Mad Catz Interactive F2Q10 (Qtr End 9/30/09) Earnings Call Transcript

Nov.10.09 | About: Mad Catz (MCZ)

Mad Catz Interactive, Inc. (NYSEMKT:MCZ)

F2Q10 Earnings Call

November 10, 2009 5:00 pm ET

Executives

Norberto Aja - Investor Relations

Darren Richardson - President, Chief Executive Officer, Director

Stewart Halpern - Chief Financial Officer

Analysts

Sean MacGowan - Needham & Company

Ronald Rodder - RLR Partners

David Brigham - Brigham Investments

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Mad Catz Interactive fiscal 2010 second quarter results 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, Sean. Welcome to our second quarter fiscal 2010 earnings call. Today on the call we have Darren Richardson, our President and Chief Executive Officer, along with Stewart Halpern, our Chief Financial Officer.

Before we begin, let me just take a few minutes to read the Safe Harbor language.

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.

With that, I would now like to introduce Mad Catz's President and Chief Executive Officer, Darren Richardson. 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 second quarter of fiscal 2010. On today’s call, I’ll provide a brief overview of the recent financial and operational achievements, after which Stewart will review our financial performance for the quarter in greater detail. I will then provide an update on our new product development initiatives and offer some thoughts on both the outlook for the coming holiday season and the balance of fiscal 2010.

Let me begin by going over some of the highlights of the quarter. First, our gross profit margin was 31.3% for the quarter, compared to 30% a year ago. Although the impact of foreign currency translation is still a drag on results, the weakened dollar has lessened the impact. As such, we expected our gross margin percentage will stay in a range of the high 20s to low 30s.

Second, we continue to drive efficiencies in our cost and overhead structure during the quarter, with a 24.3% reduction in selling, general, and administrative expenses, allowing us to deliver another quarter of EBITDA improvement in the face of lower sales.

In the first half of this fiscal year, we’ve reduced our selling, general and administrative expenses by 27.5% when compared to the prior year.

Third, we have what we believe to be a very strong product release schedule and portfolio for the coming holiday season. In particular, we are very well-positioned to benefit from today’s launch of Call of Duty Modern Warfare 2. For us, this highly anticipated title unofficially kicks off the holiday shopping season and we are fully aligned with its launch through our comprehensive range of products, including combat controllers, communicators and headsets, face places, skins, game pads, mice and keyboards for the Xbox 360, PlayStation 3, and PC.

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

Stewart Halpern

Thank you, Darren. Let me discuss our financial performance in more detail, beginning with the income statement. Net sales for the quarter were $21.6 million, representing a 16.1% decrease from $25.8 million in the second quarter of fiscal 2009. Net sales in North America fell by $2.6 million, or 18%, though we note that net sales to Canada were up over 55% in the quarter.

Net sales in Europe were down $1.5 million or nearly 15%, while net sales in our remaining markets were down 5%.

Against the backdrop of overall weakness in the interactive entertainment sector during the period, three key factors impacted our negative sales comparison for the quarter. First was the holiday season is coming later phenomenon. By this I mean that while we typically see orders beginning to ramp up for the holiday shopping season toward the end of September, this year we only began to see the beginnings of the ramp in late October.

Second, while overall videogame sales remain fairly sluggish through the quarter leading up to the console price cuts, we also had to overcome a very difficult year-over-year comparison as it relates to our products for the Nintendo Wii. As you may remember, it was in the summer of last year that Nintendo introduced the Wii Fit, a significant driver for Wii related products. This year, however, there were no such events and we had no significant new product placements on this platform. And if you do the math on the platform sales data provided in our press release and 10-Q, you will figure out that our sales relating to the Wii are down approximately 50% from Q2 in last year.

You will also note in our disclosure on our sales by category that specialty controllers were up significantly in the quarter. This was due to the continued strength of our fight stick line but it wasn’t enough to offset decline in the accessory category into which all those Wii products fall.

Thirdly impacting sales for the quarter, foreign currency translation negatively impacted our reported sales by over $900,000 in the quarter.

Directionally in line with the decline in sales, gross profit dollars in the quarter decreased 12.5% to $6.8 million from $7.7 million last year. Gross profit margin was 31.3%, slightly up from 30% reported in the year-ago quarter.

As Darren alluded to in his opening remarks, with the dollar having pulled back from its 12-month highs, we currently expect our gross margin to remain in the high 20s to low 30s range.

Looking at operating expenses, we are very pleased with the continued improvement we are making on this front and are on track to significantly exceed our previously stated goal of reducing SG&A by no less than 10% during this fiscal year. In the quarter, SG&A was down 24.3% to $5.7 million from $7.5 million last year. For the first six months of fiscal 2010, SG&A is down nearly $4.2 million, or 27.5% from the prior year.

I want to emphasize that we have achieved these reductions without cutting into the muscle that we will need as we work to continue to grow our business.

Driven by the savings in SG&A, total operating expenses in the second fiscal quarter of 2010 declined 18.8% to $6.9 million from $8.5 million in the second fiscal quarter of 2009. As a result of all of the above, we reported an operating loss of $178,000 compared to an operating loss of $819,000 in Q2 of last year. After accounting for the impact of interest expense, the foreign exchange loss and other income, we reported a pretax loss of $744,000, representing an improvement of over $600,000, or 45.4% from last year’s pretax loss of $1.4 million.

Including a tax provision of $227,000 this quarter compared to a tax benefit of $124,000 last year, our net loss for the quarter was $971,000, compared to a loss of $1.2 million in the same period last year, resulting in a loss per share of $0.02, which was flat with last year.

EBITDA again improved on both a year-over-year and sequential basis, reaching $829,000 in the quarter. This represents over 2.5 times the $225,000 from Q2 of last year and an improvement of 13.6% from $730,000 in our fiscal first quarter of this year.

Free cash flow, which takes into account the impact of investment in working capital, capital expenditures, and cash taxes, was negative $3.7 million, largely due to working capital investment, which I will discuss in a second. This number compares to a negative $5.8 million in Q2 of last year.

Let’s now move to the balance sheet -- looking at our balance sheet, the net position of our bank loan less cash at September 30, 2009 was $13 million compared to $9.4 million in the prior quarter and $11.9 million a year ago. Driving the higher net bank loan position, you will notice on our balance sheet a significant sequential and year-over-year increase in our inventory, which on September 30th of this year was $33.8 million compared to $21 million as of June 30th, and $25.7 million at the end of this period a year ago.

There are two reasons for this -- first, the fact that retailers’ holiday ramp didn’t begin in September means we had more inventory at the end of the period than would have otherwise been the case. The second is that we moved up our holiday season build in order to clear production capacity to be on time with our Call of Duty products which although is still largely on our books at September 30th has now been on retailers’ shelves for about a week or so.

Darren will close with some thoughts about the holiday season in a minute but suffice it to say that if we have the holiday season we believe we can, we think our inventory is generally in line with where we need it to be.

In summary, although sales in the period were disappointing for the reasons we discussed, we are pleased to see our gross margin back in line with where we think it should be and we are gratified with the results of our efforts to reduce our SG&A. And most importantly, with a broad range of products already in stores for the launch of Call of Duty Modern Warfare 2, we are optimistic about our prospects for this holiday season and continue to believe we will deliver on strong earnings, EBITDA, and free cash flow growth in fiscal 2010.

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

Darren Richardson

Thanks, Stewart. Our number one priority when bringing a new product to market remained adding value to the gaming experience provided by the industry’s most successful and anticipated titles. Our work with Infinity Ward and Activision on creating products for Call of Duty Modern Warfare 2 is the most recent example of this. The game launched worldwide today with an aggressive marketing and promotional campaign, was Activision’s most pre-ordered game in its history, and is likely to eclipse its predecessor in the bestseller list.

We also believe the music genre is poised to enjoy a healthy holiday season on the heels of September’s launch of MTV’s The Beatles Rockband. Our expansive line of Rockband products, including our wireless wooden Fender Stratacasta and wireless Fender Telercasta Player’s Edition for Xbox 360 continue to win enthusiastic reviews.

In addition, we have expanded our Rockband product line to include the PlayStation 3, thus allowing that console’s legion of fans to access our best-in-class guitar products.

Today we announced the opening of an office in Barcelona as another step in the expansion of our European network. With a combined population of over 50 million people, we are confident that our products can be strong sellers in these markets as their economies rebound.

We are continuously optimistic about our top line outlook for Q3 and -- we are cautiously optimistic, I should say, about our top line outlook for Q3 and the balance of the fiscal year. While consumer spending remains constrained, recent reports and retail data suggest the consumer has become incrementally more active. In this environment, we believe recent price cuts among the console manufacturers are likely to boost industry sales this quarter. During the course of September, Sony cut the price of the PlayStation 3 to $299 from $399, Microsoft cut the price of their high-end Xbox 360 Elite to $299 from $399, and Nintendo cut the price of the Wii to $199 from $249.

In fiscal 2009, our sales were front-loaded. This fiscal year, we are expecting sales to be more back-end loaded. We’ve made significant progress on cost reduction and going forward, we expect continued improvements on the operating expense line. With Mad Catz streamlined cost and operating structure and improving margins, we firmly believe that even modest revenue increases can result in significant improvements in our operating results.

Despite the challenges driven by the tepid consumer economy, we continue to move our business forward and are particularly encouraged by the evolution of Mad Catz and the opportunities we see, particularly in the current quarter. We have cut the ties completely from our past as a supplier of products through a quickly marginalized discounted or copied and we believe we have the best product lineup in our history, our widest sales and product distribution reach, and a greatly improved operating expense structure. Our strategy remains simple -- stay close to our consumers, drive innovation in our products, and operate with financial discipline.

We will encounter the inevitable challenges along the way but we are up to the task.

Throughout all this, we will remain disciplined on managing expenses to drive more dollars to the bottom line and do our best to meet the challenges that we will encounter as we look to close on new opportunities.

I am confident that we have the team, the focus, and the dedication to succeed in that effort.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Sean MacGowan with Needham.

Sean MacGowan - Needham & Company

The question I have relates to what you are seeing as the business migrates slowly but perhaps more quickly in the future towards games or add-ons that are digitally downloaded -- is this something that is good, neutral, or bad for the sale of accessories?

Darren Richardson

I think there are some opportunities where the actual -- particularly if the game requires hardware, it’s an advantage both for the publisher and also for retail because you can actually bundle digital content, or at least a scratch card to unlock digital content into hardware and get a retail presence and move forward.

One thing for sure is you can't digitally download hardware, so that part of the business should remain consistent and one of the nice things with the Mad Catz business, while there are games that require accessories, then we are definitely in the marketplace to support all those products.

Sean MacGowan - Needham & Company

Okay. Thank you.

Operator

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

Ronald Rodder - RLR Partners

Your inventories are up quite significant, especially relative to sales being down and you talked about part of that being because you wanted to be prepared for the launch of Call of Duty. Can you give us any just rough ballpark idea how much of that inventory is in fact related to Call of Duty?

Darren Richardson

There’s actually two aspects to the inventory, Ron -- one is we built the inventory early to free up the capacity; second is retailers definitely bought late, which we interpreted and anticipated. We thought that would be the case but then we also had to build the Call of Duty inventory through that period and have it shipped here, which takes a couple of weeks so that it is on shelf for launch. Call of Duty is going to be a fairly significant item for us this quarter, without any question. And so there’s a meaningful amount of sales there but basically we’ve got a lot of that inventory staged for this quarter and hopefully the quarter is going to be a strong one.

Ronald Rodder - RLR Partners

Well, I mean, is Call of Duty -- I mean, that $35 million inventory figure, is it reasonable to expect that 25% of that is related to Call of Duty?

Darren Richardson

No, no -- significantly less, significantly less but --

Ronald Rodder - RLR Partners

So where are some of the other -- I mean, you’ve got inventories up roughly 25% on a 16% sales decline, so where is the bulk of that -- I understand sales were slightly less. I mean, was the large bulk of that incremental change in inventory leftover sales from the first quarter?

Darren Richardson

Actually, no, not really -- a lot of the inventory is really staged to go out and what you typically see are the big shipments starting to run in that last couple of weeks of September. What we have seen this year is that’s been more the last couple of weeks of October as opposed to the last couple of weeks of September. Retailers are playing very, very cautious inventory management, as we expected. So the inventory in terms of normal build, once you kind of back out what the impact of that would have been if it shipped in September rather than October is not that far out of line with last year. It’s really a timing difference --

Ronald Rodder - RLR Partners

So I guess the -- you would know certainly much better than I -- are you comfortable with the levels of inventory, where they are at now?

Stewart Halpern

Yeah, and that’s what I said in my remarks, is that if we have the holiday season that we think we have a very good chance to do, then we think we’ve got the right inventory to prepare us for that.

Ronald Rodder - RLR Partners

Okay, so you’re not -- you know, obviously from the numbers clearly it’s -- you are comfortable with the level of inventories where you are at.

Darren Richardson

Yeah, and in terms of inventory left over from Q1, it really isn’t inventory left over from Q1. It’s inventory built for Q3.

Ronald Rodder - RLR Partners

Okay, very good. That’s comforting to know and that’s why I would have guessed if you did have a lot of leftover inventory, there would have been markdown in the gross margins, it would have been reflected in lower gross margins.

Darren Richardson

Yeah, no and it’s kind of interesting because every year we have seen really the holiday sale shifting from before the holiday to after the holiday. So if you go back the last seven years, you are seeing Q3 become a little bit more diminished and Q4 being the sales growth quarter.

Ronald Rodder - RLR Partners

And I know in the --

Darren Richardson

And we expect that to be much more extreme this year than last year.

Ronald Rodder - RLR Partners

And I know in the past, you’ve also had situations where you were light on inventory, you had to air freight it in, which negatively impacted gross margins, so hopefully that won't be as much an issue here in this holiday period.

Darren Richardson

Correct but there is no doubt optically the inventory looks really high, providing the consumer comes out at a reasonable way this quarter, I think we are going to be in good shape. If the consumer doesn’t come out at all, well, clearly that’s a problem but all the signs are looking like the consumer is going to be back.

Ronald Rodder - RLR Partners

Very good.

Darren Richardson

At least to some extent, yeah, so --

Ronald Rodder - RLR Partners

Sounds good.

Operator

(Operator Instructions) We do have a follow-up question from the line of Sean MacGowan with Needham.

Sean MacGowan - Needham & Company

To follow-up on the inventory question, so where do you think -- I mean obviously all year everybody has been nervous about what to build versus what you would like to sell and when the retailers are actually going to show up and take the product, so where could there be upside? Where have you placed the bet so that if there is a decent holiday, you are not going to be stuck with outages?

Stewart Halpern

That’s a good question and you are absolutely right, Sean. As you know from your experience, that’s the constant battle. Our approach, frankly, really is to philosophically be a little bit more leaning to the protect ourselves on the downside and let the upside hopefully take care of itself as best it can, as opposed to build for the potential of upside and then get stuck.

So what we just try to do is find the balance but if there is a runaway holiday season, to be candid, we’ll probably have some outages. And I think we are willing to accept the risk on that side for the sake of making sure we don’t get stuck, so --

Sean MacGowan - Needham & Company

Well, that is a higher quality problem.

Stewart Halpern

Exactly, that’s the high quality problem, so we try to build what we think is going to be supported by initial load-ins, for example, with the Call of Duty product, with hopes for some replenishment but if it is an absolute runaway beyond anybody’s expectations, you know, we are going to have some stock outs. You are absolutely right.

Darren Richardson

And then the other thing, just back to sort of the inventory staging and so forth, we do a lot of the core ongoing SKUs like the Xbox 360 controller, that’s a standard staple product for us. We got the manufacturing of that out of the way early so that we could free up as much capacity as possible to deal with Call of Duty. Because the challenge I have with hitting a product launch like that is you really have to push the camel through the eye of the needle and so we needed to have as much capacity as possible to be able to do as much as we can in a very short period of time and hit the launch dates. And on the positive front, we’ve hit all the launch dates and today if you go into any Walmart store, you will see that we’ve got product incorporated in the end cap with all of the Call of Duty software and you will see that running through most of the major retailers across North America and Europe. We’ve been in the Sunday flyers for Walmart and Best Buy the last couple of weeks and so forth, so we’ve got a great product line. It’s got a lot of depth, it’s got a lot of breadth, and it’s got a lot of PR support and a lot of great in-store presence.

But you have to get a lot of that done in a short period of time just because of the nature of getting all of the sign-offs, all of the approvals and then the gap between the flash and the bang, if you like, of getting it on the shelf is short.

So to sort of maximize the Call of Duty opportunity, we just built out all of the things that we knew we would need through the holiday period and got it in the barn well before we need it.

Sean MacGowan - Needham & Company

Okay. Thank you. If I can follow-on with another one, so what are you seeing at retail in terms of changes in competitive dynamic? You know, new players coming in with accessories or private label stuff or anything like that? Has there been a shift there?

Darren Richardson

Yeah, and I think there are some retailers, you know, are certainly feeling some pressure and some margin pressure and so forth, pushing more heavily into some private label business but one of the things that we have really focused on in the last couple of years is to build products where there is real consumer demand. So if you go back to the Mad Catz business of five to 10 years ago, the bulk of our product development was aimed at filling pegs at retail. We still do that business and that’s an important part of the business. However, increasingly things like the Streetfighter product line, the Rockband product line, the Call of Duty product line, are products that consumers actually seek out and so where we are less concerned about getting into fights over commodity products and more concerned with developing products that have longer lives and that really add some value to the game play and most of those products are extreme premiums to what you would from first party or from the regular -- like the Rockband guitars are a good example where the standard products are in the $50 to $60 range, while we are up in the $80, $100 to $300 range. And those products are being successful.

So to the extent that consumers want to buy your products because they have an edge, they have a better look and feel and so forth, then that certainly helps with a lot of those things.

Stewart Halpern

And just to add on to that, another great example is our Saitek flight sim line where a shockingly high percentage of that product is sold through online that you don’t even see much in retail stores and it is a very successful line for us, very profitable and so to Darren’s point, this isn’t the Mad Catz of three plus years ago when 50% of our business was sort of standard controllers. We’re now really focused and repositioned the company to largely be in the business of, as Darren said, products that consumers want and that they are going to go out and find.

Sean MacGowan - Needham & Company

I am glad you brought that up, Stewart, because that is kind of what I was asking earlier about that online distribution or digital distribution or different platforms -- so you are saying that you are not really seeing a disengagement with the notion of a high quality accessory, even if the consumer is not walking into an actual store, they still know what they want and they want some high quality accessory and they are still buying it even if it’s not in a store.

Darren Richardson

One of the good examples has been Streetfighter where basically if you look at all of the big professional tournaments this year and then evolution 2009 this past July in Japan which brought 1100 of the top Streetfighter players from all around the world to compete, and everybody that made it to the final round, the eight players that made it to the final round use the Mad Catz tournament edition stick and the world champion used the Mad Catz tournament edition stick and continues to play with that. And that event was held in Japan where technically we don’t even sell the product in Japan but these guys are all actually sourcing the product out of America and bringing it into Japan so that they can use it because it’s the best product. And that’s where we want to take the company and those kinds of things have trickle down effects and as a result, those Streetfighter sticks continue to sell.

Sean MacGowan - Needham & Company

Great. Thank you.

Operator

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

David Brigham - Brigham Investments

Could you tell us -- I mean, ear drives, the in-ear technology, how many of those units have you sold so far? And I have one other question, unrelated.

Darren Richardson

The ear drives product I think we’ve done a rev of the product in the last year to where we have been able to bring the costs down. I think we’ve been able to improve on some of the consumer feedback in the way it attaches to your ear and so forth. I think the product is a great product. It’s a complicated story to tell.

So in terms of how meaningful the sales are to us, the sales are not meaningful at all. We’ve had them in the Apple stores. We’ve got good online distribution but it’s a very, very difficult marketing story to tell. So in terms of what we’ve done in terms of execution, it would be a disappointment.

David Brigham - Brigham Investments

And on another matter, how much does it cost you guys to be a public company per year, would you say, roughly? Do you have some idea?

Stewart Halpern

Well, too much is the easy answer. But you know, look, part of what we are working towards is, especially being a public company and having those costs and you can kind of make some guess-timations, well, look, we publicly report our audit costs every year in our proxy, right? So you can see what that is. We were like at about -- was it about $700,000 and $800,000 in the past year, right? Which is down substantially from the prior year but still relative to our size is a big number.

Darren Richardson

It’s approaching 1% of sales just for that.

Stewart Halpern

Yeah, so -- but we are where we are so clearly one of the things we are all oriented towards doing is amortizing not just the cost of being a public company but we’ve built what we think is a very powerful global platform for the videogame and related accessories business and whether it’s the public company costs or just the costs of the distribution system we’ve built on a global basis, the product development capability that we’ve built, our goal now is to leverage the infrastructure and the capabilities that we’ve built to grow our top line at good margin with the type of product Darren is talking about and if we do that, there is a lot of operating leverage that should go to the bottom line to drive strong earnings and EPS, cash flow, and EBITDA. And that’s what we are trying to do.

David Brigham - Brigham Investments

So what would you consider the earning power of this company is if things were going along at 90% of what you would most like to see? I mean, do you have some -- can you get to be a $300 million company in five years, would you say? Is that possible?

Darren Richardson

Well, I think ultimately the goal has to get to a $300 million to $500 million company in the next five years because if we don’t do that, we are really not leveraging a lot of those fixed costs of the public company expenses and I think it is very difficult to be a $100 million public company in this environment unless you’ve got a product line that generates super margins and we’ve done a good job of getting margins up but we certainly aren’t a super-margin company.

So that is the goal and one of the things we sort of talked about a little bit on the call but we are driven to growth and so I think we’ve done a good job of bringing the OpEx down so that we can generate some more leverage but ultimately looking forward, we have to be able to deliver consistent growth.

Operator

Gentlemen, there are no further questions at this time. I will now turn the call back to you. Please continue with your presentation or closing remarks.

Darren Richardson

Well, I’d like to conclude the call by thanking you all for participating today. We look forward to speaking with all of you in the near future and reporting on our progress during the holidays and into calendar 2010. In the interim, if you do have any questions or wish to schedule a meeting or a call, please contact our investor relations firm, [Jaffony] & Collins at 212-835-8500. Thanks a lot.

Operator

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

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