The second business is Online Gaming and Services, currently contributing about 25% of sales. There are two subsidiaries that comprise this unit. FunTown is a Taiwan-focused operation that offers a wide variety of games, from casual ones like Mahjong and online versions of popular Asian table games, to licensed "massively multiplayer online role-playing games" (MMORPGs) such as Warhammer Online (licensed from Electronic Arts - EA) and Phantasy Star (licensed from Sega). FunTown has nearly 12 million registered users. The other online gaming subsidiary is T2CN, a huge (over 70 million users), China-based business whose focus is on sports games.
Gigamedia historically also ran a number of Internet service providers, but divested the last of them in September 2008. Today all of its business is focused on online gaming, a growth industry with very attractive margins and relatively low capital requirements. This is reflected in some impressive financial numbers. Gigamedia runs operating margins in the low 20% range, and free cash flow margins come in at about the same levels. Returns on invested capital are strong, averaging over 20% on a standard ROIC basis, and close to 60% using a Magic Formula calculation. The balance sheet also is solid, with $97 million in cash and about $14 million in short term borrowings.
The company has delivered some impressive growth recently, with sales averaging 38% annual growth and operating profits 67% since 2004. There is still plenty of opportunities for future expansion. Everest has struck a deal to sponsor the World Series of Poker, ensuring it substantial visibility. There have been rumblings of the U.S. easing restrictions on online gambling, which would open a whole new and lucrative market for the company. Casino offerings are being expanded, with applications such as a European sports book recently added. On the online gaming side, Gigamedia has a good relation with gaming powerhouse EA, which could lead to additional exclusive licenses for hot games, a major competitive advantage in this business. Online gaming is a huge phenomenon in Asia, and Gigamedia is well positioned to capitalize on it. Even in a weak economy, FunTown and T2CN continue to perform well. There also exists some short-term competitive advantages here, as exclusive licenses lock users in while they are stuck on a particular game.
At a 13% earnings yield, with a strong business model and plenty of room for growth, Gigamedia makes a fine MFI purchase and MagicDiligence has a positive outlook on it. However, it falls short of the Top Buys list for a few reasons. First of all, the direction management is pursuing is unclear. In the most recent quarterly report, management announced that they are in the late stages of a possible sale of the poker and casino business. This is rather shocking, as it contributes 70% of sales at over 80% gross margin! It looks like management wants to focus on the Asian online gaming business, but the timing is questionable to be sure. An announcement like that adds a lot of questions to this investment.
More generally, Gigamedia operates in a highly competitive and highly discretionary market, which means pricing power will continue to come down over time. There is no shortage of players in the Asian online gaming market - Shanda Interactive (SNDA), NetEase (NTES), and Perfect World (PWRD) are just some examples, and all larger than Gigamedia. More competition can also lead to bidding wars for hot licenses. Gaming is highly discretionary, and is easily dropped in hard economic times, leading to large revenue drops in short amounts of time. Customer retention can be difficult. Consumers will move to whatever gaming network the latest hot game is on, and rarely does one game retain the interest of gamers for more than a year or so. There are few barriers to entry, as well.
Gigamedia is a decent MFI pick, but has enough risks and uncertainties to think twice about - or wait for an even cheaper price.
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Steve does not own GIGM.
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