Description

Thesis

MCZ is an attractively priced, long-term growth story in the midst of experiencing increasing gross margins, and a recovery in their business off of trough earnings due to cyclicality in the video game industry. The company trades at 9-12x my FY07 estimates (company is currently is Q4 of FY07), and less than 7x my estimated FY08 earnings. I believe there is a very good probability that the stock could double or even triple as business conditions return to normal, and that the current valuation provides a good margin of safety in the event things do not turn out as positively as I expect them to.  

MCZ is the leading provider of gaming console peripherals, including controllers, dance pads, steering wheels and, “cheat” hardware.  MCZ has been written up on VIC twice before--most recently in 2004 by bill67.  At that time, the stock was trading roughly where it is today--Bill's write-up was predicated on the thesis that gross margins would improve, creating a significant increase in profits despite relatively small top-line growth.  The idea largely worked--margins increased and OPEX decreased, driving significant earnings increases which resulted in a doubling of the stock price.  In FY06, MCZ was hit by the console transition (discussed below), putting a temporary dent in the story, and sending the stock price plummeting .  I believe the stock is in a similar position to when it was last written up, and is on the verge of an even larger gross margin improvement than was experienced in FY05.  Despite my expectations of higher GM going forward, a mere return to FY05 operating results and margins would justify a stock price 2x the current level.

Business Overview--The Console Transition and its effect on MCZ

Video gaming peripherals refer to the multitude of devices gamers use to interact with their video gaming systems.  These range from the simple (video game controllers), to the more exotic (dancepads, steering wheels, golf clubs, etc.).  MCZ is positioned at the value range of the market--their prices are typically 30-40% less than those of the console makers, and generally appeal to the value consumer who more often purchases a new console after a price cut or two.  The peripherals market is expected to grow roughly on par with the video game market as a whole, high single to low double digits into the foreseeable future.  Margins on this business has, in general, been what you'd expect (poor), but there are a few MCZ product changes going forward which I expect to aide the gross margin story here.

The video game hardware market as a whole is comprised of three primary players: Microsoft (Xbox), Sony (Playstation), and Nintendo (Wii).  Consoles are released in waves, with each player releasing a new console released every several years.  During the 12-24 month period leading up to and during the release of the new generation of consoles, both hardware and software makes experience trough earnings.  Console makers typically sell new consoles below cost for the 1st year or two, resulting in decreased profits.  Software makers typically face increased development costs and lower sales--they must make games for more systems (typically six in a console transition rather than 3 normally), and experience lower sales across each console. due to the user base diffusing across 6, rather than 3, consoles.

As a maker of peripherals, MCZ also experiences trough earnings, though its effect from the console transition is slightly different.  MCZ is hit by a double whammy of factors--leading up to the new console releases, gamers put off investment in their current consoles, as it makes little sense to purchase extra controllers or other accessories for a console that you will soon no longer use.  As gamers begin to buy new consoles, MCZ is initially unable to reap the benefit, because it does not have peripherals ready at product launch--it typically takes them 6-12 months after launch to develop peripherals and generate sales.  These initial buyers of systems are also typically the hardcore gamers who spend $300+ on one or more systems, and are unlikely to be interested in MCZ value oriented product line.  Currently, I believe we are in the latter stages of the console transition, and that the associated negative effects on MCZ should begin to clear up over the next year or two.

Additionally, I also expect some of the cyclicality in the business to be removed going forward.  The console cycle up until recently was about 3 years on average, but going forward the major gaming system makers expect it to lengthen considerably, upwards of 6 to even 10 years. This is positive for the business overall, as it will reduce the cyclicality that can make earnings unpredictable and justify a lower valuation. In other words, this current console transition (and its trough earnings effects) will likely be the last for several years to come.

MCZ recent moves to diversify its product lines should also help reduce cyclicality. MCZ has expanded into new product lines, including iPod accessories, console faceplates, their new Inair personal sound technology, and bundling licensed games with their peripherals. Revenue is split pretty evenly across consoles, and consistent with installed base trends; on products, about 50% comes from controllers, with other 50% split across a multitude of different product offerings. The business can be very hit driven—products appear to have 1 year life cycle on average; they introduce 60-100 products per year, and discontinue about as many. The company is somewhat comparable to a video game publisher in that its business relies of continued successful releases.

Another catalyst which we can expect in the course of the next year or two will be console makers gradual discountinuance of support for the last generation of consoles.  As this happens, MCZ and other 3rd party publishers no longer need to compete with the OEMs, which should provide a boost in sales.  Also, for what it's worth, there were no questions on the most recent conference call, which I like, as it usually signals that this is still flying under the radar of most investors.

MCZ also recently added a new CFO, who was previously CFO of Take Two's prized Rockstar Games division (makers of Grand Theft Auto).  He brings a wealth of experience (and valuable connections) to MCZ, and in my conversations with him I believe he has already--and will continue--to make an impact on this business.  For those of you familiar with Take Two's troubled accounting past, the new CFO was not involved in that mess, and left Take Two in 2006 (a full year after those issues were resolved).

The Gross Margins story

MCZ has a combination of low and high gross margin products.  Their low gross margin products consist primarily of generic controls, video game cables, Ipod accessories, and other unlicensed products.  Their higher gross margin products are typically licensed in nature, and are associated with a popular brand (e.g. St. Louis Rams controllers, Gears of War Console face plate, etc.).  Also included in the high gross margin products are the company's hardware/software bundles (e.g. Xbox 360 arcade stick, Real World Golf, etc.). 

The company has made a significant effort to put more emphasis on their high margin products, and has announced increased licensing deals as of late.  These deals are pretty standard--MCZ agrees to use a brand in exchange for a cut of revenue or a flat fee.  The most recent success in this regard was with their "Gears of War" console faceplates, which are essentially plastic covers that allow gamers to customize the look of their consoles.  The faceplates were linked to the popular Gears of War series (e.g. had the games' logo, popular characters, etc.).   Because products like the Gears of War product are licensed, they cannot be produced (legally) by competitors, and carry higher gross margins.

Financial Review

MCZ experienced strong, 10%+ growth in the several years leading up to FY06, the year that began the latest console transition. Below is a review of MCZ income leading up to, the console transition in FY06.

The company was in the midst of improving its product mix, gross margins, and rationalizing its OPEX, and posted significant margin improvements in FY05. Unfortunately, the imminent console transition hit the company hard in FY06. Consumers delayed console purchases as they waited for the new bread to come out. In particular, peripherals took a big hit, as people who are about to purchase a new console are unlikely to make continued investment in getting more use out of their existing ones. This trend, combined with increased pricing pressure on more mature, discounted consoles, helped contribute to the shortfall in both revenue and GM.  MCZ was further hit by "price protection" that it offered retailers--as sell-thru slowed, prices were cut to remove the excess, resulting in unusually low margins.  These low margin goods were finally cleared out in the beginning of this fiscal year.

On the gross margins front, the company saw a successful launch of several new high margin products, including a console faceplate based on the very popular “Gears of war” Xbox 360 game.  Margins also benefited from further analysis of the company's gross margins by product and by region, which revealed some low/negative margin products which were discountinued.

Much of the poor stock and company performance leading in FY06 can be attributed to gross margin issues.  To see what happened to net income in FY06 , which turned negative for the 1^st time in over 4 years, you need to look no further than the gross margins history of the company. Below are quarterly gross margins for the last 3 years:

MCZ has a relatively fixed operating cost base (about $20M per year), so projecting their operating income is very simple. If they generate more than $5M in operating earnings, they make a profit, and if they don’t, they won’t. This is why Q1 is typically flat to a loss (revenue rarely breaks $20M), and why FY Q3 accounts for the majority of their profit (calendar Q4). As gross margins have rebounded to FY05 levels, the company has been able to return to profitability. The business is at an inflection point.  If they can grow the revenue and improve gross margins without incurring significant additional operating expenses, additional gross profit from here will fall directly to the bottom line. I expect them to be able to grow revenue 10-15% without growing needing to grow OPEX, as they did successfully in from FY04 to FY05.  Conversations with the CFO confirmed that OPEX should not increase unless they choose to invest in additional revenue generating opportunities (e.g. more biz dev staff).

One more note on gross margins--it is worth noting that, outside of FY06 (and the most recent GM jump, gross margins have been consistently in the 22-25% range for the last few years.  Though it is possible that gross margins going forward will revert to this range, I believe this most recent breakout in GM improvement is a sign of a higher GM band range that we should expect in the future, somewhere between 25-28%.  According to management, the recent GM improvement was not attributable to a one-off hit, but rather a combination of several successful high GM products, making it more likely that this improvement may be sustainable.  Obviously, the next few quarters will be key in determining whether this was a one time event, or a sign of higher gross margins to come.

Valuation

YTD, FY07 earnings are $.055 per share. Based on gross margin trends, and historical Q4 revenue (which has fallen above Q1 but typically slightly below Q2 revenue), I expect earnings of between $.005 to $.015 per share for Q4, with the possibility of slightly negative earnings, or earnings of up to $.03/share depending on how margins hold up. If MCZ can maintain 29% margins, and achieve revenue on par with that achieved in Q2, then $.03 is very achievable. Below is a sensitivity of expected Q4 results based on revenue and margin assumptions, which I believe are the two main variables that will affect Q4 earnings. I expect revenue near the high end of Q2 revenue, based on the new launch of peripherals (including PS3 wireless controllers) in Q4.  Below is a sensitivity table with projected EPS based on different GM and revenue numbers.

On $.065 FY07 earnings, or $.01 FY07 Q4 EPS, MCZ is trading at a P/E of 11, for a company with strong growth prospects and improving GM. If are able to report a q4 on par with their q2 (~$26M), and at a GM % near that achieved in q3 and hit $.08 (~28%), MCZ would have a P/E of under 9.

Though this year is important, I think going forward the opportunity looks even more compelling, as the company improves margins and emerges from the console transition slump. Lets take a look at what happens to EPS in FY08 under several different revenue growth and gross margin scenarios:

The four scenarios above reflect a variety of FY08 expectations, all of which are very conservative (with the exception of the aggresive scenario). A one basis point improvement in Gross margins over FY05, and 10% revenue growth (which is slightly below MCZ’s growth rate before FY07), would result in EPS of $.11, or a price of $1.63, or 120% above 3/16’s closing, based on a conservative 15 P/E. Even a return to slightly below FY05 gross margin and revenue levels would result in a positive upside scenario of about 32% over the next year.  If the company can maintain gross margins experienced in Q3, and grow revenue at historical rates, the stock could easily triple from here.  One could also argue a P/E of 18-20 is more appropriate, resulting in further upside to these estimates

A quick look at MCZ historical pricing supports these valuation assumptions. The company traded at $1.50 when it reported earnings if FY05 of $.09, before the bulk of the console transition, or a P/E slightly of about 17. At current levels, the risk/reward opportunity seems very favorable.

Risks:

1)  My biggest concern here has to do with the Wii, and all that its launch implies.  The Wii is differentiated from Xbox and Playstation due to its unique, motion sensing controller.  The Wii can be swung to hit a baseball in an MLB game, turned to drive a car, or swung to hit a golf ball.  Much of this functionality begins to encroach on MCZ's core business, and reduces the need for some of their unique peripherals.  Unlike in past years, Nintendo has not signed a license agreement with MCZ, which means that they have had a much more difficult time reverse engineering the technology, and creating a 3rd party version of the controller.  With the Wii appearing to have a good shot at capturing a large portion of the market, it will be important for MCZ to develop a quality Wii-like controller.  One can make the argument that the Wii is actually a boost for MCZ, as it validates the consumers desire for more interaction between the gamer and the game, which many of MCZ products facilitate.  While this may be a short term plus, I am concerned that movement in this direction will result in OEM development of these types of controllers, and create additional competition for MCZ.

2)  Though I don't believe this is the case, Q3 gross margins could merely be a one time event, and the result of a abnormally high GM product mix.  If Q1 and Q2 FY07 margins are more representative of the true GM potential going forward, there is little upside here.

3)  MCZ's business is very hit or miss, and relies on a mix of successful new releases to propel earnings. In particular, failure of MCZ to continue to secure licensing deals, or to launch successful hardware/software bundles, could result earning's misses going forward

4)  The business does not have as many barriers to entry as I would like to see, and I somewhat concerned about margin compression in new products (e.g. faceplates), and that potentially at some point specialty gaming retailers (e.g. EB games, gamespot, etc.) will make 3^rd party controllers and peripherals of their own and cut into MCZ business (this is not very difficult to do, and it seems like a logical expansion, in the same way grocery stores have their own private labeled products). This has not happened yet, nor have I heard any rumors of this, but it seems a logical step at some point.

5)  Failure of new product launches outside of gaming peripherals (e.g. Iniar technology) fail, or otherwise distract management from their core business. I believe that MCZ is taking a measured, conservative approach to diversifying their product revenues, which overall I view as a positive, but there is of course the risk that these ventures either fail or distract management.

Catalyst