Note: The large majority of this article was written before MGT's acquisition of fanthrowdown.com. Therefore, I make little mention of that deal. Please see this article for a good update on that front.
I recently invested in a stock that should exhibit very low correlation to the overall stock markets going forward. That stock is MGT Capital Investments (MGT). There's already a handful of good articles on SA and Forbes about MGT. Please see links to SA articles [here], [here], [here] and [here]. And this is another very good article from just two weeks ago. From reading these informative articles, it's clear to me that there's tremendous upside potential.
In this piece, I present my view of the upside and walk through a few scenarios. My weighted-average scenario price is a conservative $8.75 per fully diluted share. However, if one rules out the "cash value" scenario of about $2 per share, the weighted average price is $13.25.
By my calculations, today's stock price of $3.90 would be covered by a hypothetical one-time gross settlement of $24 million, (before lawyers, partnership interests and taxes). A settlement of $24 million is obviously well below the range of estimates put forth by management and various stakeholders. I think it's fair to assume that if the company receives ANY settlement at all, it will be more than enough to cover the current valuation.
The upside has been well articulated in the referenced articles. However, I have yet to see an attempt at a weighted average scenario valuation. Yes, MGT could hit $47 per fully diluted share (my estimate) upon a blockbuster settlement, but what's the probability of that event? For the purposes of this article, I assumed that probability to be 5%.
My weighted-average scenario price of $8.75 per fully diluted share is as follows.
40% probability the stock is worth, "cash value" of $2.0
30% probability the stock is worth $3.9
25% probability the stock is worth $17.7
5% probability the stock is worth $47.0 (or more)
The $2.0 Per Share, "Cash Value" Scenario, (40% Probability)
This stock should be worth at least $2.0 per share based on cash on hand of $5.0 million + $2.0 million in assumed net proceeds from the sale of its Medical Imaging assets + the value, at cost, of the company's recently acquired 63% stake in fanthrowdown.com. The math comes out to $9.0 million divided by 4.54 million (common + preferred shares) = about $2 per share. Obviously, the warrants at $3.64 per share would not be exercised, so those potential shares are not included. I think my 40% weighting for this scenario is very conservative.
The $3.9 Per Share Scenario, (30% Probability)
In this scenario, I calculated the one-time gross settlement amount that, when added to the "cash value" amount above, would equal today's valuation. A one-time gross settlement of $24 million (before lawyers, partnership interests and taxes) would net to $8.6 million. Adding that net amount to the "cash value" amount of $9.0 million (see above) = $17.6 million. $17.6 million divided by 9.4 million fully diluted shares is about $3.9 per share.
The $17.7 Per Share Scenario, (25% probability)
This scenario is the first in which I consider a favorable settlement that includes 10 years worth of forward royalties. Specifically, I assumed 3,500 infringing slot machines at $3,500 per day x 365 days at a royalty rate of 1.5%. This compares to a range of possibilities depicted in the company's corporate presentation of 3,000 to 10,000 machines operating at $3,000 to $5,000 per day at a royalty rate of 1.0% to 2.5%. I believe this scenario is fairly conservative.
The $47 Per Share Scenario, (5% Probability)
This scenario is, of course, highly important to the overall valuation exercise. Even though this scenario carries only a 5% probability, it equates to 25% of the weighted average price of $8.75 per fully diluted share. For this scenario, I doubled the assumed number of infringing machines to 7,000, increased the operating rate to $4,000 per day and increased the royalty rate from 1.5% to 2.0%. I feel this "best case" scenario is realistic and not overly aggressive given the management's public statements.
Before some readers question my 5% probability assumption as being overly generous, consider that the 5% probability also includes all outcomes above $47 per share. This is important. It's possible that the fully diluted shares could be worth $102 each. That's the valuation at the high end of MGT's rough guidance, i.e., 10,000 machines x $5,000 per day x 365 days x a 2.5% royalty. Even if I ascribe just a 1% chance for this outcome, that would account for 10% of the total weighted average price estimate.
Some readers may still be unsure about even a 1% chance of a $102 per share outcome. Admittedly, this is more art than science. However, what if I told you that there's even greater upside than $102 per share? MGT has another patent pending that could possibly increase the number of deemed infringing machines. In that case, the upside range of the number of machines could be above 10,000.
To be clear, I believe a stock price outcome of $17.7, the 25% scenario, is very reasonable. I fully recognize that valuations of $47 to $102 or above are outliers. I only point out these blue-sky outcomes in the context of a weighted average valuation. Balancing out the huge stock price scenarios is my belief that the 40% probability of a $2 "cash value" scenario is very conservative.
The reasoning behind a weighted average scenario approach is sound -- readers can attach their own probabilities. I'm confident that the top-tier law firm that took this case does this exact exercise with each bit of new information.
Even if one thinks that the probabilities of valuations of $47 to $102 per share are somewhat outlandish, remember if this case goes to a jury, anything can happen. That fact is why some of the authors of the stories linked above are saying that WMS Industries (NYSE:WMS-OLD) will have to settle with MGT before Scientific Games Corp. (NASDAQ:SGMS) consummates their acquisition. This reasoning seems right to me.
Finally, I would add that if one accepts the thesis that WMS will have to resolve this issue this year to clear the way for the merger, then my $2 per share scenario is overly conservative and possibly pulls the weighted average price down unnecessarily. With that in mind, if one assumes that the $2 per share scenario is off the table, then the adjusted weighted average stock price is $13.25 per fully diluted share.
MGT is a good speculative play. It offers low correlation to the overall markets. Since the company is sitting on roughly $5.0 million of cash, it has the financial wherewithal to play the patent(s) litigation through to the end. With a catalyst in place by virtue of the proposed acquisition of WMS and the outside probability of a huge settlement, the chances of a settlement in 2013 appear fairly good. With 50% downside to $2 per share and a decent chance of upside to my $17.7 price scenario, (25% probability), I like my odds here.