as the game cycle matures and each generation of consoles become more entrenched in the mass market. The third party accessories market had historically been led by Interact (a subsidiary of a formerly public company called Recoton) which had about 20-25% of this market in 2001, and MCZ was a relatively close second with around 14% market share in 2001. Since then, Interact has exited the market due to poor management, and MCZ is now the industry leader with an estimated 20-25% US market share, plus a significant international presence.

The video game industry as a whole runs in multi-year cycles, but overall continues to achieve meaningful long term secular growth. The multi-year cycles are driven by the introduction of new gaming consoles. Sony Playstation2 was introduced in late 2000 and Microsoft Xbox and Nintendo GameCube were introduced in late 2001. After launch, the rate of sales of these consoles increase for the next 3-5 years, and over time price cuts by the manufacturers make the consoles more and more affordable and reach further and further into the mass market. Price cuts by the console manufacturers during the cycle are important in creating further penetration of the consoles, which in turns spurs demand for accessories and software -- this is the key for why we believe MCZ is entering the sweet spot of its cycle right now. Given the lack of significant console price cuts in 2003 which has extended the current cycle, it appears more likely that the next generation of consoles will be introduced later (2006) rather than sooner (there is some industry talk that the Xbox2 might be introduced in late 2005 and the Playstation 3 and GameCube 2 in 2006).

In FY 2001 (ended 3/31/01), MCZ did revenues of $56 mm, in FY 2002 MCZ did revenues of $83 mm, and in FY 2003 (ended 3/31/03) MCZ did $91 mm. Our best guess is this year (ended 3/31/04) MCZ did $105 to $110 mm in revenues. While the growth from $91 mm last year to $105-$110 mm or so this year is around 15-20% growth in revenues, there were several factors that actually slowed down MCZ’s growth in FY 2003. 1) Previously, MCZ had a product under license from Sony (a Sony PS2 memory card) which was 30% of revenues in FY 2002 and 16% in FY 2003, and zero in FY 2004. Adjusting for this lost business, MCZ’s revenues will actually be up around 40-45% for the just ended fiscal year, on top of roughly 30% in the prior year. 2) 2003 was a weaker than expected year for the entire video game industry, because the major console manufacturers failed to make a major price cut during 2003. As a result of the lack of major price cuts, unit sales of the three major consoles were actually down 5-10% in 2003, and software sales were only up 5%, and accessories sales were down about 1% for the industry – overall this was a disappointing year for the industry, but MCZ’s 40-45% adjusted revenue growth shows that MCZ is actually executing well and growing much faster than the market (although probably roughly one third of their adjusted growth last year was from the “GameShark” software acquisition done in early 2003, assuming $10 mm of revenues from this business). This console price cut issue is an important issue which should have a major impact on FY 2005 results for MCZ, and will be discussed in more detail below.

The respective market shares of the big three consoles (excluding handheld systems) in 2002 in terms of unit sales was roughly: 61% for the leader Sony Playstation2, 23% for Microsoft Xbox, and 16% for Nintendo GameCube. Accessory sales for each of those three different games are roughly proportionate to the console sales. Thus Playstation2 accessories are much more important to MCZ than GameCube accessories.

Going into 2003, Xbox and Playstation2 were each priced at $199 retail, and GameCube was at $149. In spring 2003, Xbox and Playstation2 prices were effectively reduced to $179 – which was viewed as too minor of a price cut to spur demand (in fact the Playstation2 price wasn’t explicitly cut – Sony created a new bundled product with an internet-ready PS2 that remained priced at $199 and they sold the stand-alone non-Internet product at $179 – so PS2 likely didn’t get the full effect of this move as a price cut, since the product that Sony wanted to market as the main PS2 remained at $199). Many industry participants were looking for further price reductions for the 2003 holiday season, which didn’t happen. As a result, 2003 was disappointing overall. For the 2003 year overall, unit sales of the Playstation2 were actually down 25% to 6.4 mm units from 8.6 mm units in 2002 – Sony’s original plan was to actually sell 10 mm units in 2003. Xbox’s unit sales were basically flat in 2003 at 3.2 mm units. Effectively Sony and Microsoft decided to delay console price cuts until 2004, to extend the overall current game cycle. (The strategy of attempting to extend the game cycle makes a lot of sense – but only up to a certain point of course -- because of the enormous cost of developing the next version of the console.)

GameCube, which was the number three console in 2002 with a total of 2.3 mm units, did not cut its console price in spring 2003, and through the fall its 2003 console unit sales were basically flat with 2002. However, in September 2003, the GameCube console price was cut from $149 to $99, which created huge demand for GameCube. In Q4 2003 (the key seasonal quarter for these businesses), GameCube unit sales were up 64%, and as a result for the full year 2003 GameCube unit sales were up 40% to 3.3 mm units, which surpassed the Xbox for the year. This discussion has some important ramifications for MCZ in FY 2005. GameCube has historically been the weakest of the big three consoles – in MCZ’s 12/31/02 quarter, GameCube accessories accounted for about 8% of MCZ revenues (versus 25% for Xbox and 41% for PS2, with the balance GameBoy and other such as prior generation consoles). However, with the September 2003 GameCube console price cuts, MCZ saw very significant growth in GameCube accessories – in the 12/31/03 quarter, GameCube was about 11% of total MCZ revenues. So effectively, the GameCube price cut resulted in approximately 40% growth year over year in MCZ sales of GameCube accessories (from 8% to 11% of revenues). This shows the big impact that the eventual price cuts on Playstation2 and Xbox should have on MCZ’s revenues – and this factor is what we believe to be the big near term driver for MCZ sales and earnings growth.

Playstation2 and Xbox combined were about 54% of MCZ revenue in the 12/31/03 quarter (down from 66% in the year ago period due to the growth of GameCube and the GameShark acquisition). When the console price cuts are implemented on these two consoles, unit sales of consoles and accessories should have a significant increase, following the pattern of GameCube in late 2003. In fact, Microsoft just initiated a price cut on the Xbox from $179 to $149, effective March 30th, 2004. It’s likely that Sony will follow with a cut to $149 in April or May. This current round of price cuts should stimulate console volume over the next 6 months, and it’s likely there will be another round of price cutting to the $129 price level before the 2004 holiday season. The bottom line is that these price cuts are already in progress, and should have a big effect on MCZ’s revenues and earnings, since they will drive demand for PS2 and Xbox consoles, and accessories will go along with that. MCZ had good revenue growth in FY 2004 without price cuts from #1 Playstation2 or #2 Xbox, and in FY 2005 they should have bigger revenue growth stimulated by these console price cuts. Additionally, Playstation2 and Xbox accessories are higher priced and higher margin products than GameCube accessories, and MCZ’s high-margin software product GameShark is really a Playstation2 product – as a result, accelerated unit sales of these consoles should have a disproportionately positive effect on MCZ’s margins.

While we cannot precisely quantify the effect of the console price cuts, there is an obvious major benefit of the expected Sony and Microsoft console price cuts on MCZ fundamentally. Additionally, these price cuts could serve as a major catalyst for the stock, as small hedge funds and other small-cap momentum traders rush into stocks like MCZ that stand to benefit from these price cuts when they do happen and the effects become apparant. (Even though the stock is small-cap, it’s both quite liquid and relatively volatile, and it’s Canadian – we think there’s a good chance it will attract attention from these types of traders.) Typically major industry announcements in the video game industry happen at or before the major trade show E3 which is held in May each year, so before E3 is the likely timeframe for the PS2 console price cut. (Incidentally, leading up to E3, industry participants tend to issue numerous press releases on new products and also make strategic announcements. This tends to generate a lot of interest in the stocks of companies in the video game industry in the months before E3. Last year, MCZ stock was up 50% from March through the start of E3 in May on no substantial news – this E3 phenomenon may be a catalyst for MCZ stock again this year, especially since MCZ stock is currently depressed, well off its recent highs, and likely possesses true fundamental catalysts coming up in the near term.)

MCZ’s strong revenue growth in 2003, even considering the loss of the Sony memory card business and the generally weaker than expected console sales, shows the underlying strength in MCZ’s business. Key drivers of this strength have been the exit of key competitor Interact from the market in early 2003 (although liquidation of Interact inventory by retailers likely negatively impacted MCZ during the first half of 2003), the acquisition of a business called GameShark in early 2003 (which got off to a slower than expected start for MCZ), and overall growth in market share and international growth. MCZ has distribution through 9 of the 10 largest video game retailers in the US, and is also rapidly growing their Canadian and European operations. MCZ is the biggest third party supplier of accessories, and believes they are best positioned as the “one stop shop” where retailers can source a full range of accessories for all consoles. The Mad Catz brand name and the GameShark brand name are thought to be the leading brands in accessories and “cheat software”, respectively.

While MCZ’s revenue growth has been strong over the last three years or so, they have not brought very much of that revenue down to the bottom line as they’ve focused primarily on their growth opportunities. The company had a small loss in 2001, and had small positive EPS in each of their 2002 and 2003 fiscal years, and should be similarly modestly profitable in FY 2004 just ended. The next step in the development of MCZ is to focus on bottom line profitability. MCZ needs to translate its revenue growth and market position into bottom line profits, and management has identified this as a focus. They’ve been talking about taking actions to reduce operating and SG&A costs (such as a consolidation of their US and Canadian offices, renegotiation of certain service contracts, and doing an overall review of products for contribution and looking for other cost savings opportunities), and management has indicated that they are focused on this as the last hurdle to MCZ really generating significant earnings, now that they have the right products, can source them at acceptable gross margins, and have built distribution through the major retailers.

While MCZ’s results have been difficult to project, it’s relatively easy to see how they could do much better in 2004. If they do $107 mm revenue in the 3/31/04 FY, and revenues grow by 25% to 35%, that results in $134 mm to $145 mm in revenues in FY 3/31/05. Assuming a 25% gross margin (up from 22-23% recently due to an assumed higher proportion of revenues from higher margin PS2 and Xbox products and GameShark software), less $13 mm selling expenses (up 10% from prior year estimate), and $7 mm of SG&A (down about $1.5 mm from prior year due to $1.5 mm savings from office consolidation project), less $1.3 mm depreciation – all of this, if achieved, would result in operating income of $12 to $15 mm (9% to 10% operating margins). You then further reduce this by $1.5 mm of interest expense and use a 35% tax rate, divided by 54 mm diluted shares, and you get a result of $0.13 to $0.16 per share of EPS. We can’t really predict what MCZ is going to do, but this gives a flavor for how we believe the company could generate significant levels of earnings. $0.15 EPS times a multiple of 15-20 gets you to $2.25 to $3.00 stock price – again, a potential triple or quadruple if MCZ does what we think it could do.

MCZ has about 54 mm diluted shares, so at the current price of $0.75, the company has a market cap of about $40 mm. MCZ does carry some debt, which is supported by working capital – at 12/31/03, MCZ had $22 mm on their bank line, which along with $28 mm payables, is financing $35 mm of receivables and $19 mm of inventory. Both debt and receivables should be coming down in the current quarter after receivables are collected from the peak 12/31/03 quarter. So if average debt is more like $15 mm, then enterprise value is around $55 mm. This compares to what we believe is a reasonable near term operating income target of $12-15mm.

The main “raps” on the stock would be:
1) Some investors may think the balance sheet is a little weak at 12/31/03, with debt at $22 mm, although this should be down at 3/31/04 through the collection of receivables. We think that if the company wanted to they could do a modest equity infusion through a PIPE or other mechanism to put this potential concern behind them.

2) Misperceptions about the effect of the game cycle and overall industry demand, on MCZ. At this point, it appears the next generation of consoles will be launched in late 2005 to late 2006. The fact that Sony and Microsoft have held off from instituting the major price cuts now underway, suggests that there is still plenty of room for growth in this game cycle. For example, a total of 29-30 million Playstation1 units were sold in the prior generation of consoles, and of these total units, roughly 20 million were sold after retail prices were reduced below $150. So far, roughly 22-23 million Playstation2 units have been sold in the current generation, all of which were sold at $180 or higher – implying that there is still huge potential in the current game cycle, with appropriate console pricing. The reduction of these console prices below $150 retail (and eventually moving to under $100) will truly open up the mass market buyers for these units, where the big volume historically has been. Although peak cycle profitability may have already occurred for Sony and Microsoft, we believe MCZ is just now entering the sweet spot of its cycle. Also, the rapidly increasing installed base of these consoles should continue to allow MCZ to grow its accessories business in FY 2005 and thereafter, since the original accessories wear out over time. Additionally the launch of one or two new handheld game systems (by Sony and Nintendo) should help the market in 2005. So we think MCZ probably has two years of high growth in the sweet spot of this game cycle, followed by flat to modest sales growth for a while thereafter before later accelerating substantially again (during the sweet spot of the next game cycle). Accessory demand is linked to both the rate of sales of console units in a given period and the total installed base of consoles – as a result, accessories have a long tail (MCZ still sells some accessories for the Playstation1 system for example), which should help MCZ even when the current game cycle fades.

3) Pending litigation against MCZ by a company called Pelican, a competitor in the accessories market, relating to MCZ’s acquisition of GameShark in early 2003. Pelican’s allegations include that MCZ conspired with cheat code content provider Fire International (now a vendor to MCZ) to misappropriate Pelican’s proprietary game codes, and also that MCZ and Fire conspired to use confidential information from Pelican to win the bidding for the GameShark brand. Pelican was unsuccessful in getting a restraining order to stop MCZ from selling GameShark products, but the litigation is ongoing. MCZ says the claims are baseless and without merit. In any event, GameShark revenues are less than 10% of total MCZ revenues.

4) MCZ has done well over the last few years in building itself into the dominant third party accessories marketer, but so far they haven’t brought significant profits down to the bottom line. This has resulted in volatility in the stock (including the current buying opportunity). We think some investors may have thrown in the towel on MCZ because it hasn’t been able to translate its revenue growth into earnings – for example, the two Canadian analysts who follow MCZ have recently gone negative on the company, which suggests the stock is pretty washed out and could now be a good opportunity now. There has recently been a shift in senior management, with the former CEO retiring and being replaced by the COO – this change in leadership provides the opportunity to refocus on profitability. Also, if management fails to earn good margins, we suspect that the Board, led by Canadian entrepreneur and investor Patrick Brigham who owns 16% of the company, will ultimately sell MCZ to a bigger company which can leverage MCZ’s revenues and brand names into real earnings. MCZ’s $55 mm enterprise value is roughly 40% of expected revenues, so even if MCZ management can’t create good profits out of its expected $130mm of revenues, there is probably upside for a consumer electronics company who can acquire this company and generate 10% operating margins by reducing overhead and making other efficiency improvements.

In conclusion, we find MCZ very interesting at this particular point in time due to 1) the fact that MCZ sold off from over $1.20 in February after their most recent quarterly results down to $0.75 presently – there just aren’t many beat-up stocks out there today with decent prospects and operating momentum like MCZ, 2) the significant changes that have taken place at MCZ over the last few years which have allowed MCZ to grow revenues at a fast clip and which should continue to provide for revenue growth – the exit of Interact from the market, the acquisition of GameShark, in combination with the recent focus on profitability at MCZ, and 3) the potential near term catalyst of major console price reductions by Sony and Microsoft which will stimulate overall demand for consoles and accessories, driving MCZ revenues, and put more visibility on the industry (along with overall industry hype leading up to E3 trade show in May 2004).

Disclosure: We and our affiliates are long MCZ, and may buy additional shares or sell some or all of our shares, at any time. We have no obligation to inform anybody of any changes in our views of MCZ.

Catalyst

Console price cuts, leading to higher industry visibility and revenue growth, which should eventually translate into significant earnings.