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, Philadelphia eagles controllers. Madcatz currently has exclusive agreements with several large sports associations for accessory rights, and is hoping to sign several companies to longer term deals.

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.


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.

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