Description

Short Multimedia Games (Nasdaq: MGAM)

How would you like to short a company that does not have a sustainable business model, extremely aggressive accounting, and a catalyst that should ultimately send this company into bankruptcy?

Business: Multimedia Games supplies class II gaming machines (over 2/3 of total revenues) to Indian reservation casinos (primarily in Oklahoma). Its business model is to place its machines on the casinos’ floors for free and take a cut of the hold (revenue/machine), which was about 30%, in 2004. Most importantly, these machines usually do not have a contract (about 2/3 of the installed base of class II machines).

Side note: Class II gaming is defined as a game that one plays against another human being (such as bingo). Since Oklahoma only allowed class II gaming, MGAM basically took the game of bingo and put it into a slot machine where by people would play a very fast game of bingo (a few seconds/game) as a result of MGAM’s machines being linked to each other throughout the state of Oklahoma. Class III gaming is a game where one plays against the house such as traditional slots in Las Vegas. State laws determine what class of games is allowed in casinos.

History: MGAM had much success early on in its corporate life because it identified a niche in gaming that other slot gaming competitors such as industry power house International Game Technology (NYSE: IGT) and others such as Alliance Gaming (NYSE: AGI), and WMS Industries (NYSE: WMS) largely ignored because at that point in time Indian gaming was a small industry relative to class III gaming (i.e. the Las Vegas market). Fast forward and today Indian reservation gaming is a much bigger business that is growing rapidly and thus it now makes sense for the big gaming power, IGT, to get its fair share, which should be no different that its 70%+ market share in class III gaming.

Business model: Since MGAM identified this niche that been largely ignored by major industry players it decided that it wanted to penetrate the market very quickly and get scale. So MGAM bought its machines (instead of making its own) from WMS Industries and leased content from Alliance Gaming (instead of developing its own), packaged the two together, which is how it was able to place class II gaming machines. The customer proposition was great for the Indian casinos because they did not have to put up any capital for machines and in turn would get 70% of the hold. Plus MGAM was pretty much the only option (had about 85% market share at end of 2003) so even if the casinos wanted to buy its own machines and keep 100% of the hold, they really did not have that option at the time. MGAM never really invested any of its profits into R&D of content, but rather bought more machines to place with new and existing customers.

At the end of the day the slots gaming business lives and dies by the quality of content within the machine. It is not by luck that IGT has 70%+ market share of the class III market- the reason is that its machines produce 2-3x the hold of its competitors’ machines, which has been the case for many years and has shown no signs of changing. You only have to look at AGI’s current state of business and subsequent stock price decline over the past year to see. Since IGT’s best content (i.e. Wheel of Fortune among other games) is so superior, people play its machines over others and play them longer and more times thus generating significantly greater, IGT is able to place its best machines for free on the casinos’ floor and take a cut of the hold rather than just sell machines (WMS and AGI’s business model). If you do the math you can see this very easily: 70% x 2X= 1.4X (X is what WMS/AGI’s machines do and 2X is what IGT’s best machines do conservatively in hold/machine). The only reason AGI and WMS really exist is because casino operators want a few other companies to use for negotiating leverage against IGT and thus prevent it from enjoying a monopoly in slots, which would allow it to take a greater percentage of the hold per machine.

IGT’s sustainable competitive advantage: Since IGT’s best content/machines generate holds of 2-3x that of its competitors’ machines, it is able to take about a 30% cut of those holds, while still allowing the casino operators to earn greater profit dollars (versus buying a lower producing machine from AGI/WMS) while putting up no capital to buy the machines. Since IGT has 70% market share and a recurring revenue business model, it is able to invest a lot more back into its business every year- IGT spends more than twice that of the rest of its slot gaming competitors on R&D for developing new content. It is this cycle- significantly better content that leads to significantly better holds that allows IGT to take a 30% cut of the casinos’ slot holds on its best games that allows IGT to continue to spend a lot more money on R&D for content that allows it to maintain its advantage over its competition.

The reason I am writing so much about IGT is because this gaming behemoth is NOW just entering the class II gaming market - i.e. THE CATALYST. It began beta testing its machines in 2004 and will be largely entering the Oklahoma market among others in 2005 (for reference read IGT’s conference call transcripts from the first three quarters of 2004). Remember that IGT did not focus on this market because 5-10 years ago it was relatively small to class III gaming. This late start will not hurt its future success in class II gaming for two important reasons: at the end of the day the best content is going to win the floor space and about 2/3 of MGAM’s machines have NO CONTRACT, so they can be displaced or its cut of the hold can be negotiated downward at any given time, which has already begun to happen.

MGAM’s financial statements: Total revenues are up 13.7% in the 12/31/04 ending quarter (all numbers are year over year). Meanwhile, accounts receivable, net is up 74.3% and total notes receivable, net is up 28.2%. Leased gaming equipment, net has almost tripled while class II gaming revenue/class II machine has declined 9.3%, total class II gaming revenue has declined 5.7%, while the total installed base of machines is up 47.5%. Intangible assets, net/other assets are up about 2.5x. Free cash flow (defined as operating cash flow - total capital expenditures - acquisition of intangible assets - advances under development agreements) for the last three fiscal years is -$37.3mm in 2004, -$1.1mm in 2003 and $2.5mm in 2002. Free cash flow in the most recent quarter was -$22.4mm.

Analysis of recent financial statements and MGAM’s current state of business: How can MGAM’s take/machine and total class II revenues be down year over year if it is placing so many new machines? First, the Indian reservations are asking for a larger cut because they can use IGT’s future entrance as leverage in negotiating with MGAM while at the same time some other smaller players have entered the market and are willing to take a lower cut. Also, MGAM is buying its future business by lending money (advances) and giving slotting fees (intangible assets) to Indian tribes so they can build new casinos in exchange for placing their machines on their floor. Acquisition of intangible assets and advances under development agreements are BALLOONING- up 2.5x and 2.9x, year over year, respectively. These items do not flow through the income statement and are instead capitalized on the balance sheet as assets. This same accounting was present in the now famous VIC short of Orthodontic Centers of America (NYSE: OCA) and we all know how that one turned out! So don’t bother looking at the income statement to value this company because it does not give one an accurate depiction of MGAM’s true cash flow and future earnings potential. One should also be aware that when MGAM places a machine on a casino floor for free, this cost does not immediately flow through the income statement. The reason is because the machine is moved from inventory to leased gaming equipment and amortized over the “useful life” of the machine, which is deemed to be 3-5 years. What is the real economic useful life of majority of MGAM’s machines? Another year at best as IGT comes into the market and likely displaces most of them.

Field checks: I have spoken to a number of casino managers in Oklahoma that currently have MGAM machines. They tell me that they are “extremely excited” to have IGT machines “because everyone knows how well they do in their class III markets.”

Pro-forma 2005E REAL CASH earnings (assumes 1/3 of MGAM’s installed base remains at current take of its hold based on 12/31/04 ending quarter financials):

Revenues: $82.9mm
Operating costs and expenses: $70.7mm
Net interest expense: $0.5mm
Pre-tax income: $11.7mm
Taxes: $4.5mm
Net Income: $7.2mm
EPS (diluted shares outstanding of 30.3mm): $0.24/share

Now before you say this current stream of cash earnings is worth $2.50 to $3.00 per share, you must consider that this stream of earnings will likely only last for 3-5 years at best since the only reason 1/3 of its customers will stay is because they have a contract with MGAM. But it is very possible that the Indian tribes will not honor their contracts with MGAM once IGT enters the market with better machines and its casinos are not doing as well as and possibly losing customers to competing casinos who are using IGT machines. These tribes may just pay back part of the advances, but nobody except management and the tribes know what the provisions in the contract are. In 2004 one tribe that MGAM lent to gave back the money not more than a few months later- that has been publicly disclosed. My pro-forma numbers also assume that the cut MGAM will receive in 2005 on the 1/3 of its installed base it keeps will not come down, which may very well be at risk. Note that MGAM has $22.8mm of net debt or $0.75/share. So if you put a 5x multiple on 2005E cash EPS and subtract the net debt you get $0.45/share of enterprise value. If you put a 3x multiple on 2005E EPS, you get an enterprise value of zero.

Rebuttal to potential question of why short MGAM now if the stock is down 67% from its 52-week high and currently at its 52 week low: If a stock can go to zero then it ultimately does not really matter what price you short it at. If you short MGAM now and it goes bankrupt in 1-2 years then you will have a great IRR (about 50-100%). I have shorted several stocks after they have been more than cut in half because I believed they were going to zero- some examples are Winn Dixie, Bally Total Fitness, and OCA.

Disclosure: We are currently short MGAM, but we may cover and/or trade the position at any given time for whatever reason.

Risks: There is high short interest (about 30% of the float), but one should be able to borrow the stock for no extra charge- we were able to within the past few weeks. This stock may be volatile because of the high short interest, but any stock that can ultimately go bankrupt is a good short to have in one’s portfolio, despite high short interest and trading volatility. There is very low risk of acquisition, but it is still a potential risk. IGT is clearly not interested in buying MGAM, but WMS or AGI could. AGI has so many problems with its core class III business that I doubt it is interested. WMS knows all too well about competing against IGT and buying an installed base that it likely to be largely displaced within the next 12 months.

Catalyst

Catalyst: IGT enters the class II gaming market with significantly better hold producing machines causing at least 2/3 of MGAM’s installed base (those with no contract) to be displaced and/or reduce its cut of the hold significantly within the next 12 months leading to a dramatic reduction in the earnings power of MGAM’s business and resulting in a company with little to no economic value/reason to ultimately exist in the class II gaming market.