GigaMedia: Gaming the System

Jul.23.09 | About: GigaMedia Limited (GIGM)

GigaMedia Limited (NASDAQ:GIGM) is a provider of gaming software and services to the online gaming industry, particularly the online poker and casino markets, and an operator of online games in Greater China, including the People’s Republic of China (PRC), Taiwan, Hong Kong and Macau. Through its gaming software and service business, it develops and licenses online poker and casino gaming software solutions and application services, primarily targeting continental European markets. Its online games business operates a portfolio of online games, primarily targeting online Greater China markets. The Company provides the Everest-branded gaming platform to various online poker and casino game sites, including Everest Poker.

GigaMedia Ltd [NDQ:GIGM] July 23, 2009 $5.24
52-week range: $2.64 (Nov. 21, 2008) - $13.47 (Jul. 23, 2008)

GIGM showed tremendous earnings growth from 2004 through 2008. Fully diluted EPS expanded steadily from $0.03 to $0.74. The first quarter of 2009 was disappointing at $0.08 versus $0.20 and the shares have come down to $5.24 from their $13.47 high exactly one year ago. The company blamed recessionary conditions and the strength of the Euro for the lesser results to start the new year.

Current estimates for 2009 and 2010 are running $0.42 and $0.63 respectively. That puts GIGM’s multiple at just 12.5x this year’s and about 8.3x next year’s expectations.

Average P/Es for the years 2004 – 2008 were much higher at 58x, 16.1x, 27.7x, 23.8x, and 21.7x.

GigaMedia has a strong balance sheet. As of its most recent report, the company held about $97 million in cash against total debt of under $15 million. Debt to equity was a very low 7% with total interest coverage at 39x.

Year-end 2008 book value was $4.20 /share. Net profit margins ranged between 14.7% - 24.9% in the four years 2004 – 2008.

Unless business deteriorates significantly more than expected, these shares likely have more than discounted the weaker earnings compared to last year. Standard and Poor's rates GigaMedia with their highest, 5-Star rating, and has a 12-month price target of $7.50 /share.

Here’s a nice play for the next 18 months that generates great returns even if the shares do nothing between now and January 2011:

..................................................... Cash Outlay .......... Cash Inflow
Buy 1000 GIGM @$5.24 ................ $5,240 .
Sell 10 Jan. 2011 $5 calls @$1.80 ................................ $1,800
Sell 10 Jan. 2011 $5 puts @$1.50 ................................ $1,500
Net Cash Out-of-Pocket ................. $1,940

If GIGM shares close above $5 on the Jan. 2011 expiration date:

  • The $5 calls will be exercised.
  • You will sell your shares for $5,000.
  • The $5 puts will expire worthless.
  • You will have no further option obligations.
  • You will end up with no shares and $5,000 cash.

That would be a best-case scenario net profit of $3,060.

$3,060 / $1,940 = 157% cash-on-cash

Achieved in about 1 ½ years on shares that:

  • Went up.
  • Stayed unchanged.
  • Dropped by up to (-4.5%) from trade inception price.

What’s the risk?

If GIGM shares finish below $5 on the Jan. 2011 expiration date:

  • The $5 calls will expire worthless.
  • The $5 puts will be exercised.
  • You will be forced to buy another 1000 GIGM shares.
  • You will need to lay out an additional $5,000 cash.
  • You will have no further option obligations.
  • You will end up with 2000 GIGM shares.

What’s the break-even point on the whole trade?

On the first 1000 shares it’s their $5.24 purchase price less the $1.80 /share call premium = $3.44 /share.

On the ‘put’ shares it’s the $5 strike price less the $1.50 /share put premium = $3.50 /share.

Your average net cost would be $3.47 /share or 31.8% below your starting price of $5.24.

Summary:

If GIGM shares remain above $5 at expiration (as they already are) you will have made over 157% cash-on-cash.

You are protected against loss on any drop down to $3.47 /share.

Disclosure: Author is long GIGM shares and short GIGM options.