Description

Tecmo is a Japanese manufacturer of video game software, pachinko and pachislot software, arcade games, and an operator of video game arcades.  Founded in 1967 as an operator of Japanese arcade parlor, Tecmo released its first video game in 1981.  In 1988, the company enjoyed its first video game hit in Japan with Captain Tsubasa, which was quickly followed by the US hit football game Tecmo Super Bowl in the US in 1989.  

The company provides investors a cheap opportunity to benefit in the strong coming upcycle in the video game software industry, driven by the increasing installed bases of the next generation consoles.  Trading at 3.7x 12/06EBITDA and 1.5x my 12/08 expectations, I think Tecmo is far too cheap for the bright future ahead of it.

***Note, units=JPY Mln****

Video Game Segment

The Industry- 2006 has been a challenging year for video game producers.  Industry-wide sales have disappointed as consumers have begun holding back purchases in anticipation of the launches of Sony’s and Nintendo’s next generation launches and another holiday selling season for Microsoft’s Xbox 360.  However, 2007 should be the first year of a multi-year upcycle for the software industry, as the increasing installed base on next-generation consoles leads to consumers purchasing higher quantities of next generation software.  I can go into more details about the coming industry wide upcycle in the comments if there is demand but will not post it here in the interest of time as I think the thesis has been adequately reported, as evidenced by the recent performance of ERTS, ATVI, Capcom etc.  Suffice to say, the entire industry appears poised to enter a multiyear upcycle as new hardware placements drive significant increases in software demand.

The Company-.  Tecmo makes titles for Microsoft, Sony, and Nintendo consoles.  The company’s main development team, known as Team Ninja, is responsible for the development of Tecmo’s two core home console franchises, Dead or Alive, and Ninja Gaiden.  Team Ninja’s work on these two core franchises, showcase Tecmo’s extremely strong production ability and graphics technology.  Industry magazine Gamespy comments on Team Ninja’s contributions to the first Xbox, “Perhaps more than any third-party developer, the work of Tecmo’s Team Ninja came to represent the best that the original Xbox had to offer.” (http://xbox360.gamespy.com/xbox-360/dead-or-alive-4/678880p1.html) Tecmo expects Team Ninja to increased its current capacity from 1 title/yr to 2 titles/yr in 2007. 

Dead or Alive-  The Dead or Alive franchise is s series of 1 on 1 martial combat games. DoA 4, the most recent iteration was released Dec 29^th 2005 and is currently the 25^th best selling Xbox 360 title on Amazon.com. The series is renowned for its high quality graphics and addictive gameplay, with game reviewer Gamespot saluting the games “gorgeous presentation.” (http://www.gamespot.com/xbox360/action/deadoralive4/review.html)  Tecmo expects to release DoA 5 in H2 2007 and is to expand the audience of previous iterations of the DoA franchise to different platforms like Sony’s PSP, Nintendo DS, PS3 (PS3 for DoA 4 possible but not certain once the 12mo MSFT exclusive ends), and pachinko/pachislot machines (see below), which should represent fairly easy methods to gain more revenues from its core franchise.

Ninja Gaiden is a long running action franchise (originally released for NES in 1988), centering around a young ninja taking revenue on villains who destroyed his hometown.  The most recent version (2004) of Ninja Gaiden for the Xbox received an Editor’s Choice award from Gamespot who considered it, “one of the best, most challenging action adventure games ever made.” (http://www.gamespot.com/xbox/action/ninjagaiden/review.html).   The company plans to release Ninja Gaiden 3 for PS3 in Spring 2007.

Dead or Alive Xtreme- In January 2003, Tecmo decided to broaden the franchise with the Dead or Alive Xtreme Beach Volleyball Title, which featured the core franchise’s female characters competing in various tasks, including volleyball. This game has been extremely successful.  When DoAX initially launched in 2003, the game immediately became the #1 selling Xbox title and the # 2 seller across all platforms in Japan in its first week of sales.  DoAX 2 will launch in November 2006. 

Other Titles

In November 2006, the company plans to launch Super Swing Golf Pangya for the Nintendo Wii, utilizing Nintendo’s new motion sensing controller.  Other games include horse racing game Gallop Racer, Heroes of Annihilated Empires for the PC. 

Overall, Tecmo has extremely well regarded development abilities and strong core franchises.  The company is poised

Recent History

During 2005, Tecmo wrote off Y1bln of development costs in regards to some non-core titles that the company had created which were underperforming.  Most sell-side analysts did not remove this non-recurring charge from the 2005 profitability, which made video game and overall EBIT appear significantly down on a y/y basis.  After the 2006 transition year, revenue and profitability should dramatically increase in both 2007 and 2008 as Tecmo’s strong games benefit from the industry wide upcycle. 

Pachinko/Pachislot

Tecmo also manufactures content software for pachinko games.  This division has been phenomenally profitable.  Demand for good pachinko content will continue to be strong as pachinko/pachislot game manufacturers have been dramatically increasing their competition to try to take market share in an increasingly competitive market.  While many pachinko/pachislot manufacturers currently develop their own in-house content, the trend towards outsourcing to third party content providers like Tecmo is likely to accelerate due to their content expertise and valuable library of proven popular content.  Tecmo also enjoys a huge cost advantage vs. internal production in this division as much of the software in the segment merely adapts previously home console content that Tecmo owns and adjusts for the pachinko/pachislot mkt, allowing the company to enjoy significantly lower development costs and very high margins.  Tecmo commented that the the company is seeing so much demand for its pachinko/pachislot content expertise that the company is turning away significant amounts of business and has dramatically expanded this division in 2006.    

To get more comfortable with the future for this division, I met with major customer Heiwa (pachinko/pachislot manufacturer) who commented that they expected to continue outsourcing content to Tecmo.  Heiwa noted that Tecmo could do content much better than they could and that content was the critical factor in gaining mkt share which was their major goal in a market with slowing growth. 

Arcade operations

Tecmo currently operates 55 (56 by end of year arcades throughout Japan.  While this is a much less profitable business than Tecmo’s core business, the company plans to continue to operate these businesses as it was the intital business of TEcmo and they believe that it helps them remain close to their customers.  The company tends to focus its arcade operations in shopping centers, as the company believes foot traffic there is more consistent than urban/suburban locations.  Mgmt has been focusing on cost cutting in this division to improve margins but dramatic improvement is unlikely.  Overall though, this business should be stable.

Mobile

Tecmo has launched 9 titles in 2006 for the Japanese wireless market.  The company has partnerships with key wireless provides DoCoMo, KDDI, and Softbank.  Most subs pay a Y300-500 monthly membership fee (except for KDDI which is per download).  Revenues should continue to grow steadily as the number of fee paying subscribers continues to grow.  The company plans to use mobile as another platform for its content and hopes to expand to N. America and Europe in 2008. 

Online

Tecmo has 3 online titles that it is launching in FY 07.  The core strategy in online relies on generating revenues through micropayments.  Micropayments involve players joining the game for free and then using real money to purchase game assets, new maps, secrets etc and are considered to be a significant revenue opportunity in the LT for video gaming firms.  The company’s strategy is to partner with firms (Korean firms Seed C and Shaft) that have online experience to help create the online infrastructure while Tecmo helps providing the content.  The company is also looking to adapt popular foreign titles for the Japanese market.  For example, one of the 3 2007 titles is a Korean game called War Rock which has 3.8mln subs WW and will be adapted and launched by Tecmo in Japan.  Overall, the online division seems like another channel for Tecmo to monetize its content expertise.  Below are the company’s forecasts for this division.

Rights

The company has begun to licenses out some of its contents, generating a highly lucrative stream of rights income.  While small, it represents a very lucrative stream of income.

The following are the company’s forecast’s for the division:

Financials

Below is my abridged income statement which aggregates forecasts from the divisions listed above.

 Overall, I expect significant growth in both revenues and profits over the next 2 years. 

Valuation

Tecmo is extremely cheap on an absolute basis and on a relative basis (esp when compared to international competitors).  While I agree that the company deserves some discount due to its smaller size, I would argue that the current gap provides an investor with a significant margin of safety. 

****** Tecmo has a 12/31 FY and most competitiors have a 3/31 FY.  Thus, for comparative purposes, I am comparing FY 12/06 to FY 3/07 (PE 06 etc) and FY 12/07 to FY3/08 (PE 07 etc.) just to give an idea of the relative valuations.

Why is the stock cheaper than comps?

Two reasons in my opinion:

 1) Tecmo is somewhat difficult to research, with most of the company documents in Japanese and the stock under followed by sell-side analysts with just 5 analysts (publishing infrequently and no true major sell-side houses) covering the name vs. 10-15 for Capcom, Square Enix, and Konami. 

2) Those analysts covering Tecmo seem to purely focus on P/E where Tecmo’s valutation discrepancy vs competitors is less apparent.  The following is from an 8/29/06 Daiwa report (Neutral): “The shares (Tecmo’s), trading atg an FY06E P/E of 25.1x, are not inexpensive relative to the 26.1x average for peers, so we stay with our “3” rating.”   Yes, it may be trading at a premium P/E, but the stock is trading at a significant discount on other valuation metrics.

Conclusion

Overall, I think Tecmo’s core businesses have a bright future ahead of them that is clearly misunderstood due to the company’s cheap valuations. The company is poised to enter a multi-year upcycle in its core video game business and has other growth drivers in the attractive online, mobile, and pachinko/pachislot space, which have not been adequately priced into its stock. 

Catalyst