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Mad Catz Interactive, Inc. (NYSEMKT:MCZ)

F1Q10 Earnings Call

August 12, 2009 5:00 pm ET

Executives

Norberto Aja - Investor Relations

Darren Richardson - President, Chief Executive Officer, Director

Stewart Halpern - Chief Financial Officer

Analysts

Ronald Rodder - RLR Partners

Matthew Sanso - Private Investor

Buck Vasser - Fulton Trust

David Brigham - Brigham Investments

Joseph Miranda - Private Investor

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Mad Catz Interactive fiscal Q1 2010 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Mr. Norberto Aja, Investor Relations. Please go ahead, sir.

Norberto Aja

Thank you. Today’s discussion will contain forward-looking statements about the company’s financial results, estimates, and business prospects that involve substantial risks and uncertainties. The company assumes no obligation to update the forward-looking statements contained in this conference call as a result of new information or future events or developments.

You can identify these statements by the fact that they use words such as "anticipate," "estimate," "expect," "project," "intend," "plan," "believe," and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. Among the factors that could cause actual results to differ materially are the following: the ability to maintain or renew the company's licenses; competitive developments affecting the company's current products; first party price reductions; price protection taken in response to price cuts; the ability to successfully market both new and existing products domestically and internationally; difficulties or delays in manufacturing; delays in the company’s ability to obtain products from its manufacturers in China; market and general economic conditions. A further list and description of these risks, uncertainties and other matters can be found in the company's reports filed with the appropriate regulatory authorities.

Today’s call and webcast includes non-GAAP financial measures within the meaning of SEC Regulation G. When required, a reconciliation of all non-GAAP financial measures to the most directly comparable financial measure calculated and presented in accordance with GAAP can be found in today’s press release.

As part of Mad Catz's ongoing investor relations effort, the company regularly meets or conducts calls with members of the investment community. If you are interested in meeting with Mad Catz's management, please call me at 212-835-8500.

And with that, I would now like to introduce Mad Catz's President and Chief Executive, Darren Richardson, who will be joined on today’s call by CFO Stewart Halpern. Darren.

Darren Richardson

Thank you, Norberto. Good afternoon and thank you all for joining us on the call today. Earlier today we announced our results for the first quarter of fiscal 2010. On today’s call, I’ll provide an overview of the recent financial and operational achievements, after which Stewart will review our financial performance for the quarter in greater detail. Afterwards, I’ll provide an update on our new product development initiatives and offer some thoughts on the outlook for the balance of fiscal 2010.

Our performance in the first quarter of fiscal 2010 was notable in that we held our sales decline to 4% despite the difficult environment and tough comps with the year-ago period, which included the launch of our highly popular Wii Fit products. We had a number of positive achievements that drove top line sales, including the addition of new accounts, new product placements and the ongoing strength of our Streetfighter 4 product line. Unfortunately, those successes were more than offset by overall industry weaknesses and the ongoing top line impact from exchange rates.

Gross margins improved to 28.4% this quarter from 24% last quarter. That is significant progress but we are still focused on getting margins back over 30% on a consistent basis. The most significant achievement, however, was the reduction of operating expenses by 30% which allowed us to deliver record EBITDA for the quarter.

With that, let me turn the call over to Stewart to review our financial results for the quarter. Stewart.

Stewart Halpern

Thank you, Darren. Sales for the quarter were $22.4 million, down 4% from last year’s Q1 record $23.2 million. We are very pleased to report that sales in North America were up nearly $1.6 million, or 13%. However, sales in Europe were down $2.8 million, or nearly 28%. $1.7 million of the decline in Europe is due to the dollar being stronger this year versus last year and its impact on non-dollar denominated sales when translated into U.S. dollars for financial reporting purposes. The rest of the decline in European sales came from Germany, where over 90% of our business is currently on the PC platform, which has been particularly impacted by the economic environment.

Although faced with very tough comparisons due to last year’s Q1 sales of accessories for Wii Fit, we benefited greatly this quarter from the continued success of our Streetfighter 4 product line. We’ve also seen additional retail placements as additions to our sales team over the past year are increasing our market penetration.

I would like to point out a modification in the product category disclosure in our press release and 10-Q, which we hope will help give better visibility and understanding of our business. We have now broken out a category called specialty controllers, which includes products such as our fight sticks, Rock Band guitars, and some of the flight sim products, for example. The specialty controller products this quarter accounted for 36% of total revenue, up from 17% in Q1 last year.

Gross profits decreased 22% to $6.4 million from $8.2 million last year, with a gross profit margin of 28.4%, down from 35.3% last year. Virtually all of the gross profit margin decline is due to the currency translation impact I previously described.

Looking at operating expenses, we are very pleased to report that we are on track toward our goal of reducing SG&A by no less than 10% this fiscal year. Total operating expenses in Q1 decreased 30% to $6.4 million from $9.1 million in Q1 of fiscal ’09. Within operating expenses, SG&A this quarter was down 31% to $5.5 million from $8 million last year. This left us at approximately a break-even operating result this quarter versus an operating loss of $884,000 in Q1 of last year.

After the impact of interest expense, FX loss and other income, we reported a pretax loss of $774,000, an improvement of over $0.5 million or 40% from last year’s pretax loss of $1.3 million.

After a tax provision of $223,000 this quarter versus a tax benefit of $509,000 last year, the net loss this quarter increased to $996,000 from $777,000 last year, resulting in a loss per share of $0.02 versus last year’s loss per share of $0.01.

As mentioned earlier, EBITDA was a record for our first fiscal quarter -- $730,000, up from $283,000 in Q1 last year. And as you’ll see from the cash flow statement in the 10-Q, free cash flow was a positive $1.2 million, whereas in Q1 last year we had negative cash flow of over $5 million, largely due to differences in working capital flows.

Looking to the balance sheet, the net position of our bank loan less cash at June 30, 2009 was $9.4 million compared to $10.4 million at March 31st and $10.9 million at June 30th of last year. We’ve also had significant improvements in accounts receivables, with DSOs at June 30th of 2009 at 54 days, down from 63 days at March 31st and 66 days at June 30th of 2008.

Also relating to our balance sheet, you may remember from our year-end call that we previously announced the extension of our working capital facility with Wachovia and the restructuring of the [seller note] in connection with the acquisition of Saitek to extend the maturity of that note. We continue to believe these deals provide us the financial flexibility we need to continue to grow our business and build shareholder value.

In summary, despite continuing challenges of the economic environment and the exchange rate impacts on our financials, we are pleased that we are achieving some market success with new products and that we are able to meaningfully reduce our operating costs even as we continue to grow our product portfolio and increase our sales penetration on a global basis.

I would now like to turn the call back over to Darren for closing remarks.

Darren Richardson

Thanks, Stewart. We remain focused on bringing value-added products to market and aligning our products with today’s most successful gaming titles. We’ve had success in doing so and continue to make great progress in that area. In particular, our line of Streetfighter 4 and Rock Band products continue to generate significant sales and positive reviews. Together, these two product lines have given us great traction with a pair of the most successful gaming titles on the market today.

As you can see from the summary of upcoming products listed on our earnings release today, plus some new yet-to-be-announced products and licenses that we are working on, we believe we will have a solid roster of new products for the second half of the year and beyond. In particular, we are really excited to be working with Infinity Ward and Activision on the upcoming Modern Warfare 2, the sequel of the highly acclaimed best-selling first-person action game in history, Call of Duty 4: Modern Warfare, scheduled to launch in November.

We also expect a September launch of MTV’s The Beatles Rock Band to continue to fuel demand for our expanding range of music genre products.

During the first half of fiscal 2010, we continue to see an industry wide slow down as we work through a tough prior year comp and the effects of the macroeconomic environment. Although retailers remain cautiously optimistic on the videogame category outlook for the year, they continue to exercise extreme caution in regard to inventor exposure, especially through the slower summer months.

In Q1, we had the benefits of some successful new business initiatives but really saved our way to a good result in what was always going to be a tough quarter. For Q2, we are expecting a difficult comp for sales and margins to be offset to some extent by continued improvements on the OpEx line from the cost reductions previously implemented.

Over the last two years, we’ve cemented our global distribution footprint, we’ve diversified our product portfolio and brought our operating costs in line. We are now intently focused on rebuilding our margins and driving revenue to leverage the platform we’ve built.

As we move through the balance of fiscal 2010 and beyond, we are focused on a number of key objectives that we believe will position us to deliver EBITDA and earnings growth over the course of the year. We expect to continue to leverage our product development capabilities to increase the flow and timeliness of new products, increase the market penetration of our PC products with a particular emphasis on North America and further expand our portfolio of licensed products. We will also remain disciplined on managing expenses which will bring more dollars to the bottom line.

The company’s future is bright as we have the best product lineup in our history, the most sales and product distribution reach ever, an improved operating expense structure and amended credit and note agreements. Our strategy remains simple -- stay close to our customers, drive innovation into our products and operate with financial discipline.

That concludes our prepared remarks. I would now like to turn the call back to the Operator for questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Ronald [Rodder] with RLR Partners.

Ronald Rodder - RLR Partners

Congratulations on a real good quarter in a very difficult environment. You spoke in the release about seeing significant gains in EBITDA for the year. Could you express your thoughts at all on whether you would see in this environment look for any gains in revenues or would all of this basically be coming from a margin improvement?

Darren Richardson

Well, I think if you look at the portfolio of products that we have on the press release today, we’ve got a lot of new product initiatives so I would like to think that it’s a two-pronged approach. I would like to think that we can drive the top line a lot harder. I think most people think that this year for the videogame space is going to be back loaded. At the same time, no one really knows what the holiday period has got in store for us but hopefully it’s going to be an improvement on last year. And we hope to be able to continue to drive improvements on margin. And I think with the OpEx reductions that we’ve got in place, which we see as an ongoing kind of run-rate, if we can actually drive revenue and get some margin improvement, then we’ll really get some leverage benefits as we get through the back half of the year.

Stewart Halpern

Just to add to that, and I don’t know if this underlining your question, when we talk about growth in EBITDA and earnings, that growth isn’t really dependent on revenue growth, which in the uncertain environment, as optimistic as we are about the product portfolio, you have to take a conservative expectation towards revenue growth. So we think that on the cost savings alone, we can generate good growth in earnings and to the extent that we can get revenue growth on top of that, there should be upside beyond that.

Ronald Rodder - RLR Partners

And in the second quarter, which wasn’t all that particularly strong for you last year, this year you are going to have the benefit of the launch of the Rock Band Beatles. Is that a significant enough event that you could be looking for revenue increases in the current quarter?

Darren Richardson

Yeah, tough to call at this stage, Ron. I mean, as we get closer to it, we’ll have a better fix on that. I think the early signs, the trends are very much like Q1 where pretty much across most accounts, we are seeing softness in the sales of ongoing SKUs and in Q1, we are able to kind of offset that with some sales to some new accounts that we’ve opened up and also some new placements that we’ve managed to get going where we’ve got some nice launching quantities as well. The real question is what’s that ongoing run-rate of existing products going to be and early signs are that it’s a little bit soft but now we are getting to the point that retailers are going to start putting some money back into inventory as we come through some higher store traffic driven by those kind of products but it’s usually that last couple of weeks of September that we see either a sales up-kick or it gets delayed until October. Right now, I’d be more confident to say it’s probably going to be October that we get the load in because retailers are still running very, very cautious on inventory.

Ronald Rodder - RLR Partners

Okay, so Rock Band -- the Rock Band Beatle launch in itself isn’t going to make or break the quarter.

Darren Richardson

No, I think it’s going to be important but I think the real thing is when does the ramp-up for the holiday period start to ship -- is it the last two weeks of September that retailers start pulling inventory in or the first couple of weeks of October that that starts? And that’s -- for Q2, that’s usually the thing that makes or breaks the top line.

Ronald Rodder - RLR Partners

And finally, Saitek had a meaningful drop in revenues in the quarter. Is there anything you can do or are doing to change the tone of business there?

Darren Richardson

If you look at the console side, I think if you look at retailers like Gamestop and some of the publishers, you get a fairly good sort of indicator as to what’s happening in terms of overall market there and you can see that there’s softness there with sort of like single-to-low double-digit kind of reductions in same-store sales and so forth.

When you turn to consumer electronics, and particularly the PC space, and you look at a couple of companies that operate in that space, you see much more dramatic fall-off in sales. So one of the things that Stewart I think was talking about a little bit earlier, in our German business where we are kind of like 90% PC, so that’s less about gaming and more about PC input devices -- mice and keyboards and so forth -- we saw some real significant impact in those kinds of segments.

So there’s a few -- a couple of different moving pieces. Gaming doing better than just straight PC product, so we maintain the placements, we’ve actually grown some placements, which is actually improved but the same product sales are actually trending lower than they have been prior year.

Ronald Rodder - RLR Partners

Thank you.

Operator

(Operator Instructions) Our next question comes from the line of Matthew [Sanso], a private investor.

Matthew Sanso - Private Investor

I wanted to ask a question about your process, concept to ramp-up for a typical product. And really what I am looking for is what gets done in-house and what gets done by independent contractors or third parties, as you move a product concept through the early design and mock-ups to an actual production ramp?

Darren Richardson

Actually, the bulk of what we do is in-house an one of the nice things with the Saitek acquisition is it really gave us a lot deeper engineering capabilities, product development capability, both in Europe but also in China. So the bulk is in-house. We occasionally use out-source services for specific bits and pieces but the bulk of what we do is in-house.

Matthew Sanso - Private Investor

Even the fabrication, you would say the bulk is now in-house, done with equipment that Mad Catz owns?

Stewart Halpern

No, no -- what I was just about to jump in to say is when you get to the point of manufacturing, that’s really done all on an out-source basis. So the design and development work, done in-house. Once you get towards manufacturing, that’s all outsource.

Matthew Sanso - Private Investor

And if some of that development work, you know, when you are doing prototypes, mock-ups, and early pilot runs, is any of that fabrication in-house or is it just the engineering and design that you are saying is in-house and you still are going all to outside vendors for the parts, even in the mock-up phase?

Darren Richardson

For mock-up phase, we’ll typically use some out-sourced services and some internal but when we get to detailed mock-ups, we’ll typically outsource that.

Matthew Sanso - Private Investor

Okay. And then I had one other question -- you mentioned the Rock Band and Streetfighter products as particularly successful and I assume that includes profitable. I was wondering if you could confirm that, that you would call those products profitable and then if you could maybe point to something else in your very large array of SKUs that you might characterize as an unprofitable product to be the sort of product that you are looking to move away from in the coming year, something that despite -- regardless of the economic climate, you would characterize as something that you are trying to move off your books.

Darren Richardson

I think if you look at the last couple of years, we went through a phase through 2006, 2007 where we implemented a return on investment analysis really by every SKU placement at every retailer and we trimmed out a lot of unprofitable or marginal SKUs. At the same time, we refocused our product development initiatives on to products that really are a value-add for gamers so higher profile, typically higher priced which, given where the economy is going, maybe not the ideal timing but you can't control that. But it has been successful and so we really don’t do very many products that are unprofitable and if they are, we quickly discontinue those products and move on and get on to the products that are profitable.

So the products that we support are definitely profitable products and we have very little time or tolerance for products that are not generating strong gross margins. And that same approach and diligence we are using to continue to grow our margins and work through some re-pricing and so forth in markets that have been impacted by foreign exchange. It just takes a little bit of time to get those pricing things worked through and you can start to see some benefits now. I think we will get some more as we move through in time.

Operator

Our next question comes from the line of Buck Vasser with Fulton Trust.

Buck Vasser - Fulton Trust

Your gross profit last year was 35% and this year was 28%. I was wondering if you could comment on gross margins and any specific numbers you can share with us on new products?

Stewart Halpern

Is that one question and you are saying gross margin on new products or --

Buck Vasser - Fulton Trust

Gross margin on new products. I know that some of the -- well, I’m assuming your gross product was affected this year by your currency adjustment but in terms of looking forward, your margins on new products.

Stewart Halpern

As Darren was alluding to, as part of our analysis of moving forward with the product, we really look at an ROI on every individual SKU at every individual placement and what we are trying to do is continually move that ROI hurdle higher. So for the most part, the products that we are making going forward should have inherent in them gross margins, currency aside, you know, at least as high as what we’ve been doing in the past. The gross profit margin for this quarter, as we talked about, really all of the reduction on a year-over-year basis is related to the currency impact so it’s not as if we’ve had in the product portfolio a decline in let’s call it sort of the margin at the factory level on a currency adjusted basis.

Buck Vasser - Fulton Trust

Okay, so looking forward, should we be expecting a 35% gross profit margin or higher or less?

Stewart Halpern

Well, let’s put it this way, not to be simplistic but if the dollar going forward was where the dollar was last year, then we would very quickly start showing gross margin of more like the gross margins we had last year. As Darren alluded to, we started to see a little bit of benefit and as you can just look at currency charts, you can see the dollar has fallen off from its peaks earlier in this calendar year. So we are hopeful that we might start to see some of that come back but we are not in the currency trading business -- it’s a little bit hard to foresee. Absent that, we are doing what we can to improve margin, as Darren mentioned. You know, we can talk to our partners, our retail partners in those European jurisdictions and talk about price increases but that’s not done quickly and it’s not done easily in the economic environment that they are in.

Darren Richardson

And then just to add to that, it’s easier to rectify pricing on new product launches than it is to go and retrospectively try and change pricing. So as we roll out our new products for this quarter -- for this holiday period, we will have the pricing right.

Buck Vasser - Fulton Trust

Great, and one other small comment on your European sales -- were the unit sales way down or was it mostly currency?

Stewart Halpern

Well, as we talked about a little bit, certainly Germany we saw a big impact on sales fall off even on a native currency basis, so I don’t have the unit numbers right in front of me but my presumption is that there’s probably a fall-off in units consistent with a pretty noticeable decrease in sales, even on a native currency basis. Throughout the rest of Europe on balance, sort of taking Germany out, which is obviously a very big market for -- especially for PC, we actually did reasonably well relative to the currency issue. But without question, Germany would have had a significant fall-off in units.

Buck Vasser - Fulton Trust

Thank you.

Operator

Our next question comes from the line of David Brigham from Brigham Investments.

David Brigham - Brigham Investments

Good afternoon, gentlemen. My question is kind of a corporate strategy question -- I am trying to determine whether you see Mad Catz getting to the two, three, four, $500 million category in sales say within five years? Because what I have seen over the last few years is that you have successfully replaced your products that are perhaps peetering out with new products and you are coming along but -- for example, the in-air technology, the -- that we were all excited about a few years ago. I haven’t heard you talk about that. It seems like you are going to have to hit a home run or two to get the company to where -- to get to the next level in sales, to $0.5 billion. Is that your goal? Tell us about how you see the company in five years in terms of sales -- how big can it be? Do you have enough financing to get to there? Do you need to have some kind of a product that just blows the -- unexpectedly just catches fire? Tell us about that.

Darren Richardson

Definitely. Well, first of all, we are targeting $300 million to $500 million over the next period and we know we are not going to get there tomorrow but we are definitely focused on getting there.

If you look at the cost of being a public company, just the static cost, it is quite heavy for a $100 million revenue public company so we need to be up in around $300 million plus to be able to amortize that and so that it’s not such a material part of our cost base.

The second thing is we’ve been a fairly significant player in the console accessory space and so I think we’ve done a great job of building that out. We’ve had a couple of set-backs there with the new generation of consoles limiting access to wireless, which has now become the absolute mainstream way to connect to the system. We are working our way through some of those things and I think being able to do specialty controllers for Xbox 360 is a step in the right direction there.

But I think the most significant thing we’ve done is the acquisition of Saitek which brings us into the PC space. A, PC gaming which is not a huge category but it is certainly an important category and a category where we can crossover some things that are happening there with Saitek’s fantastic product line that we can bring across to console, and that’s nice. But more importantly it also puts us into a place where we now have a play in the whole PCIZ space and that space is occupied by companies that we could compete directly with [who are a couple] of billion dollar companies. And so now we’ve got -- we are a very, very, very small player in a very much bigger market so to the extent that we can execute in that space over time, I think we have now positioned ourselves where we can start to move in that direction.

In a perfect world, it would have been nice for the economy to cooperate and to have been able to do some more sort of M&A activity this year. It’s not going to happen so this year is very much focused on getting our operating expense base tuned to what the economy is doing and then secondly really, really working hard on organic products. We’ve got a couple of distribution deals that, like Turtle Beach in Europe, for example, that will help supplement there and we are open to that sort of thing -- anything, in fact, that leverages our distribution footprint. But we are focused on being a serious player in the console space, in the PC gaming space, but also increasingly in PCIZ.

And I think on top of that, there’s some software opportunities on the gaming side that once we hit some more calm water here, we can start to build into as well and I think that starts to become really quite exciting on some of the opportunities on that front. So we are working a lot of different angles but the last year-and-a-half has really been about kind of incorporating the Saitek acquisition, the Joytech, and the air drives and we continue to look at how we can grow out into adjacent categories, so something we are very much committed on, committed to.

Operator

Our next question comes from Joseph Miranda, a private investor.

Joseph Miranda - Private Investor

Good afternoon, gentlemen. Thank you for taking my call. In your press release, you give gross sales by category and you list that audio products accounted for 10% of the total gross sales. Of those audio products, what percentage of your air drives?

Darren Richardson

The air drives is still quite small, so the audio is really led by -- we have a PS3 bluetooth wireless headset that has been quite successful for us, and then we’ve got a range of other gaming headsets so within audio the air drive is still quite small.

Joseph Miranda - Private Investor

Okay. Also you mentioned in that same area that specialty controllers represent 36% -- let me go back. About how many SKUs do you have currently?

Darren Richardson

We are probably running in and around sort of 600 to 800 SKUs, which sounds enormous but for some of the sports licenses, for example, NFL, you will have 32 SKUs for one -- during one controller across all the different teams. So we’ve got quite a broad and quite extensive product base.

Joseph Miranda - Private Investor

Okay, so of those, if we are saying between 600 and 800, in the press release you represent -- specialty controllers represent 36% and accessories represent 23%. It’s almost 60% of your total sales. Of that 60%, how many SKUs are represented there?

Darren Richardson

Well, in the accessories, you’ve got a lot of things like bundles for NDS and PSP and other sort of things like that, so you find there’s a lot of different SKUs but many of them are different combinations of the same products internally.

Stewart Halpern

And also in that, specialty controllers somewhat implied by the name, the types of product in there tend to be products with higher ASPs, so you can have a fewer number of SKUs in the specialty controller category, a much bigger number of SKUs in the accessory category.

Joseph Miranda - Private Investor

And do you see a threat from that -- didn’t Steven Spielberg come out with a product or -- that was controller like but without the controller, something like that? Is that a threat?

Darren Richardson

It’s actually Project Natal from Microsoft, which I think is a really cool product. I think the most -- the way people are typically seeing that is really as a way of augmenting input as opposed to replacing a lot of input, so I think it really opens up a whole new genre of games that have some kind of tie-back to expressive things but we and most of the industry insiders that you talk to don’t necessarily expect to see the traditional controllers going away. Streetfighter, for example, is an arcade game. People are going to play that on arcade controllers as opposed to trying to do it on a camera.

So the camera really opens up a whole different style of game play that is different to what is there today and I think to the extent that that happens, that’s great for the entire industry.

Joseph Miranda - Private Investor

Okay. And in the press release, it also mentions that the breakdown, Xbox 360 gross sales were higher, PlayStation 3 higher than a year ago but Wii dropped. Can you explain a little of that?

Stewart Halpern

Well, the Wii, there was the tough comp we alluded to with the launch of the Wii Fit last year and we had a swing of accessories out that were very successful and so the Wii fall-off is largely a function of that comparison.

Joseph Miranda - Private Investor

Okay, because I see further down in the press release that you are expanding the Wii product offerings --

Stewart Halpern

Yes, but that didn’t all show up in this quarter. On a go-forward basis, we do have an expanded range of Wii products but that’s not reflected in the Q1 financials, not the least of which is the Wii Fit suite of products was an immensely successful group of products.

Operator

Sir, there are no further questions in queue. I now turn the call back over to you. Please continue with your presentation or your closing remarks.

Darren Richardson

Great. Well, thank you to everyone for joining us on the call today. We look forward to updating you on our progress when we host our second quarter results later on this year. Thank you.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.

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