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GigaMedia (NASDAQ:GIGM) operates online games in continental Europe and greater China. It offers gambling-type games like poker and sports-betting, casual games like MahJong and more immersive MMORPGs like WarHammer.

After a few years of strong growth and profitability, the company exhibited weak performance in Q2 and Q3 2009, culminating with a small loss of 4c/share in Q3 2009. The stock is down about 40% in 2009 and trading near its 52 week low. I believe GIGM’s stumble in 2009, coupled with its recent partial sale of one business segment, offers a rare opportunity to pick up the other segment and $51m in cash for free.

Business Description

GIGM operates in two business segments with very similar (and confusing) names: A) Gaming software and service, and B) Online game and service. Segment A focuses on casino-type games, especially poker. Segment B offers casual and MMORPG-type games. However, there’s a good deal of overlap in the offerings, and I think a better way to understand the segments is by their geographical focus: Segment A is focused on continental Europe and segment B is focused on greater China (PRC, Hong Kong, Taiwan, Singapore). Segment A accounted for 70% of 2009 Q1-3 revenue. It includes Everest Poker, which the company claims is the 4th largest poker site in the world. It is a major sponsor of the World Series of Poker, covered on EPSN.

It would be hard to argue that online gambling and gaming are “bad” businesses. To paraphrase Warren Buffett, Las Vegas was built thanks to numerous customers engaging in small but disadvantageous capital transactions. Compared with physical Casinos, their online counterparts are considerably less costly to maintain, support even smaller and more numerous capital transactions, are arguably less regulated and potentially even more addictive.

There many ways to illustrate the addictive nature of this business. One example that I found entertaining (and sad) was a 2007 law introduced in China. This law, called “Notice on the Implementation of Online Game Anti-addiction System to Protect the Physical and Psychological Health of Minors” requires online game operators to implement anti-addiction measures for users under eighteen years of age. Under this law, the first three hours of game-playing time of a user are considered “healthy time”, the following two hours are designated “fatigue time” and any time spent playing beyond five consecutive hours is categorized as “unhealthy time.” Beat that, Facebook.

Why is GIGM ugly?

GIGM had a great run from 2004 to 2008: Revenue grew from $11M to $190M and profits grew from $1.7M to $44M. Then, it delayed its report on Q2 and Q3 2009 until December, which was suspicious. When it finally reported, the results were dismal: zero income in Q2 and a loss of 4c/diluted share in Q3. The company blamed the poor showing on a) seasonality, b) the financial crisis and c) competition and d) management distraction, due to the deal with Mangas. Let’s take these factors one by one.

a) Seasonality: According to the company, segment A which caters to European customers and is 70% of revenue, is weakest in Q2 and Q3 when European weather improves and customers spend less time indoors. This is true but isn’t a complete explanation: Seasonal effects did not stop the company from exhibiting strong growth in prior years. Even when comparing 2009 Q2 and Q3 versus the same quarters in 2008, revenue dropped 23% and 19%, respectively. Gross profit dropped 28% and 25%, reflecting the operating leverage in the business, working against shareholders in this case.

b) Financial Crisis: This is probably true, but is less relevant for the future of the business (and its valuation) than the next point. I don’t think anyone would argue that the financial crisis of 2007-09 will permanently alter the demand for online gambling.

c) Competition: This is, in my view, the crux of the problem. GIGM’s two leading competitors in greater China are Shanda Interactive (NASDAQ:SNDA) and NetEase (NASDAQ:NTES), and gained share in 09: SNDA’s games revenue in Q3 2009 was up 45% YoY. NTES, which operates the leading World of Warcraft MMORPG, saw Q3 09 revenue from online games up 16% YoY. This problem will likely get worse, since GIGM is not planning any new MMORPG releases in 2009 Q4. GIGM has further stated that the MMORPGs it released earlier in 2009 are underperforming, and will likely need to be written down in Q4 2009 to the tune of $35-45m. This trend is very worrisome for someone contemplating buying GIGM’s China business…unless that business came for free. More on this in the next section.

d) Management distraction due to deal with Mangas: On December 16, GIGM sold 60% of its European business (Segment A) for $100M. This was a big deal for GIGM. If management was distracted in Q2 and Q3 because of this deal, it’s embarrassing but well worth it, as I hope to show in the next section.

Deal with Mangas

The deal with Mangas is significant for GIGM from a strategic and valuation perspective. The strategic trigger for the deal was a series of changes in the regulatory landscape in Europe (England, Italy and France establishing their own regulations for online gaming), indicating a transition from pan-European to country-specific regulation. When regulation was more standardized across Europe, GIGM’s strategy was to develop economies of scale in a single pan-European operation. Country-specific regulation tends to limit player pools, which in turn will limit achievable scale.

As a result, strategic advantage should shift from larger international (Chinese) players to smaller local players who are more familiar with local regulation and taste. Everest Poker, which has a strong presence in the French market, should do better with an owner like the principality of Monaco than with GigaMedia. This is pretty much the case laid out by the company, and it makes sense to me. You don’t have to agree with it, though, to see value in GIGM’s stock, as the analysis below will show.

The Mangas deal is also significant from a valuation perspective, because it puts a clear value on GIGM’s European business (segment A), which is 70% of revenue. If 60% of it was sold for $100M then the whole thing is worth $167M, and the 40% piece retained by GIGM is worth $67M.

Why GIGM is cheap?

We can now estimate the value of GIGM’s business. After the deal, GIGM shareholders are entitled to GIGM’s large cash and marketable securities reserves, 40% of segment A and 100% of segment B. They are on the hook for some debt and the pre-deal minority interest in segment B:

After MG Deal, GIGM shareholders will own (in $M)

Non-operating assets

Cash & Marketable Sec.

130

Includes non-current mktable sec.

Mangas pmt Dec09

100

Mangas pmt 2013-15

<Unknown>

See note below

Equity-method investments

2

Non-operating liabilities

S.T. Debt

(22)

Upcoming 2009Q4 writeoff

(40)

35-45m range, announced in Q3 concall

Pre-deal minority interest

(8)

Operating Assets & Liabilities

40% of segment A (Eu)

67

Could be higher. See note below

100% of segment B (PRC)

<Unknown>

Total value of GIGM equity

229

Or more

Total price of GIGM equity

178

As of 12/31/09

= Mkt Cap

In other words, even if you assign zero value to segment B and to the future Mangas payment (see note below), the value of GIGM equity exceeds its market cap by $51m, which is a nice margin of safety.

Note: Mangas paid $100M for 60% of segment A. A second “earn-out” payment from Mangas will be due 2013-2015, based on the value of segment A in early 2012. GigaMedia will continue to hold 40% of segment A with a put option to sell to Mangas beginning in 2013. Beginning in 2015, Mangas will have a call option to buy the rest. For both options, the price will be determined based on FMV on 2012.

Segment A will be revalued in early 2012, at which point there will be a second payment from Mangas if the value of segment A goes up from 2009. The rest of the payment is due in 2013-2015, based on the value of segment A as of 2012. To be specific, the Mangas deal is structured with an up-front payment of $100M in exchange for 60% and a second payment due 2013-15. GIGM structured the deal this way because it believes segment A’s value is currently depressed, and will be higher in 2012. If it is, that will be pure upside. If it isn’t, the analysis above holds.

Value of segment B (China)

As the analysis above shows, if segment B is worthless, we have a $51m margin of safety. However, even in 2009Q3, when GIGM recorded an overall loss, segment B contributed $12M in revenue and $7M in gross profit. How much could this segment be worth?

It’s tough to say, because the market is in such flux. However, we can estimate B’s value based on segment A which was just valued in the M&A transaction: Segment A is worth $167M, which is 1.15x its 2008 revenue and 2x its 2009Q1-2 revenues. If we apply these multiples to segment B, we’d get a value of $53-72M.

We can also benchmark segment B’s value against other public comparables. Let’s take the two leading ones: SNDA is trading at 6.7x 2008 revenue, and 6.4x 2009Q1-3 revenue; NTES is trading at 11x and 13x sales, respectively.

Comparables

SNDA

NTES

EV 12/2009

3,490

4,790

Rev 2008

523

452

Implied Multiple

6.67

10.60

EV 12/2009

3,490

4,790

Rev Q1-3 09

545.8

369

Implied Multiple

6.39

12.98

As discussed above, we have reason to believe segment B was at some competitive disadvantage to NTES and SNDA. Let’s say that NTES and SNDA merit an EV / Sales multiple twice as high as segment B’s. In this case, segment B should trade at an EV / Sales multiple of 3.3-5.3x 2009Q1-3 revenue, and its value would be $120-190M.

Let’s take the low end of this range and assume segment B is worth $53m. Let’s further assume no strategic synergies from the Mangas deal, and therefore no additional Mangas payment in 2013-15. In this event, GIGM equity should be worth $282m or $4.74 per fully diluted share, an upside of 45% from today’s price.


Disclosure: No position

Source: Opportunity in GigaMedia?