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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