In the interest of actually have some semblance of an adventurous life before committing myself to a hedge fund office later this summer, I'll be heading off on a trip to Asia and Europe for a couple months starting tomorrow. I will likely still update the blog once a week (I've stored up a couple articles I'll be releasing), but just wanted to let everyone know in case I fall behind on updates or answering e-mails.
The response thus far to the blog has been more positive than I ever expected--in particular, I never thought this blog would be such an effective means for exchanging ideas. Thanks again for reading, and please do continue to post comments/e-mail me to exchange ideas.
Thrive,
Eric
Saturday, March 24, 2007
Thursday, March 22, 2007
MCZ--Conversation with the CFO
Note: See full write-up and thesis for MCZ here
Below are the highlights from the call with the CFO. I am preparing for a trip abroad for a couple months (more on this shortly), so I unfortunately do not have time to write this up as cleanly as I would like. These are based on my notes and interpretation in several cases, and should not be seen as direct word or guidance from the company:
1) We should likely only expect about 1 game/year to be released by MCZ for the time being. They are trying to take a measured approach to ramping up software releases
2) They are very excited about the Inair technology. They see it as a low risk/high reward situation
3) They do not yet have a license with Nintendo to produce Wii's controller. Also, from what I could tell from his careful choice of words, they do not appear to have reverse engineered it yet, though it sounds like they are working on it (he did not confirm this, but that was my impression of what he was saying between the lines).
4) On gross margins, they have made some tangible changes the last 2-3 quarters to try and improve these. Though they don't want to guide for 29% every quarter, it was clear to me that, in the historical range of 22-29%, they are hoping to hit the higher end of that range, primarily through the sale of more licensed products ( e.g. NFL controllers) and keeping costs under control.
5) They clearly have ambitions to grow revenue up from $100M going forward, and it sounds as though they expect they are able to do so.
A few other points I learned:
1) On licensed product, the main issue in getting these deals done is that some publishers want to protect their brand, and are concerned with diluting it by providing accessories. Also, some publishers that decide to make accessories want to control the quality of those accessories, and thus decide to produce in house. That said, publishers like these deals because its free money, and some don't like doing it themselves because its not their core competency, and not enough money on its own right to be worth the bother of doing it in house. I found this explanation helpful to better understanding the dynamic in how publishers decide whether or not to do a deal.
2) Management appears to take a very measured, risk-adverse approach to developing and launching products. They do not take big risks--they go for singles and doubles, not homeruns. This is good, in the sense that one big mistake likely won't sink a year's earnings, but at the same time this to a degree limits the possibility of a fast ramp in revenue (e.g. by investing heavilly in releasing more hardware/software bundles, which are higher risk/reward).
3) They expect strong operational leverage, meaning they can grow revenue from here with limited increases in expenses pertaining to operations. This was a good confirmation, as it supports my FY07 earnings expectations of ~$.11, if we can grow revenue 10% and have gross margins of 26%.
Overall, though I have some concerns about the Wii controllers not being ready (particularly given the potential here if they could get something out the door), things still seem on target. Q4 in terms of both revenue and gross margins should be helpful going forward in assessing what to expect for next year.
Eric
Disclosure: I am long MCZ shares
Below are the highlights from the call with the CFO. I am preparing for a trip abroad for a couple months (more on this shortly), so I unfortunately do not have time to write this up as cleanly as I would like. These are based on my notes and interpretation in several cases, and should not be seen as direct word or guidance from the company:
1) We should likely only expect about 1 game/year to be released by MCZ for the time being. They are trying to take a measured approach to ramping up software releases
2) They are very excited about the Inair technology. They see it as a low risk/high reward situation
3) They do not yet have a license with Nintendo to produce Wii's controller. Also, from what I could tell from his careful choice of words, they do not appear to have reverse engineered it yet, though it sounds like they are working on it (he did not confirm this, but that was my impression of what he was saying between the lines).
4) On gross margins, they have made some tangible changes the last 2-3 quarters to try and improve these. Though they don't want to guide for 29% every quarter, it was clear to me that, in the historical range of 22-29%, they are hoping to hit the higher end of that range, primarily through the sale of more licensed products ( e.g. NFL controllers) and keeping costs under control.
5) They clearly have ambitions to grow revenue up from $100M going forward, and it sounds as though they expect they are able to do so.
A few other points I learned:
1) On licensed product, the main issue in getting these deals done is that some publishers want to protect their brand, and are concerned with diluting it by providing accessories. Also, some publishers that decide to make accessories want to control the quality of those accessories, and thus decide to produce in house. That said, publishers like these deals because its free money, and some don't like doing it themselves because its not their core competency, and not enough money on its own right to be worth the bother of doing it in house. I found this explanation helpful to better understanding the dynamic in how publishers decide whether or not to do a deal.
2) Management appears to take a very measured, risk-adverse approach to developing and launching products. They do not take big risks--they go for singles and doubles, not homeruns. This is good, in the sense that one big mistake likely won't sink a year's earnings, but at the same time this to a degree limits the possibility of a fast ramp in revenue (e.g. by investing heavilly in releasing more hardware/software bundles, which are higher risk/reward).
3) They expect strong operational leverage, meaning they can grow revenue from here with limited increases in expenses pertaining to operations. This was a good confirmation, as it supports my FY07 earnings expectations of ~$.11, if we can grow revenue 10% and have gross margins of 26%.
Overall, though I have some concerns about the Wii controllers not being ready (particularly given the potential here if they could get something out the door), things still seem on target. Q4 in terms of both revenue and gross margins should be helpful going forward in assessing what to expect for next year.
Eric
Disclosure: I am long MCZ shares
WZEN: Another undervalued Asian Name?
For whatever reason, the majority of the value I've been finding recently is amidst several Asian companies with businesses in transition, that are trading near cash value. Though I am hesitant on the prospects of China to keep up its tepid growth, value is value, and cash is cash.
Thesis
WZEN is a South Korean based game developer that is in the process of building a series of high profile releases from proceeds received in IPO about 2.5 years ago. They are currently trading near book value, with limited value being assigned to their attractive game porfolio going forward. Though I am excited about the prospects of the company, I can see this trading down even further, more near something approaching cash value, and would be looking to add the name on weakness before several of their big releases later this year.
Business Overview
WZEN is one of the leading game development company's in south Korea. About three years ago, they released "MU online", which was one of the more popular games in major Asian markets for a couple years. This game propelled the stock, and gave WZEN the clout to become a national game developer. After IPOing, WZEN ramped up development on several big budget titles, including SUN, Huxley, Kingdom of Warriors, and APB. WZEN began developing many of these games 2+ years ago, when they received their big cash infusion, and are getting ready to release many of these games within the next year or two. As WZEN has ramped up developement, they have accrued significant costs without any revenue benefit (they do not receive revenue until the games launch). At the same time, they have experienced a decline in MU revenue, due to the natural aging of the franchise. This combination of investing in the future, and eventual winding down of MU revenue has led to an apparently grim operating picture, though things aren't nearly as bad as them seem. Typically, developers expense upcoming games while they are receiving current income from the games they have developed in the past. Becasuse WZEN has been ramping up its developement so rapidly, and because they have not released a game for quite some time, the financial picture is currently distorted. As new games are released over the next year or two, we will begin to see the investments of the past two years ($50M+) reap dividends.
The Games
WZEN has several games in varying stages of development. I will outline a few of the big launches below, including timing, and thoughts on potential
Huxley -- End of 2007
Huxley is a Massively multi-player online game being developed for the PC and Xbox 360. Of all releases to be released in the near future. Though I do not have specific expectations for the release, nor the knowledge at this point to predict sales, I can give some anecdotal evidence I believe to be compelling:
WZEN announced in February that it had sold the rights for China publishing to NCTY, one of the leading Chinese publishers, for an estimated $35M over 3 years (actual can be more or less, depending on milestones) plus a 22% royalty. From what I can tell of operating expenditures over the last 3 years, it would appear as though this one up front payment in China has paid for most, if not all of Huxley's development costs.
In the US, Huxley has received very favorable coverage from Gamespot, the largest online videogaming news/review site. The Xbox 360 version is ranked #5 out of 415 games in popularity, very impressive for a game not launching for at least 6 months. It has also won awards and received very favorable coverage at E3, the largest yearly videogame conference. Though I have not conducted scientific studies on this, gamer anticipation is usually an excellent sign of things to come. Assuming the quality is there (which, by early indications, it is), this seems to be lining up to be a hit.
SUN -- 2007 in various geographies
NCTY also agreed to purchase Chinese rights here, this time for $13M in payments + 22%. NCTY profiled this acquisition as a milestone on its Q4 2005 conference call, and said they had high expectations. Also, accoring to 17173.com, a popular chinese gaming site, SUN was in the top 2 most aniticpated online games in the several months between August and November. Sun was released in Korea in November, though I have had trouble assessing its success. One thing to note is that, at least in Korea, the game will be free, and be supported through "micropayments", or the in-game purchase of game items (e.g. special swords, charaters, etc.). Because of this payment model, I would expect that revenue will ramp up more slowly, but have more longevity. By providing free access to the game, WZEN creates a hook that gets people to play, and will hopefully eventually induce them to spending as much (or more) as they would have paid under a subscription model.
Though the game appears to have presence in China, prospects in the US seem more dull (it has gotten very little coverage and does not seem to have much anticipation, again using gamespot rating as a proxy.
APB: 2008 Release
Still a year off, but this game is one to watch. It is by the creator of Grand theft auto, which may very well be the most successful gaming franchise of all time. More details to come on this as it is still early in development, but this appears promising
TBD Red 5 game:
Last year, WZEN brought further clout by teaming up with Red 5 to publish their first game. Red 5 was founded by a team of World of War craft developers who have been involved some of the more popular games of the last several years, including Diablo 2, Warcraft 3, and starcraft. They have some very ambitious goals, and though their project has not been announced, WZEN will be set to launch it worldwide when it is ready. WZEN is clearly intent on becoming a force in the development of multiplayer online games.
Other games:
WZEN has 2-3 other games in developement. Though these are not on the same scope as the prior games, they do provide revenue potential as they move from development to launch.
Financials
WZEN's ADS shares are equivalent to 3/10 of one share on the KOSDAQ. WZEN's market cap is a bit difficult to track down, but from what I can tell the ~13M shares outstanding translates into about a $180M market cap @4.15. If you back out the ~$100M in cash, the company is trading for an EV (market cap - cash + debt) of ~$90M. WZEN is also burning through about $20M in cash/year, and I won't expect this to change until we see the release of Huxley later this year, so I'll assume they burn through another $20M before breaking evening, giving them an EV of ~$110M. On a Price:book value basis, this is trading at about 1.25x book.
My big concern with the business is that costs have really ballooned here, well beyond what seems to be required for the business. Gross margins on MU revenue fell from about 90% three years ago to under 30% in 2005. I'd assume that this is partially related to the aging of the game, and that a number closer to 80% is what is expected on multiple games (though I need to confirm this). Additionally, SG&A has gone up about $10M. Add onto this $20M is R&D costs (which I expect the company will continue to need going forward, to produce continued hits), and the business is operating on a fixed cost basis of about $45M, much more than the $20M it operated on when it released MU and achieved $36M in profit several years ago. That same revenue, on today's cost basis, would generate $6M in operating profit. At an 80%, instead of 90% margin, the company would have lost a couple million.
In other words, WZEN will need hits about twice the size of MU (~$100M in annual revenue @ 80% gross margin) to return to net income of $35M. This is where the analysis gets tricky, because the video game business has a relatively unpredictable hit cycle. Nevertheless, I'll take a very rough look at how this may play out.
Between SUN and Huxley, I think there's a good chance we can expect MU style revenue, given the existing contracts in place with NCTY, and the degree to which these have been tracking high on the hype meter.
The real wildcard then, in my mind, is the success of Huxley in the US. If present coverage is any indication, this is lining up to be a hit. Even if it is a hit however, it will need o generate $50M+ in revenue to really create the kind of net income impact that would allow WZEN to move substantially from here, given the increased cost base.
Conclusion:
For the time being, I will sit on the sidelines here, though I'll be watching to see if this drops nearer to its book value (about $3/share). As the company will continue bleeding money for the next couple quarters, and with the slow revenue ramp of SUN and coninued cooling in Asian names, I think there is a decent possibility. At that price, however, I think the risk/reward becomes favorable enough to make a go at this one. Since I don't forsee any upward catalysts for ~6 months (as we near the release of huxley, and as SUN revenue ramps up), I think this will become a more attractive play
Thesis
WZEN is a South Korean based game developer that is in the process of building a series of high profile releases from proceeds received in IPO about 2.5 years ago. They are currently trading near book value, with limited value being assigned to their attractive game porfolio going forward. Though I am excited about the prospects of the company, I can see this trading down even further, more near something approaching cash value, and would be looking to add the name on weakness before several of their big releases later this year.
Business Overview
WZEN is one of the leading game development company's in south Korea. About three years ago, they released "MU online", which was one of the more popular games in major Asian markets for a couple years. This game propelled the stock, and gave WZEN the clout to become a national game developer. After IPOing, WZEN ramped up development on several big budget titles, including SUN, Huxley, Kingdom of Warriors, and APB. WZEN began developing many of these games 2+ years ago, when they received their big cash infusion, and are getting ready to release many of these games within the next year or two. As WZEN has ramped up developement, they have accrued significant costs without any revenue benefit (they do not receive revenue until the games launch). At the same time, they have experienced a decline in MU revenue, due to the natural aging of the franchise. This combination of investing in the future, and eventual winding down of MU revenue has led to an apparently grim operating picture, though things aren't nearly as bad as them seem. Typically, developers expense upcoming games while they are receiving current income from the games they have developed in the past. Becasuse WZEN has been ramping up its developement so rapidly, and because they have not released a game for quite some time, the financial picture is currently distorted. As new games are released over the next year or two, we will begin to see the investments of the past two years ($50M+) reap dividends.
The Games
WZEN has several games in varying stages of development. I will outline a few of the big launches below, including timing, and thoughts on potential
Huxley -- End of 2007
Huxley is a Massively multi-player online game being developed for the PC and Xbox 360. Of all releases to be released in the near future. Though I do not have specific expectations for the release, nor the knowledge at this point to predict sales, I can give some anecdotal evidence I believe to be compelling:
WZEN announced in February that it had sold the rights for China publishing to NCTY, one of the leading Chinese publishers, for an estimated $35M over 3 years (actual can be more or less, depending on milestones) plus a 22% royalty. From what I can tell of operating expenditures over the last 3 years, it would appear as though this one up front payment in China has paid for most, if not all of Huxley's development costs.
In the US, Huxley has received very favorable coverage from Gamespot, the largest online videogaming news/review site. The Xbox 360 version is ranked #5 out of 415 games in popularity, very impressive for a game not launching for at least 6 months. It has also won awards and received very favorable coverage at E3, the largest yearly videogame conference. Though I have not conducted scientific studies on this, gamer anticipation is usually an excellent sign of things to come. Assuming the quality is there (which, by early indications, it is), this seems to be lining up to be a hit.
SUN -- 2007 in various geographies
NCTY also agreed to purchase Chinese rights here, this time for $13M in payments + 22%. NCTY profiled this acquisition as a milestone on its Q4 2005 conference call, and said they had high expectations. Also, accoring to 17173.com, a popular chinese gaming site, SUN was in the top 2 most aniticpated online games in the several months between August and November. Sun was released in Korea in November, though I have had trouble assessing its success. One thing to note is that, at least in Korea, the game will be free, and be supported through "micropayments", or the in-game purchase of game items (e.g. special swords, charaters, etc.). Because of this payment model, I would expect that revenue will ramp up more slowly, but have more longevity. By providing free access to the game, WZEN creates a hook that gets people to play, and will hopefully eventually induce them to spending as much (or more) as they would have paid under a subscription model.
Though the game appears to have presence in China, prospects in the US seem more dull (it has gotten very little coverage and does not seem to have much anticipation, again using gamespot rating as a proxy.
APB: 2008 Release
Still a year off, but this game is one to watch. It is by the creator of Grand theft auto, which may very well be the most successful gaming franchise of all time. More details to come on this as it is still early in development, but this appears promising
TBD Red 5 game:
Last year, WZEN brought further clout by teaming up with Red 5 to publish their first game. Red 5 was founded by a team of World of War craft developers who have been involved some of the more popular games of the last several years, including Diablo 2, Warcraft 3, and starcraft. They have some very ambitious goals, and though their project has not been announced, WZEN will be set to launch it worldwide when it is ready. WZEN is clearly intent on becoming a force in the development of multiplayer online games.
Other games:
WZEN has 2-3 other games in developement. Though these are not on the same scope as the prior games, they do provide revenue potential as they move from development to launch.
Financials
WZEN's ADS shares are equivalent to 3/10 of one share on the KOSDAQ. WZEN's market cap is a bit difficult to track down, but from what I can tell the ~13M shares outstanding translates into about a $180M market cap @4.15. If you back out the ~$100M in cash, the company is trading for an EV (market cap - cash + debt) of ~$90M. WZEN is also burning through about $20M in cash/year, and I won't expect this to change until we see the release of Huxley later this year, so I'll assume they burn through another $20M before breaking evening, giving them an EV of ~$110M. On a Price:book value basis, this is trading at about 1.25x book.
My big concern with the business is that costs have really ballooned here, well beyond what seems to be required for the business. Gross margins on MU revenue fell from about 90% three years ago to under 30% in 2005. I'd assume that this is partially related to the aging of the game, and that a number closer to 80% is what is expected on multiple games (though I need to confirm this). Additionally, SG&A has gone up about $10M. Add onto this $20M is R&D costs (which I expect the company will continue to need going forward, to produce continued hits), and the business is operating on a fixed cost basis of about $45M, much more than the $20M it operated on when it released MU and achieved $36M in profit several years ago. That same revenue, on today's cost basis, would generate $6M in operating profit. At an 80%, instead of 90% margin, the company would have lost a couple million.
In other words, WZEN will need hits about twice the size of MU (~$100M in annual revenue @ 80% gross margin) to return to net income of $35M. This is where the analysis gets tricky, because the video game business has a relatively unpredictable hit cycle. Nevertheless, I'll take a very rough look at how this may play out.
Between SUN and Huxley, I think there's a good chance we can expect MU style revenue, given the existing contracts in place with NCTY, and the degree to which these have been tracking high on the hype meter.
The real wildcard then, in my mind, is the success of Huxley in the US. If present coverage is any indication, this is lining up to be a hit. Even if it is a hit however, it will need o generate $50M+ in revenue to really create the kind of net income impact that would allow WZEN to move substantially from here, given the increased cost base.
Conclusion:
For the time being, I will sit on the sidelines here, though I'll be watching to see if this drops nearer to its book value (about $3/share). As the company will continue bleeding money for the next couple quarters, and with the slow revenue ramp of SUN and coninued cooling in Asian names, I think there is a decent possibility. At that price, however, I think the risk/reward becomes favorable enough to make a go at this one. Since I don't forsee any upward catalysts for ~6 months (as we near the release of huxley, and as SUN revenue ramps up), I think this will become a more attractive play
Tuesday, March 20, 2007
MCZ—Conversation with IR
MCZ—Conversation with IR
Spoke to MCZ Investor relations today, and am hoping to set up a meeting with management later this week. Overall, call was very positive. I am getting comfortable with the thesis, and am increasingly confident that the gross margin and revenue recovery will play out as I expect it to.
Gross Margins
A big focus of the call was getting a better sense of the reasons for the fluctuations in gross margins. As was apparent in the scenario analysis I posted in my longer write-up, the GM % is crucial going forward in determining an ultimate valuation for the company. Should we expect GM as experienced in Q1 and Q2 FY07 (~22%), that experienced in FY04 (25%), or that we say in Q3 FY07 (29%?). Though not stated explicitly, my impression is that going forward we can expect margins between 25-29%, based largely on managements focus on releasing more higher margin products. Though I was not able to get specific gross margin numbers by product, I did get a sense of what products are high v. low margin:
High Margin
This includes hardware and software bundles (e.g. Xbox arcade game stick, real world golf, dance pad + game) and licensed accessories, including console/controller skins, and other licensed accessories like, for example,
Low Margin
Lower margin products include unlicensed 3rd party accessories (e.g. Madcatz Xbox controller), as well as iPod accessories and cables where MCZ competes primarily based on price. Going forward, it is clear that these will not be abandoned, but that the high margin products are the focus of management’s attention.
Console Transition & FY06 numbers
Confirmed that console transition, combined with price protection terms given to retailers contributed to the abysmal FY06. As console makers slashed prices and consumers held off accessories consoles they were about to replace, there was too much inventory in the pipeline and prices fell considerably. This hit margins, though most all this product has now been sold off, contributing to the rebound in gross margins in Q3. If past trends hold true, FY08 should be much stronger, and FY09 and beyond should show the true earnings potential of this business at peak earnings.
New Opportunities
--CFO actually left Rockstar in 2006, not 2005 as I previously reported. He was not involved in the accounting issues at TTWO at all, and will be taking on a very active role at MCZ. This is an exciting opportunity, as Halpern brings with him a wealth of experience and success at one of the hottest gaming companies out there, in addition to valuable experience on the street and with the sell-side.
--MCZ is still mum on the Iniar technology and specific products to be launched from this, though they are very excited about its potential and believe they can create a very valuable business out of it. If this is a hit, its all gravy. If not, MCZ confirmed that it is a low risk/high reward play. They purchased the technology on the cheap, and will not need to outlay much capital to launch the product.
--MCZ was also mum on future licensing deals for accessories alongside upcoming major product launches. That said, a very logical, big deal that MCZ would appear to be the front-runner for would be exclusive accessories for the new grand theft auto game, given Halpern and his connections there. I think this could be a huge catalyst going forward, if such a deal were to be announced. MCZ alluded to a meeting later this week to discuss the possibility of such a deal.
Conclusion
Overall, I am very excited about this investment going forward. A combination of both short and long term catalysts, downside protection, and a cheap valuation have the possibility to make this a win over the next 6-18 months. I’ll continue to track this name on an ongoing basis.
Disclosure: I own shares in MCZ. This write-up is for educational purposes only, and not a recommendation to buy or sell shares.
Top 5 reasons why you should not manage your own money
Despite my interest in investing in individual stocks, and the good amount of time I’ve put into securities analysis over the last several years, I actually have a large portion of my holdings in mutual funds. Though I enjoy investing in individual securities, I have, until recently, not been able to devote the time, nor have I had the skills, to invest in individual securities in such a way that I believed would generate risk-adjusted returns above what certain respected professionals are capable of achieving. Though many mutual funds (read: most) are no better or worse than investing in ETFs or even on your own, there are several standouts that have consistently outperformed the market over long periods of time, or that employ sophisticated, unique strategies that even the most educated of investors are likely unable to employ themselves. Before moving posting a follow-up article with my specific mutual fund holdings, I want to illustrate why I believe mutual funds are a crucial part of any do-it-yourself investor’s portfolio, particularly those who have little experience, little time, or little track record of positive, risk-adjusted returns over a long period of time. A monkey can make money in an upmarket, but it is significantly more difficult to outperform the stock market over a full bull/bear cycle.
1) As much as most of us would like to believe in our abilities to outsmart the whole of the population, the fact is that most individual investors do themselves a disservice by taking their finances into their own hands. The market is an extremely complex beast, made more difficult to beat by the fact that inexperienced investors in particular tend to be extremely emotional, and do not have the skills required to thoroughly assess the deserved valuation of a business. I wish I had bookmarked it, but I remember reading a couple years ago a study that was released which estimated that the average individual investor had returns, after transaction fees, of about 2%, vs. 12% for the market. (If anyone knows the article I am referring to, or similar studies, please e-mail me so I can footnote this).
2) If you are like most inexperienced investors, you aren’t investing in the stock market, you are gambling. Investing, in my mind, refers to an investment in the company based on a thorough, in-depth analysis of a company’s business prospects, how those business prospects are likely to translate into future cash flows, and at what multiple those cashflows are likely to be valued in the future. Investors who buy a company because they like their product make the common, deadly mistake of investing in a company, not a stock. Investing in a company has a variety of pitfalls. Most notably, it does not take into account valuation. Let’s examine a hypothetical company, “The Best Company in the World” (TBCW). TBCW makes the highest quality MP3 players imaginable—they are as cool and functional as iPods, but at 1/5th the cost. They use the best materials, and are commited to 100% customer satisfaction. Most people are convinced that TBCW will quickly become the market leader in every consumer goods market imaginable. So, should you invest in TBCW? Not nessecarilly. If TBCW is valued at $100 billion dollars, it is unlikely to be valued at an attractive multiple of its future cash flows. Also, it is entirely possible that TBCW is losing boatloads of money, and will never be profitable. In this case, even though the product is spectacular, the stock will eventually be worth $0. Without the skills to assess valuation and basic finance, investors are gambling, not investing, their money. Just as it would be a poor strategy to go to Vegas and gamble 100% of your money at blackjack, it is similarly wise not to do the same with the stock market.
3) Perhaps the most important reason for putting a significant portion of your money with a professional is most people’s tendency to be extremely emotional with their investments. Countless anecdotes and bear markets have shown that most investors buy most aggressively at market tops, and sell most aggressively at market bottoms. In fact, most top managers have made a living playing the opposite side of the “dumb money flow”. Being able to make intelligent investing decisions requires a clear investment thesis, and a general understanding of valuation concepts and market cycles. If you have a holding that has dropped by 80% on news that you believe does not impact your long-term thesis, you can have the confidence to go ahead and double down. If are holding that same company, and bought it on the recommendation of Jim Cramer, a friend, or another questionably credible source, you have no basis on which to make a future investment decision. Chances are, if you are like most investors, you will panic and sell at the absolute bottom, and curse yourself two years later once the stock rebounds.
4) There are many experienced professionals who have devoted their whole lives to investing. Though there are many irresponsible fund managers out there, it is generally very easy to find several strong, long-term performers that have out-performed the market. What are your odds of outperforming a top manager who has vast resources, experience, and a track record of beating the market over long periods of time? Possible if you know what you are doing (and understand where individual investors with the right skills have an edge over funds), but unlikely if you are merely buying your favorite companies or on the advice of friends. This may work for a short period of time, but just as in Vegas, the house will likely eventually win. One additional point here is that even if you are experienced, you likely are inexperienced in certain types of investing that you want exposure to (e.g. commodities, bonds), or that you simply don’t have access to (emerging markets, foreign stocks, etc.).
5) Most important of all, investing is not a game. For most people, this is retirement money, a kid’s college education, or other important issues. If you want a game, start a play money portfolio on one of the many finance sites out there and try your luck. If you want to gamble, get a night at the Wynn in Vegas and gamble with a few hundred bucks (this will be a much cheaper proposition for most people long term, anyhow).
For the individual investor who does not have the time or experience to devote to their portfolio’s, mutual funds have always been a popular strategy.
So now I’m terrified—five things you can do:
I am not saying that you should not invest in stocks on your own if you have little experience. All I am saying is that you should invest with an amount you can afford to lose, and that if you are serious about investing on your own, you educate yourself on the tools of the trade (this does not mean reading this article and a couple others, this means buying (and reading) investment books, reading reputable sites (especially this one, haha), and honestly assessing your skills on a regular basis. My father is a great example of someone who should be as far removed from his money as possible. Though he is incredibly intelligent, he is very emotional about his money. He successfully timed the 2000 market top, and 2002 market bottom by moving 100% into stocks in 2000, and moving 100% into bonds in 2002. If this sounds like you, find yourself a professional to manage your investments.
When I first started somewhat-intelligently investing several years ago, I limited my allocation of individual stocks to 20% of my portfolio, and put the other 80% with external managers. As I have continued to become educated and confident in my abilities, that number has shifted to about 50/50 (my short positions complicate the actual calculation). Though I may cut this down in the future, I always expect to invest some in mutual funds. There are some incredibly talented investors out there, particularly in areas where I am not myself skilled (e.g. Foreign bonds), that I always expect to outsource to other managers.
Mutual funds are an excellent way to diversify your holdings, and invest alongside some of the more talented investment managers out there. I highly recommend Morningstar as a starting point for your research, and a subscription to get their write-ups. Here are some quick, general guidelines for choosing mutual funds:
1) Examine performance over long-periods of time; 5-10+ years. If the manager has outperformed the market in this time frame, chances are that you are in pretty good hands
2) Make sure the manager in place now was the manager that got those great returns for the prior 10 years. Many top managers have left for hedge funds recently, so make sure the guy who got those returns is still around
3) Examine the funds performance in market downturns. In general, I like to avoid volatility, as I believe investors behave badly when their funds drop a good deal. If you know you are emotional with your investments, you are better off choosing a fund that has consistently deliver 10% returns, vs. one that has delivered 15% returns on average, but with severe downdrafts in bear markets. You are unlikely to achieve those 15% returns that the fund gets, because, if you are like most investors, you are likely to sell that fund near its bottom, and buy it back on the way up. Also, I am personally bearish on the market currently, so in my mind this analysis is more important than usual.
4) If you are confident in your ability to assess the strength of other’s skills, but not to invest in individual securities, I highly recommend reading commentaries or other articles about managers who run funds you are looking at. My two favorite mutual funds, (Hussman & Fairholme), I invested in more because I thought the managers were incredibly smart and disciplined, and less because of their performance (which, unsurprisingly, was also incredibly strong).
5) One major disagreement I have with Morningstar is on the topic of expenses. Morningstar is hesitant to recommend mutual funds with high management expenses, regardless of their performance. I think this is rather silly. Below you will find the 10 year annualized returns of two funds, pre-expenses. Which one would you rather invest in?
Fund A: 10%
Fund B: 15%
Fund B, obviously. Now, lets say Fund A has a .5% management fee, and fund B has a relatively expensive 3% management fee. Which one would you rather invest in now?
Fund A: 10%-.5%=9.5%
Fund B: 15%-3%=12%
Again, the answer is B. Don’t let high funds scare you off—one of the more respected fund families (Hotchkis and Wiley), has deservedly high fees. If you outperform your peers as some funds do, you can afford to charge significantly higher fees and still be a more attractive place for investors to park their money.
Conclusion
Unless you have a strong track record of outperforming the market in both up and down markets, or over a full investment cycle, I think it is a very prudent decision to not put 100% of your money in individual securities. Limiting yourself to 10-20% of your portfolio allows you to experience the joy and excitement of investing (or gambling, if you prefer), while ensuring that your retirement, kids college fund, and other causes are well-served.
Monday, March 19, 2007
Full MCZ Write-up: A potential double or triple from here
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 business. The company trades at 9-12x my FY07 estimates, and less than 7x my estimated FY08 earnings. I believe there is a very good probability that the stock could double or even triple if the turnaround continues as expected, and that the current valuation provides a good margin of safety in the event things do not turn out as positive as I expect them to.
Business Overview
MCZ is the leading provider of gaming console peripherals, including controllers, dance pads, steering wheels and, “cheat” software. The overall accessories market is about 12%, or $1.5B of the total
The video game market as a whole is comprised of three primary players: Microsoft (Xbox), Sony (Playstation), and Nintendo (Wii). It is cyclical in nature, and typically reaches trough earnings during a console transition (which we are in midst of emerging from right now), and peak earnings 2-3 years after new console releases. The console cycle up until recently was about 3 years on average, though 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. In other words, this current console transition (and its trough earnings effects) will likely be the last for several years to come.
Recently, 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 10-15% from other peripheral types (dancepads, steering wheels, etc.). 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. Somewhat comparable to a video game publisher in this regard Management believes that they will get a good lift from older consoles as companies discontinue peripherals for older consoles to focus on new ones. Company seems to be emerging from the console transition slump, and should be resuming growth that started in 05’ this year. There were no questions on the most recent conference call, which I like, as it usually signals that people aren’t paying much attention to the company
New CFO was head of finance at Take Two’s prized Rockstar games division, part of troubled take-two interactive, which I believe was the same company that had some notorious accounting issues a couple years back. From what I could tell in my research, Halpern wasn’t involved in the issues at Take-Two, and resigned the company in 05’. I like the experience in the business, and from the way he sounded on the conference call, it sounds like he will take a fairly active role in helping to shape the company’s overall strategy.
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:
| | FY02 | FY03 | FY04 | FY05 | FY06 | FY07 (9 months) |
| Revenue | $83,337 | $91,657 | $102,143 | $112,071 | $100,768 | $80,367 |
| Cost of revenue | $64,927 | $70,699 | $79,078 | $83,644 | $87,343 | $60,390 |
| Gross profit | $18,410 | $20,958 | $23,065 | $28,427 | $13,425 | $19,977 |
| GM % | 22.1% | 22.9% | 22.6% | 25.4% | 13.3% | 24.9% |
| Operating Expense (OPEX) | $14,342 | $18,959 | $20,248 | $19,785 | $22,576 | $15,019 |
| OPEX as % of sales | 17.2% | 20.7% | 19.8% | 17.7% | 22.4% | 18.7% |
| Net Income | $2,161 | $1,210 | $1,062 | $4,326 | ($6,653) | $3,009 |
| Net Margin | 2.6% | 1.3% | 1.0% | 3.9% | -6.6% | 3.7% |
| EPS | $0.03 | $0.02 | $0.02 | $0.08 | ($0.12) | $0.05 |
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.
This year should be flat to slightly up in terms of revenue (depending on Q4 performance), though I expect revenue growth to resume going forward, roughly in line with the high single digit/low double digit growth experienced by the industry as a whole.
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. In particular, it appears as though the face plates have been a hit—just as in cell phones, this accessory appears to be becoming popular amongst younger audiences, and could present a lucrative, high margin new business line. MCZ seems to be in a good position to get licensing deals in the future to produce these for other games (in particular, in conjunction with Microsoft). The company also successfully instituted a cost cutting plan that resulted in about $2-3 million savings in annual operating expenses, further aiding net margin improvement going forward.
To see what happened to net income in FY06, which turned negative for the 1st 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:
| | Q1 | Q2 | Q3 | Q4 | FY07 |
| FY07 | 22% | 22% | 29% | | |
| FY06 | 14% | 17% | 15% | 4% | 13% |
| FY05 | 25% | 24% | 25% | 24% | 25% |
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.
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. I expect revenue near the high end of Q2 revenue, based on the new launch of peripherals (including PS3 wireless controllers, and rumors of a Wii controller launch) in Q4. The wii launch in particular would be a boost, as there are still large shortages reported of wii controllers, and MCZ could capitalize as the 1st major 3rd party distributor to sell the product. Below is a sensitivity table with projected EPS based on different GM and revenue numbers.
| Q4 rev & GM % | 22% | 24% | 26% | 28% |
| $20M | ($0.011) | ($0.004) | $0.003 | $0.008 |
| $22M | ($0.003) | $0.004 | $0.009 | $0.015 |
| $24M | $0.004 | $0.010 | $0.016 | $0.022 |
| $26M | $0.009 | $0.016 | $0.022 | $0.029 |
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 (note--I'm having trouble getting this to display properly--see next paragraph for summary)
| Scenario | Worst-case | Conservative | Likely | Aggressive |
| FY07 rev (est) | $102,000,000 | $102,000,000 | $102,000,000 | $102,000,000 |
| Rev Growth | 0% | 5% | 10% | 15% |
| FY08 Revenue | $102,000,000 | $107,100,000 | $112,200,000 | $117,300,000 |
| Gross Margin | 22% | 24% | 26% | 29% |
| Gross Profit | $22,440,000 | $25,704,000 | $29,172,000 | $34,017,000 |
| Operating Exp | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 |
| EBIT | $2,440,000 | $5,704,000 | $9,172,000 | $14,017,000 |
| Interest exp net other income | ($500,000) | ($500,000) | ($500,000) | ($500,000) |
| Income pre-tax | $1,940,000 | $5,204,000 | $8,672,000 | $13,517,000 |
| Net Income | $1,319,200 | $3,538,720 | $5,896,960 | $9,191,560 |
| EPS | $0.02 | $0.07 | $0.11 | $0.17 |
| Probability of scenario occuring | 15% | 25% | 45% | 15% |
| Price @ max of 15 P/E or .5 P/S | $0.51 | $0.98 | $1.63 | $2.54 |
| Upside @ $.74 | -31% | 32% | 120% | 244% |
| Weighted Upside (probability x upside) | -4.7% | 8.1% | 54.2% | 36.5% |
| Probable Upside (sum of weighted upside) | 94% | | | |
Basically, what I’ve done here is assumed four different scenarios for FY08 and assigned a probability of each occurring (my best guesses). As you can see, small revenue growth on higher gross margins (26-28%), will result in strong operating leverage, and could send the stock much higher. 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.
A quick look at the MCZ charts 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.
Catalysts:
-Q4 earnings announcement
-Entering new console growth phase spurred by increased production of new consoles (as supply begins to catch up with demand), and eventual price cuts that will drive new adoption, and a need for owners to accessorize their new systems.
-Improved product mix resulting in better gross margins that are more in line with those experienced in Q3 of FY07 and double digit revenue growth as the company emerges from the console transition
-Accessories for the new generation of consoles. Madcatz just released wireless controllers for the PS3, and rumors on the internet appear to show them having developed Wii controllers as well. This could be lucrative short term, as Nintendo has had trouble keeping up with demand for these controllers
-Iniar personal music technology—a recent acquisition, company is very excited about this products potential. Allows people to simultaneously get good quality sound from headsets, while also being able to interact with their environment. I could see this taking off or falling flat—younger audiences, in particular, are notorious for their ability (and desire) to do 8 things at once, and I could see this becoming a popular way for kids to listen to music. Company brought on the inventor as management. Product will launch later this year, and company thinks it has strong potential with relatively small investment.
Risks:
**Business is very hit or miss, and relies on a mix of successful new releases to propel earnings. In particular, failure of MCZ to launch successful high margin products could result in results below expectations.
**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 3rd 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.
**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.
Disclosure: I own shares in MCZ. This write-up is for educational purposes only, and not a recommendation to buy or sell shares.
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